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Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 CORPORATE OWNERSHIP & CONTROL КОРПОРАТИВНАЯ СОБСТВЕННОСТЬ И КОНТРОЛЬ Postal Address: Почтовый адрес редакции: Postal Box 36 Sumy 40014 Ukraine Почтовый ящик 36 г. Сумы, 40014 Украина Tel: +380-542-611025 Fax: +380-542-611025 e-mail: [email protected] [email protected] www.virtusinterpress.org Тел.: 38-542-611025 Факс: 38-542-611025 эл. почта: [email protected] [email protected] www.virtusinterpress.org Journal Corporate Ownership & Control is published four times a year, in September-November, December-February, March-May and June-August, by Publishing House ―Virtus Interpress‖, Kirova Str. 146/1, office 20, Sumy, 40021, Ukraine. Журнал "Корпоративная собственность и контроль" издается четыре раза в год в сентябреноябре, декабре-феврале, марте-мае, июне-августе издательским домом Виртус Интерпресс, ул. Кирова 146/1, г. Сумы, 40021, Украина. 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Corporate Ownership & Control Корпоративная собственность и контроль ISSN 1727-9232 (printed version) 1810-0368 (CD version) 1810-3057 (online version) ISSN 1727-9232 (печатная версия) 1810-0368 (версия на компакт-диске) 1810-3057 (электронная версия) Certificate № 7881 Свидетельство КВ 7881 от 11.09.2003 г. Virtus Interpress. All rights reserved. Виртус Интерпресс. Права защищены. за информацией 3 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 EDITORIAL Dear readers! This issue of the journal Corporate Ownership and Control has a very unique feature – a truly international focus of corporate governance research. Our contributors made their utmost to deliver the newest knowledge on corporate governance in many countries such as the USA, Australia, South Africa, Italy, Portugal, China, Brazil, Jordan. We would like to remark that during last five years of our activity we published in Corporate Ownership and Control journal papers about corporate governance in 54 countries of the world. Authors of the papers were very convincing in delivering the conclusions to the editors and reviewers. Almost all papers are the result of team working and this fact makes us more than optimistic regarding the future of research of corporate governance. Academic teams from Australia, Japan, Portugal, Spain, Germany, Brazil and truly international teams from Jordan and Australia, the USA and Taiwan demonstrated ability of academic community to unite their efforts toward establishing and further development of the best standards in corporate governance research. We really enjoyed cooperating with these researchers during the process of reviewing their papers. Team working contributed sufficiantly to their ability to be realiable and accurate in revising their papers. Having published in Corporate Ownership and Control journal papers of more than 1450 authors since 2003 we were sure about very systematic progress in this sphere of our relationships. We would like to draw the attention of the reading audience to the issue of progress made by contributors over the last five years. Their papers improved remarkably from the point of view of the research methodology and conceptual consideration. Authors are very effective in mixing practice and theory of corporate governance. Doing so they maximize an outcome from their research. Over last five years we published in Corporate Ownership and Control journal papers on various issues of corporate governance, from such widely accepted as corporate ownership to such unique as stock options. Any field of research in corporate governance was developed by our contributors as much as possible. The previous issue of the journal Corporate Ownership and Control was a jubilee issue of our journal – the 20th issue. We outlined a main objective for the next five years - international representation with a focus on corporate governance issues. With this issue of the journal we start the move in that way and invite you to join us. 4 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 CORPORATE OWNERSHIP & CONTROL Volume 6, Issue 1, Fall 2008 CONTENTS Editorial 4 SECTION 1. ACADEMIC INVESTIGATIONS AND CONCEPTS GOVERNMENT CONTROL AND THE HIGHER COSTS OF GOING PUBLIC: EVIDENCE FROM A NEW STOCK MARKET IN CHINA 9 Nobuyuki Teshima, Katsushi Suzuki IPO underpricing or the indirect cost of going public is extremely high in China. We hypothesize that government control over the corporate economy underlies this puzzle. Specifically, bureaucratic managers in state-owned firms as well as regulatory authorities have incentives to underprice. Using a sample of a new stock market in China, we find evidence supporting this hypothesis. Underpricing is higher for state-owned firms and for IPOs before the reform making IPO prices less affected by the regulator. Furthermore, we find that the reduction in underpricing or indirect cost by the reform more than offsets the increase in direct costs for compensating underwriters‟ higher efforts. Overall, the reform making IPO process more market-oriented is beneficial to Chinese firms going public. SEPARATION BETWEEN MANAGEMENT AND OWNERSHIP: IMPLICATIONS TO FINANCIAL PERFORMANCE 16 Zélia Serrasqueiro, Paulo Maçãs Nunes Using panel data, this article shows that agency costs, a consequence of the separation between ownership and management, are not relevant in explaining the financial performance of Portuguese companies since, on the one hand, greater size, greater liquidity and higher level of risk do not mean decreased financial performance and, on the other, greater level of debt does not mean increased financial performance. The results indicate that the fact of managers being better informed than owners, about companies‟ opportunities and specific characteristics, does not necessarily mean behaviour that contributes to diminished financial performance in Portuguese companies. THE DETERMINANTS OF CAPITAL STRUCTURE: THE CASE OF LONG-TERM DEBT CONSTRAINT FOR JORDANIAN FIRMS 22 Rami Zeitun, Gary Tian This paper contributes to the capital structure literature by investigating the determinants of capital structure of Jordanian companies with the constraint of inadequate long-term debt as their source of financing and regional risk. We firstly document that Jordanian companies mostly depend on shortterm debt, as a result of the banking credit policy that promotes short-term debt. Our results suggest that the level of gearing in Jordanian firms is positively related to size, tangibility, and earning volatility, and negatively correlated to profitability, the level of growth opportunities, liquidity and stock market activities. The level of gearing measured by short-term debt is, however, negatively 5 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 correlated to tangibility. The Gulf Crisis between 1990 and 1991 is also found to have a significant but positive impact on Jordanian corporate leverage. DIVIDENDS AND INSTITUTIONAL INVESTORS ACTIVISM: PRESSURE RESISTANT OR PRESSURE SENSITIVE? 38 José María Diez Esteban, Óscar López-de-Foronda This paper provides new international evidence on the relationship between dividend policy and institutional ownership by analysing a sample of US and UK and Irish firms characterised by an AngloSaxon tradition and a matching sample of other EU companies from Civil Law legal systems. We find that while in firms from Anglo-Saxon tradition the relation between dividends and institutional investors, pension and investment funds, is possitive, in Civil Law countries the relation is negative where investors are banks or insurance companies with other private interest inside the firm. INFORMATION SIGNALING AND OWNERSHIP TRANSITION – VALUE EFFECTS OF SHARE ISSUE PRIVATIZATIONS 44 Martin Ahnefeld, Mark Mietzner, Tobias Roediger, Dirk Schiereck This paper discusses whether SIPs generate positive announcement returns because of increased efficiency after the ownership transition. We apply a market model event-study methodology based on a sample of 134 SIPs in the 1979-2003 period. We identify significantly negative CAARs between 0.125% and -1.766% and find that firm and offering size, the proportion of secondary shares issued within the SIP as well as the market environment have a negative impact on announcement returns. In contrast, the negative CAARs are less distinctive for enterprises that had prior SIPs. CEO DUALITY AND FIRM PERFORMANCE—AN ENDOGENOUS ISSUE 58 Chia-Wei Chen, J. Barry Lin, Bingsheng Yi Whether dual CEO leadership structure is better for corporations is one of the most hotly debated issues in corporate finance. This paper uses a recent data to re-examine the relationship between CEO duality and firm performance, controlling for other important variables such as firm characteristics, ownership structure, CEO compensation, and agency costs. We find a recent trend of increased number of firms converting from dual to non-dual CEO structure. However, our empirical results do not show a significant relationship between CEO duality and firm performance nor improvement in firm performance after change in leadership structure. We find evidence of endogeneity, and we attribute the insignificance of the relationship between CEO duality and firm performance to the possibility that CEO duality is endogenously and optimally determined given firm characteristic and ownership structure. VALUE BASED FINANCIAL PERFORMANCE MEASURES: AN EVALUATION OF RELATIVE AND INCREMENTAL INFORMATION CONTENT 66 Pierre Erasmus This paper investigates the ability of four VB measures to explain market-adjusted share returns and compare it to that of some traditional measures. Empirical results indicate that the relative information contents of the VB measures are not greater than that of earnings. The incremental information content tests indicate that their components add significantly to the information content of earnings, but that the level of significance is relatively low. MIGRATION TO ―NOVO MERCADO‖: DOES IT REALLY MEAN IMPROVEMENT OF CORPORATE GOVERNANCE PRACTICES? 78 Andre Carvalhal, Guilherme Quental This paper addresses this question by investigating the stock market reaction to the listing on Novo Mercado without improving governance practices. We provide evidence that firms that list on NM and improve governance practices earn positive abnormal returns, have higher liquidity and lower 6 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 volatility. On the other hand, firms that list on NM without improving governance practices do not earn positive returns, but are rewarded with higher liquidity and lower volatility. OWNERSHIP AND CONTROL OF ITALIAN BANKS: A SHORT INQUIRY INTO THE ROOTS OF THE CURRENT CONTEXT 87 Leonardo Giani This work does a short inquiry into the past experience of the Italian banking law and the ownership structure of the Italian credit industry. The inquiry is especially focused on the role played by culture and other historical events (e.g. political ones) in shaping the Italian economic framework. In other words, this paper wants to trace a short and descriptive outline of the evolution of the Italian banks‟ ownership structure in order to show how political and social factors counted in determining the present features of the system. THE EFFECT OF THE SOUTH AFRICAN MARKET CONCENTRATION ON PORTFOLIO PERFORMANCE 99 Jakobus Daniël (JD) van Heerden, Sonja Saunderson Portfolio risk is mainly a function of portfolio concentration and covariance between the assets in a portfolio. This study shows that South Africa experiences a high level of market concentration and that assets with large weights in the FTSE/JSE All Share Index (ALSI) have large covariances with each other. Together these two phenomena suggest that a high level of portfolio risk can be expected. Active portfolio managers in South African generally attempt to decrease portfolio concentration by deviating from the benchmark‟s weighting structure in order to decrease their portfolio risk. The effect of such a portfolio construction process on the measurement of relative performance, where the ALSI is used as the benchmark, was investigated by means of a simulation process. The results indicated that during times when those shares with larger weights in the index perform well, the probability of outperforming the ALSI is very small, while the probability of outperforming the ALSI during times when those same shares perform poorly is very high. These findings suggest that investors need to be educated about the bias regarding relative performance measurement using broad market indices, while alternative or additional methods of performance measurement need to be investigated to minimise this bias. SECTION 2. STOCK OPTIONS THE IMPACT OF EXPENSING STOCK OPTIONS IN BLOCKHOLDER-DOMINATED FIRMS. EVIDENCE FROM ITALY 107 Andrea Melis, Silvia Carta This paper has investigated the economic consequences of recording the cost of stock options at its fair value, in terms of its impact on the companies‟ reported earnings, and other key financial performance indicators, such as diluted earnings per share (EPS) and return on assets. The impact of the mandatory recording of the cost of stock options measured at its fair value has generally reduced the reported earnings and other key performance measures moderately. Despite some evidence of creative accounting which was found concerning the elusion of the substance over form principle for the accounting of stock options plans set up before 7 th November 2002, accounting regulation has increased the level of disclosure by making companies report the “true” cost of stock options in their Profit or Loss. Based on 2004 stock-based remuneration disclosures of the value of options given to directors and employees, the expensing of options have a material negative impact on nearly 30 per cent of the sample firms‟ reported income and diluted EPS. IS THERE A FIRM-SIZE EFFECT IN CEO STOCK OPTION GRANTS? 115 Bruce Rosser, Jean Canil We substitute Hall and Murphy‟s (2002) pay-performance sensitivity metric to detect a firm size effect in CEO stock option grants. After adjusting for small-firm risk aversion and private diversification „clienteles‟, we document evidence of a residual small-firm effect impacting on incentive strength 7 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 principally through grant size. Given lower small-firm deltas, grant size appears to have been increased by compensation committees to ensure small-firm CEOs are not under-compensated relative to their large-firm counterparts. SECTION 3. NATIONAL CORPORATE GOVERNANCE: AUSTRALIA A PRINCIPLES-BASED ANGLO GOVERNANCE SYSTEM IS NOT A SCIENCE BUT AN ART 127 Suzanne Young, Vijaya Thyil This paper through interviewing a number of Australian business executives adds to the academic literature by providing evidence from the field of the important characteristics of the Australian governance system, the drivers of change and the effectiveness of the principles-based approach. It argues that debate needs to move beyond the principles versus rules approach to look at how firms can be provided with more guidance in operationalising some of the principles that appear to be key to governance effectiveness. It concludes that there is a need for a holistic model of governance that is broader than that focusing on the control/legalistic approach; that top management is important in setting and driving the in-firm governance agenda; that the public needs to be informed and educated about governance and its importance; and that disclosure still requires an improvement in quality. THE IMPACT OF CORPORATE GOVERNANCE LEGISLATION ON THE MARKET FOR CORPORATE OWNERSHIP 138 Joseph Canada, Tanya Benford, Vicky Arnold, Steve G. Sutton The purpose of this study is to examine how a company‟s decision to shift corporate ownership and/or corporate control in the face of new corporate governance legislation and regulatory requirements can alter the traditional markets for ownership and control. In order to examine this issue, the paper first develops a typology for predicting the type of organizational restructuring that might occur. This typology incorporates factors from prior research and disentangles the market for ownership from the market for corporate control. The typology is then used as a basis for an in-depth examination of an organization whose corporate structure changed in response to mandated changes in corporate governance. The results provide evidence that corporate governance legislation can potentially induce incumbent management to voluntarily compete in the market for ownership, notwithstanding the associated exposure in the market for managerial control. SECTION 4. PRACTITIONER’S CORNER THE SOX 404 PROCEDURE; IS IT STILL SO REPELLING TO FOREIGN ISSUERS? 147 Marina Stefou The recent banking crises and the famous financial scandals have revealed the need for strong internal control mechanisms. However, due to the inherent limitations of internal control achievement of the financial reporting objectives cannot be absolutely ensured. A great reform in the internal control mechanism was introduced by the controversial Article 404 of Sarbanes-Oxley Act of 2002. This paper lays out the internal control provision described in Sarbanes-Oxley Act, presents the extraterritorial effects on foreign issuers, compares and summarizes overall findings towards ensuring a better financial environment with regard to the international and European corporate governance framework applied. 8 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 РАЗДЕЛ 1 НАУЧНЫЕ ИССЛЕДОВАНИЯ И КОНЦЕПЦИИ SECTION 1 ACADEMIC INVESTIGATIONS & CONCEPTS GOVERNMENT CONTROL AND THE HIGHER COSTS OF GOING PUBLIC: EVIDENCE FROM A NEW STOCK MARKET IN CHINA Nobuyuki Teshima*, Katsushi Suzuki* Abstract IPO underpricing or the indirect cost of going public is extremely high in China. We hypothesize that government control over the corporate economy underlies this puzzle. Specifically, bureaucratic managers in state-owned firms as well as regulatory authorities have incentives to underprice. Using a sample of a new stock market in China, we find evidence supporting this hypothesis. Underpricing is higher for state-owned firms and for IPOs before the reform making IPO prices less affected by the regulator. Furthermore, we find that the reduction in underpricing or indirect cost by the reform more than offsets the increase in direct costs for compensating underwriters‟ higher efforts. Overall, the reform making IPO process more market-oriented is beneficial to Chinese firms going public. Keywords: IPO underpricing; Government control; State ownership; Underwriting fee; Shenzhen SME Board *Nobuyuki Teshima ([email protected]) is with School of Commerce, Senshu University, Japan, and Katsushi Suzuki ([email protected]) is with School of Management, Tokyo University of Science, Japan. We are grateful to the participants of the 4th SMEs in a Global Economy Conference in Shah Alam, Malaysia for their helpful comments. We acknowledge financial support by “Open Research Center” Project for Private Universities: matching fund subsidy from MEXT (Japanese Ministry of Education, Culture, Sports, Science and Technology), 2004-2008. Corresponding author: Nobuyuki Teshima Address: Senshu University, School of Commerce, 2-1-1, Higashimita, Tamaku, Kawasaki, Kanagawa, 214-8580, Japan. Tel: +81-44-900-7937 Fax: +81-44-900-7849 Email address: [email protected] 1. Introduction The large IPO underpricing in Chinese IPO market presents us with a puzzle. In Ritter‘s (2003) list of 38 countries, average underpricing in China for 1990– 2000 is by far the largest at 256.9%, followed by Malaysia at 104.1%.1 IPO underpricing guarantees a handsome return to investors who have been allocated IPO shares, while creating an indirect cost to the firms going public, since they issue shares at prices 1 More recently, Chen et al. (2007) indicate average underpricing of 213.4% for 1,213 IPOs of state-owned firms in China during1993–2006. 9 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 that are lower than what investors in the market are willing to pay. The attempts to explain this large underpricing by traditional and mostly U.S. IPO literature are not sufficient, since, in the literature, the government plays no material part, which is obviously not the case in China. We argue that government control over the corporate economy underlies the large underpricing in China. In typical Chinese IPOs, the issuers and the regulator are the government, and the managers of issuing firms and the underwriters have close ties with the government. Those parties share incentives to underprice IPO shares in pursuit of their respective interests.2 In particular, we focus on the incentives of managers and regulators, and hypothesize that the incentives of both parties cause the large IPO underpricing in China. First, managers in state-owned firms are appointed by the government and have no significant shareholdings in their firms. It is quite common that the government appoints government officials as managers of state-owned firms or, conversely, appoints managers as government officials (Chen et al., 2007). In such circumstances, managers are likely to attach more importance to their bureaucratic careers than to value maximization of the firms they manage. In the case of IPOs, they have incentives to underprice the firms‘ shares in order not to be penalized for putting the stock market in disarray. 3 Our hypothesis implies that underpricing is higher for state-owned firms, which can explain the large average IPO underpricing in China, where stateowned firms are predominant.4 Second, the China Securities Regulatory Commission (CSRC), which is the regulatory authority of the stock market, also has incentives to underprice IPO shares. The CSRC or Chinese government deliberately underprices so as not to upset IPO investors. Once investors suffer a loss in IPOs, they turn away from the stock market and the subsequent IPOs of state-owned firms are jeopardized. Since the reopening of the Chinese stock market in 1990, the CSRC has strictly controlled or greatly affected IPO share prices. In the beginning of 2005, however, the IPO process was changed to a new one in which share prices are determined through bookbuilding. Under bookbuilding, IPO share prices 2 We do not explicitly consider the incentives of underwriters. Presumably, however, the interests of the managers of state-owned underwriters are in line with those of the managers of state-owned issuing firms. 3 Chen et al. (2007) further speculate that managers of stateowned firms pursue promotion in the bureaucratic hierarchy by allocating underpriced shares to parties that are important to their careers. 4 Dewenter and Malatesta (1997) compare the underpricing between state-owned firms and privately owned firms. They find that underpricing for state-owned firms is higher in France and in the U.K., but lower in Canada and in Malaysia. Their sample does not include IPOs in China, where state-owned firms are predominant. 10 are determined after solicitation to institutional investors, including qualified foreign institutional investors (QFIIs) presumably skilled in IPO investment. Since IPO prices after the 2005 reform reflect more investor demand and less government intention, our hypothesis implies that IPO underpricing in China is reduced after the 2005 reform.5 This study is related to those of Datar and Mao (2006) and Chen et al. (2004), which associate Chinese IPO underpricing with the nation‘s institutional features. Using a sample of IPOs for 1990–1996, Datar and Mao (2006) find evidence indicating that the Chinese government deliberately underprices IPO shares. Chen et al. (2004) find that state-ownership is positively correlated with IPO underpricing during 1992–1997. These two studies suggest that government control affects underpricing in China. However, the fact that virtually all the sample firms in these studies are state-owned makes it difficult to detect the impact, if any, of government control on large underpricing. Besides, the IPO prices were determined by the CSRC in terms of P/E multiples until March 2001. Thus, it is not certain if the managerial incentives of state-owned firms had any effect on underpricing before 2001. Finally, also until March 2001, the Chinese regulatory authority imposed stiff quotas on the issuance of IPO shares. Thus, large underpricing in the previous studies is possibly attributable to the quota system. Since the restart of the Chinese stock exchanges in the early 1990s, most firms listed on them have been large state-owned firms, and it is no exaggeration to say that these stock exchanges have served as places for state-owned firms to raise capital. In June 2004, the Shenzhen Stock Exchange launched the SME Board to deal exclusively in securities of small and medium enterprises (SMEs). Our sample is from this new market, where the level of underpricing is yet to be examined. Moreover, due to its SME-oriented nature, almost equal number of state-owned firms and privately owned firms are listed on this market, which is advantageous in studying the effect of state ownership. Using this market, we detect how underpricing has been affected by state ownership and the 2005 reform.6 It should be noted that if the indirect cost of IPOs (i.e., underpricing) is reduced by the 2005 reform, as we expect, this does not mean that the total costs of 5 The theoretical model of Benveniste and Spindt (1989) as well as empirical findings by Ljungqvist et al. (2003) suggest that bookbuilding method per se does not necessarily reduce IPO underpricing. 6 Prior to the opening of the SME Board, regulatory reforms enhancing transparency in IPOs were implemented in December 2003 and February 2004. Our sample starting from June 2004 has the merit of being unaffected by these reforms. Since in China IPOs were suspended in June 2005 for another reform aiming at the elimination of nontradable shares, we set our test period from June 2004 (the opening of the SME Board) to June 2005 (IPO suspension). Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 going public are reduced by the reform. Since the new procedure requires more effort on the part of underwriters, they presumably charge higher underwriting fees to issuers, which is a major component of direct IPO costs. We examine this issue after testing our hypothesis above. In the empirical analysis, we find that underpricing is significantly higher for state-owned firms and it is significantly reduced by the 2005 reform. The results support our hypothesis that government control over the corporate economy underlies the large underpricing in China. Finally, we examine how the total costs of going public are affected by the 2005 reform. We find that the direct IPO costs are raised significantly, which suggests that underwriters charge higher fees compensating for their greater effort. However, the reduction in underpricing more than offsets the increase in direct costs. Overall, we conclude that the reform making the IPO procedure more market-oriented is beneficial to Chinese firms going public. The rest of the paper is organized as follows. In section 2, we develop the hypothesis regarding government control and IPO underpricing. Section 3 describes our sample and data. Regression results on underpricing and total costs are presented in section 4. Section 5 concludes. 2. Hypothesis IPO underpricing in China is the highest among major stock markets. The attempts to explain this large underpricing by traditional and mostly U.S. IPO literature are not sufficient, because in this literature the government plays no material part, which is obviously not the case in China. We focus on the relation between government control over the corporate economy and IPO underpricing. In particular, we hypothesize that managers of state-owned firms as well as regulatory authorities have incentives to underprice IPO shares. First, managers in state-owned firms are appointed by the government and have no significant shareholdings in their firms. It is quite common that the government appoints government officials as managers of stateowned firms, or conversely, appoints managers as government officials (Chen et al., 2007). In such circumstances, managers are likely to attach more importance to their bureaucratic careers than to value maximization of the firms they manage. In the case of IPOs, they are concerned more about a personal penalty for putting the stock market in disarray than they are about underpricing, which creates indirect cost for the firms. Consequently, we expect that underpricing is larger for state-owned firms than for privately owned firms in China. Second, the CSRC, which is the regulatory authority of the stock market, also has incentives to underprice IPO shares. The authority or Chinese government deliberately underprices so as not to upset investors. Once investors suffer a loss in IPOs, they turn away from the stock market, which could jeopardize subsequent IPOs of state-owned firms. Since the reopening of the Chinese stock market in 1990, the CSRC has determined or greatly affected IPO prices. In the beginning of 2005, however, the IPO process was reformed, in order to make it more market–oriented. In the new procedure, issuers and underwriters commence sales promotion and bookbuilding, once IPO applications have been approved by the CSRC. Bookbuilding is divided into two stages. Issuers and underwriters set a price range through preliminary bookbuilding, and actual issuing prices are determined through formal accumulative bookbuilding. Moreover, the bookbuilding process is conducted with institutional investors including qualified foreign institutional investors (QFIIs), who are presumably skilled in IPO investment. As a result, IPO prices after this reform reflect more investor demand and much less governmental intention than before. Thus, we expect that IPO underpricing in China is reduced by the reform in 2005. 3. Sample and data China reopened its stock exchanges in the early 1990s in Shanghai and Shenzhen. Most firms listed on these stock exchanges are large state-owned firms, and it is no exaggeration to say that they have served as places for state-owned corporate groups to raise capital. In June 2004, the Shenzhen Stock Exchange launched its SME Board to deal exclusively in SME securities. Our sample is from this new market, where the level of underpricing has not been explored. Moreover, our sample has the following advantages as a laboratory of exploring the effects of government control. First, preceding Chinese IPO studies use samples consisting predominately of stateowned firms, and this makes it difficult to abstract the effects of state ownership. On the SME Board, however, almost equal number of state-owned firms and privately owned firms are listed due to its SMEoriented nature. Second, since the Chinese IPOs were conducted under a stiff quota for 1990–2001, underpricing during this period was more or less affected by the quota. Finally, Chinese IPOs underwent material reforms in December 2003 and February 2004. The SME Board, opened after these reforms, arguably makes a good IPO laboratory. Our sample consists of 50 firms that were listed on the SME Board from its opening in June 2004 to June 2005 when IPOs were suspended in China. All data used in our analysis are obtained from prospectuses available on the Shenzhen Stock Exchange website. Table 1 shows the summary statistics for our full sample as well as for subsamples of 24 state-owned firms and 26 privately owned firms. Firms are classified as state-owned if they have the government or another state-owned entity as shareholders. [Insert Table 1 about here] 11 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Underpricing or the indirect cost of an IPO is measured as the initial return, using the offer price and the aftermarket price (the closing price of the first trading day). The mean (median) underpricing is 60.7% (48.6%) for our full sample, which is smaller than the levels previously reported for Chinese IPOs but is still larger than other major markets. The mean (median) is 76.9% (55.1%) for state-owned firms and 45.9% (28.4%) for privately owned firms. The difference in mean is statistically significant at the 10% level.7 The mean gross proceeds (the issue price multiplied by the number of new shares) are significantly smaller for state-owned firms. Interestingly, however, the average number of new shares (in 10 millions) is almost identical between state-owned firms and privately owned firms (2,735 and 2,767 respectively, with a t-value of −0.134), while the average issuing price is lower for stateowned firms than for privately owned firms (RMB8.47 and RMB9.83 respectively, with a t-value of −1.425). Thus, the smaller gross proceeds for stateowned firms are possibly a result of larger underpricing. We measure firm size by total assets and sales revenues in the year preceding the IPOs. Total assets are not significantly different, while the sales revenues are larger for privately owned firms at the 10% significance level. Finally, about three quarters of the sample firms conducted IPOs before the 2005 reform, and the ratio is almost identical between the two subsamples. 4. Regression analyses 4.1 Underpricing In order to test our hypothesis that large underpricing in China is associated with government control over the corporate economy, we regress underpricing on dummy variables for state-owned firms (STATEOWNED) and for IPOs conducted before the 2005 reform (PRE-REFORM). We expect the coefficients of the two dummy variables to be positive, which indicates that underpricing or the indirect IPO cost is higher for state-owned firms and for IPOs before the 2005 reform. Control variables are included in the regressions based on previous IPO literature. Both issue size and firm size are expected to be negatively related to underpricing, since the larger an IPO, the smaller the informational asymmetry and uncertainty (Beatty and Ritter, 1986). We use the natural logarithm of the gross proceeds (LN (proceeds)) to control issue size effect. The natural logarithm of total assets (LN (assts)) and sales revenue (LN (sales)) are used to control firm size effect. As Ritter and Welch (2002) suggest, market conditions are also associated with underpricing. 7 Hereunder we use a t-test assuming unequal variance in comparing state-owned firms and privately owned firms. 12 Traditional IPO literature documents that higher market returns are associated with larger underpricing (e.g., Derrien and Womack, 2003). However, under our hypothesis that bureaucratic managers and the government put a higher priority on their own interests than on the firm‘s value, they may well underprice more when the market is moving downward and difficult IPOs are expected. We use the buy-and-hold return of the Shenzhen Stock Exchange A-Share Index for the 15 days before listing (MARKET) as the proxy for market conditions.8 Table 2 shows regression results. The coefficients of STATE-OWNED and PRE-REFORM are positive, and they are significant at the 10% and 1% level, respectively. These results support our hypothesis. In addition, the negative (not statistically significant) coefficients of MARKET, which are unusual in IPO studies, suggest that underpricing in China is caused by the incentives of bureaucratic managers and regulators to avoid unpopular IPOs. The insignificance of the size variables suggests that for Chinese underpricing, informational asymmetry is less relevant than institutional features. [Insert Table 2 about here] 4.2 Direct and total IPO costs The results in the previous section show that the indirect IPO cost (i.e., underpricing) for Chinese firms is reduced by the reform in 2005. The results support our hypothesis that large underpricing in China is associated with government control, and thus, it is reduced by the reform making IPO process more market-oriented. Now, we turn to the issue of total IPO costs for Chinese firms going public. Other than the indirect cost of underpricing, firms assume direct costs in IPOs (Ritter, 1987). Direct costs include underwriting, auditing, and reviewing fees. In particular, underwriting fees paid to investment banks make up a substantial portion of the direct costs. 9 The new IPO process introduced by the 2005 reform requires more effort on the part of underwriters who are supposed to conduct deliberate bookbuilding. Thus, it is quite natural if the underwriters charge higher fees to issuers (Ljungqvist et al., 2003). We collect the data of direct costs (in RMB 10,000) for the 50 IPOs from the prospectuses and calculate the ratio of the direct costs to the gross proceeds (direct cost ratio). The results are summarized in Table 3. The mean of the ratio is 8 Ma and Faff (2007) document that underpricing in China is influenced much more by market conditions before the listing than those before offering. 9 Chen and Ritter (2000) report that underwriting fees cluster around 7% of gross proceeds in the U.S., where bookbuilt IPOs are predominant. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 significantly higher for IPOs after the reform, supporting our conjecture that Chinese underwriters are charging higher fees. [Insert Table 3 about here] Next, we examine the change in total IPO costs caused by the reform. In the regressions, the dependent variable is defined as the sum of underpricing and the direct cost ratio. The variable indicates the ratio of total costs to gross proceeds or funds raised by the firms. We use the same independent variables as in the regressions of underpricing. Table 4 shows the results. The coefficients of PRE-REFORM are positive and statistically significant, which suggests that the total costs of going public in China are reduced by the reform. Overall, the move to the more marketoriented IPO process is beneficial to Chinese firms going public. [Insert Table 4 about here] 5. Conclusion The Chinese IPO market has exhibited large IPO underpricing. We argue that government control is behind this puzzle. First, in China, most listed firms are large state-owned firms and managerial shareholdings are insignificant. The managers attach more importance to their bureaucratic careers than to value maximization of the firms they manage. In such circumstances, managers have incentives to underprice IPO shares, in order to avoid being penalized for conducting unpopular IPOs, which will stand in the way of successive IPOs. Second, the CSRC, the regulatory authority of the stock market, also has incentives to underprice IPO shares. The CSRC or Chinese government deliberately underprices so as not to upset investors. If investors suffer a loss in IPOs, they turn away from the stock market and subsequent IPOs of state-owned firms are jeopardized. Using a sample from a new stock market in China, we find evidence supporting this hypothesis. Underpricing is higher for state-owned firms and for IPOs before the reform which made IPO prices less affected by the regulator. Furthermore, the reduction in underpricing by the reform more than offsets the increase in direct costs involved in compensating the increased efforts of underwriters. In sum, we find evidence showing that government control over the corporate economy raises the cost of going public. We expect that in the future, IPO underpricing as well as the cost of going public in China will decline further as the liberalization of the corporate economy proceeds. References 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. Beatty, R. P., and Ritter, J. R. (1986). Investment banking, reputation, and the underpricing of initial public offerings. Journal of Financial Economics 15, 213–232. Benveniste, L. M., and Spindt, P. A. (1989). How investment bankers determine the offer price and allocation of new issues. Journal of Financial Economics 24, 343–361. Chen, G., Firth, M., and Kim, J. -B. (2004). IPO underpricing in China‘s new stock markets. Journal of Multinational Financial Management 14, 283–302. Chen, H. -C., and Ritter, J. R. (2000). The seven percent solution. Journal of Finance 55, 1105–1131. Chen, Z., Choi, J. J., and Jiang, C. (2007). Private benefits in IPOs: evidence from state-owned firms. Working Paper, Temple University. Datar, V., and Mao, D. Z. (2006). Deep underpricing of China‘s IPOs: sources and implications. International Journal of Financial Services Management 1, 345–362. Dewenter, K. L., and Malatesta, P. H. (1997). Public offering of state-owned and privately-owned enterprises: an international comparison. Journal of Finance 52, 1659–1679. Derrien, F., and Womack, K. L. (2003). Auctions vs. bookbuilding and the control of underpricing in hot IPO markets. Review of Financial Studies 16, 31–61. Ljungqvist, A., Jenkinson, T., and Wilhelm, W. (2003). Global integration in primary equity markets: the role of U.S. banks and U.S. investors. Review of Financial Studies 16, 63–99. Ma, S., and Faff, R. (2007). Market conditions and the optimal IPO allocation mechanism in China. PacificBasin Finance Journal 15, 121–139. Ritter, J. R. (1987). The costs of going public. Journal of Financial Economics 19, 269–281. Ritter, J. R. (2003). Investment banking and securities issuance. In G. Constantinides, M. Harris, and R. Stulz (eds.), Handbook of the Economics of Finance, Vol. 1A, Corporate Finance. Amsterdam: NorthHolland, pp. 255–306. Ritter, J. R., and Welch, I. (2002). A review of IPO activity, pricing, and allocations. Journal of Finance 57, 1795–1828. 13 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Appendices Table 1. Descriptive Statistics Full sample State-owned firms Privately owned firms t -value Underpricing mean median st. dev. 60.7% 48.6% 56.8% 76.9% 55.1% 63.0% 45.9% 28.4% 44.3% 1.956 * Gross proceeds (RMB 10,000) mean median st. dev. 23,945 21,105 8,577 21,419 20,007 5,892 26,276 24,489 9,761 -2.106 ** Assets (RMB 1) mean median st. dev. 386,483,261 282,728,029 410,762,607 357,651,087 242,675,443 537,454,326 413,097,575 342,293,190 223,316,865 -0.460 Sales (RMB 1) mean median st. dev. 479,537,595 263,536,736 865,239,854 254,469,966 216,122,546 151,194,657 687,292,330 327,406,568 1,140,121,133 -1.880 Pre-reform dummy mean median st. dev. 0.760 1.000 0.427 0.750 1.000 0.433 0.769 1.000 0.421 -0.156 50 24 26 Observations * The full sample consists of all 50 firms that conducted IPOs on the Shenzhen SME Board during 2004–2005. Sample firms with government and/or state-owned entity shareholders are classified as state-owned firms. Underpricing = (closing price of the listing day – offer price) / offer price. Gross proceeds = offer price multiplied by the number of shares offered in the IPO. Assets = total assets at the end of the fiscal year before listing. Sales = sales during the fiscal year before listing. Pre-reform dummy = a dummy variable taking the value of one for the IPOs before the 2005 reform. **, * denote statistical significance of the difference at the 5% and 10% levels, respectively, for two-tailed tests assuming unequal variance. Table 2. Regression Results of Underpricing Model 1 Model 2 Constant 542.84 (2.11) ** 402.62 (1.30) STATE-OWNED 30.08 (1.67) * 33.52 (1.93) * PRE-REFORM 36.56 (2.72) *** 44.73 (3.17) *** LN (proceeds) -19.01 (-0.86) -36.99 (-1.19) MARKET -349.79 (-1.39) -358.34 (-1.31) LN (assets) 14.86 (0.89) LN (sales) 1.55 (0.89) Adjusted R2 0.12 0.10 Observations 50 50 The dependent variable is underpricing [(closing price of the listing day – offer price) / offer price]. STATE-OWNED = a dummy variable taking the value of one for the firms with the government and/or state-owned entity shareholders. 14 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 PRE-REFORM = a dummy variable taking the value of one for the IPOs before the 2005 reform. LN (proceeds) = natural logarithm of the gross proceeds (offer price multiplied by the number of shares offered in the IPO). MARKET = buy-and-hold return of the Shenzhen Stock Exchange A-Share Index for the 15 days before listing. LN (assets) = natural logarithm of total assets at the end of the fiscal year before listing. LN (sales) = natural logarithm of sales during the fiscal year before listing. White heteroskedasticity consistent t-values are in parentheses. ***, **, * denote statistical significance at the 1%, 5%, and 10% levels, respectively, for two-tailed tests. Table 3. Direct IPO Costs Direct cost ratio Full sample Before reform After reform t -value 6.43% 6.13% 2.14% 6.01% 6.01% 1.46% 7.79% 7.37% 3.24% -2.672 50 38 12 mean median st. dev. Observations *** The full sample consists of all 50 firms that conducted IPOs on the Shenzhen SME Board during 2004–2005. Sample firms are divided into those that used the IPO procedure before the 2005 reform and those that used the procedure after the reform. Direct cost ratio = the ratio of direct IPO costs to gross proceeds. The direct IPO costs include underwriting, auditing, and reviewing fees. *** denotes statistical significance at the 1% level, for two-tailed test. Table 4. Regression Results of Total IPO Costs Model 1 Model 2 Constant 549.82 (2.21) ** STATE-OWNED 27.99 (1.55) PRE-REFORM 34.86 (2.47) LN (proceeds) -14.97 (-0.69) -34.07 (-1.13) MARKET -392.14 (-1.52) -417.86 (-1.56) ** 397.57 (1.34) 31.12 (1.79) * 45.17 (3.24) *** LN (assets) 20.20 1.20 LN (sales) -1.84 (-0.14) Adjusted R2 0.11 0.09 Observations 50 50 The dependent variable is total IPO costs (underpricing + direct cost ratio), where underpricing is (closing price of the listing day – offer price) / offer price, and direct cost ratio is the ratio of direct IPO costs to gross proceeds. STATE-OWNED = a dummy variable taking the value of one for the firms with the government and/or state-owned entity shareholders. PRE-REFORM = a dummy variable taking the value of one for the IPOs before the 2005 reform. LN (proceeds) = natural logarithm of the gross proceeds (offer price multiplied by the number of shares offered in the IPO). MARKET = buy-and-hold return of the Shenzhen Stock Exchange A-Share Index for the 15 days before listing. LN (assets) = natural logarithm of total assets at the end of the fiscal year before listing. LN (sales) = natural logarithm of sales during the fiscal year before listing. White heteroskedasticity consistent t-values are in parentheses. ***, **, * denote statistical significance at 1%, 5%, and 10% levels, respectively, for two-tailed tests. 15 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 SEPARATION BETWEEN MANAGEMENT AND OWNERSHIP: IMPLICATIONS TO FINANCIAL PERFORMANCE Zélia Serrasqueiro*, Paulo Maçãs Nunes** Abstract Using panel data, this article shows that agency costs, a consequence of the separation between ownership and management, are not relevant in explaining the financial performance of Portuguese companies since, on the one hand, greater size, greater liquidity and higher level of risk do not mean decreased financial performance and, on the other, greater level of debt does not mean increased financial performance. The results indicate that the fact of managers being better informed than owners, about companies‟ opportunities and specific characteristics, does not necessarily mean behaviour that contributes to diminished financial performance in Portuguese companies. Keywords: Agency Costs, Financial Performance, Information Asymmetry, Managers, Owners, Panel Data * Management and Economics Department, Beira Interior University and CEFAGE Research Center Évora University, Évora, Portugal **Corresponding author: Universidade da Beira Interior, Departamento de Gestão e Economia, Estrada do Sineiro, 6200-209 Covilhã, Portugal, Phone Number.:+351 275 319 600; Fax Number:+351 275 319 601; E-mail address: [email protected] 1. Introduction Until the mid 70s, economists viewed the firm as a unit transforming inputs in outputs, not bothering to study its organizational structure, nor the possible implications of its agents‘ behaviour for performance. From the mid 70s, economists begin to concern themselves with studying the organizational structure of the company, and in this context appears the work of Galai and Masulis (1976) and Jensen and Meckling (1976), originating Agency Theory. Agency Theory is based on construction of the utility functions of the agents involved in the organizational relationships established in the company, the main question being the possibility of the utilities of the different agents involved in its functioning being divergent. Galai and Masulis (1976) and Jensen and Meckling (1976), conclude that the existence of information asymmetry limits the functioning of the company, since the different agents do not all have the same amount of information. Based on different levels of information, agents try, in particular circumstances, to maximize their individual utility, conflicts of interest being inevitable. The theoretical and empirical development of Agency Theory has tried to analyse the conflicts of interest among the various agents who make up the company, also trying to find ways of minimizing those conflicts. One of the most relevant aspects of Agency Theory in the context of business organizations deals with the conflict of interests between managers and owners, a consequence of information asymmetry existing in their relationship. According to Galai and Masulis (1976), Jensen and Meckling (1976), Fama 16 and Jensen (1983), Jensen (1986), and Stulz (1990), managers are better informed than owners about certain specific aspects of company management, for example, about investment possibilities. The fact that owners have less information leads managers to try to maximize their utility, to the detriment of owners‘ utility, investing in projects that contribute to improving their personal benefits but harm financial performance. In this study, using panel data, the research question is to find out if agency costs, a consequence of the separation of management and ownership, limit the financial performance of Portuguese companies. An increase in company size can contribute to greater separation of management and ownership, a consequence of information asymmetry, affecting financial performance. Higher levels of debt, and lower levels of liquidity, can help to mitigate agency costs, a consequence of the separation of management and ownership, since managers must make periodic payment of debt charges, having less finance available for investments that may contribute to diminished financial performance. A higher level of risk can contribute towards managers investing in projects with a currently negative net value, without the owners realizing, contributing to diminished financial performance. Therefore, we intend to test empirically if size, debt, liquidity and level of risk limit the financial performance of Portuguese companies, as a consequence of aggravated agency costs resulting from the separation of management and ownership. With this aim, we divide this study as follows: in section 2 we present the hypotheses for investigation according on the expected relationship between Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 explanatory variables and financial performance, based on agency costs resulting from the separation of management and ownership; in section 3 we present the methodology used; in section 4 we present the results obtained; and in section 5 we present the conclusions of this study. on the arguments set out, we formulate the following hypothesis: H2: Higher company debt means increased financial performance, as a consequence of diminished agency costs resulting from the separation of management and ownership. 2. 2.3. Liquidity Hypotheses for Investigation Next we present the relationships expected between the variables already mentioned and financial performance, based on agency costs resulting from the separation of management and ownership. 2.1. Company size Jensen and Murphy (1990), conclude that company size is negatively related to financial performance since managers, taking advantage of the lesser possibility of control by owners, given the greater size of companies, invest in projects that allow them to obtain better personal benefits, rather than increase management efficiency and consequently financial performance. Gardner and Grace (1993) and Cummins et al. (1999) reinforce the arguments of Jensen and Murphy (1990), concluding that the possible existence of less ownership control over managers‘ actions can lead to the latter investing in projects that give them greater prestige, such as those which contribute towards maximising company market share, something that can cause diminished financial performance. Larger companies are subject to an aggravation of agency costs resulting from the separation between management and ownership. Based on the arguments set out, we formulate the following hypothesis: H1: Greater company size means diminished financial performance, as a consequence of increased agency costs resulting from the separation of management and ownership. 2.2. Debt Fama and Jensen (1983), Jensen (1986), Berger et al. (1995), Wells et al. (1995) and Adams (1996), based on agency costs resulting from the separation of management and ownership, conclude that debt can positively influence the financial performance of companies. On one hand, owners resort to debt with the purpose of disciplining managers‘ actions, reducing free cash flows, since managers must make periodic payment of the debt capital and interest. On the other hand, increased debt means increased probability of bankruptcy which also contributes towards to increased discipline among managers. Improvement in management efficiency, a consequence of increased debt, means, according to Fama and Jensen (1983), Jensen (1986), Berger et al. (1995), Wells et al. (1995) and Adams (1996), an increase in companies‘ financial performance. Based Fama and Jensen (1983) and Jensen (1986) conclude that greater levels of company liquidity can mean lower financial performance, a consequence of increased agency costs resulting from the separation of management and ownership, since managers are better informed than owners about the functioning and investment possibilities of companies. Managers, given the greater ease of meeting the short-term responsibilities of companies, a consequence of a higher amount of free cash flows, can invest in projects with a negative liquid current value that allow them to increase their personal prestige, but which mean diminished financial performance. Based on these arguments, we formulate the following hypothesis: H3: Higher levels of company liquidity mean diminished financial performance, a consequence of increased agency costs resulting from the separation of management and ownership. 2.4. Risk According to Galai and Masulis (1976), Jensen and Meckling (1976), Lamm-Tennant and Starks (1993), Oppenheimer and Schlarbaum (1993) and Adams and Buckle (2003), we can expect a negative relationship between the level of volatility of companies‘ operational results and their financial performance, a consequence of increased agency costs resulting from the separation of management and ownership. The authors state that greater volatility of operational results has, in many situations, its root in the greater competition companies face, which causes considerable volatility in receipts. Managers, better informed than owners about the functioning of companies, realize the greater level of risk and try to maximize their personal benefits, something which can imply diminished financial performance. Based on the arguments set out, we formulate the following hypothesis: H4: Higher levels of company risk mean diminished financial performance, as a consequence of increased agency costs resulting from the separation of management and ownership. 3. Methodology 3.1. Database In this study we use a database of the Exame Review that publishes annually (from 1991) a database of the 500 biggest companies in Portugal, with data 17 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 collected by the local filial of the Dun & Brad Street Consulters Multinational. The companies included in the database were selected on basis of total value of sales and excludes companies that don‘t send their financial documents to be analyzed. We study a panel data of firms from 1999 to 2003. First, to avoid selection issues we study a balanced panel data of 162 during 5 years. Finally, we selected the companies with separation between ownership and management to period from 1999 to 2003. Based on the criteria mentioned above, we selected 141 companies for the period 1999-2003, and so we have a panel made up of 705 observations. 3.2. Variables According to the literature, and previously defined hypotheses for investigation, we consider as possible variables that can influence the performance of Portuguese companies: size, debt, liquidity, and level of risk. The following table gives us a description of the variables used and their corresponding measurement. (Insert Table 1 About Here) 3.3. Method of Analysis Companies‘ specific characteristics are distinct in the majority of situations. The data assessment methods using panel models have the great advantage of measuring those different characteristics, called nonobservable individual effects. A regression by the ordinary least square method does not allow for measurement of companies‘ non-observable individual effects, and so normally the assessed parameters do not evaluate correctly the relationships between variables. Consideration of non-observable individual effects has the great advantage of mitigating the problem of the absence of possibly relevant variables not included in explaining the dependent variable. In this study we use initially three distinct forms of assessment: 1) regression by the ordinary least square method; 2) panel model admitting the existence of random non-observable individual effects; and 3) panel model admitting the existence of fixed non-observable individual effects. We can present the assessment model in the following way: yit X ´it uit , with i 1,...,162; t 1,...,5 , in which i represents each of the companies and t the periods, y it is the vector of the explained variable, X´it is the vector of the explanatory variables of each company in each period, is the vector of the assessed parameters, u it is the error vector given by: uit vi eit , 18 vi is the non-observable individual effect of each company and eit is the error which assumes in which normal distribution. After evaluation, we test the relevance of companies‘ non-observable individual effects, applying the LM test. The LM test verifies the null hypothesis that non-observable individual effects are not relevant in explaining the dependent variable, against the alternative hypothesis that non-observable individual effects are relevant. If we reject the null hypothesis, we can conclude that a simple regression by the ordinary least square method is not the most correct form of assessment, given the relevance of non-observable individual effects. If we conclude that non-observable individual effects are relevant, we proceed to comparison of the panel model assuming the existence of random nonobservable individual effects, with the panel model assuming the existence of fixed non-observable individual effects. The random non-observable individual effects model assumes that non-observable individual effects are not correlated with the explanatory variables. On the other hand, the fixed non-observable individual effects model assumes the existence of correlation between non-observable individual effects and the explanatory variables. With the aim of testing which model is most appropriate, we use the Hausman test. The Hausman test verifies the null hypothesis that there is no correlation between non-observable individual effects and the explanatory variables, against the alternative hypothesis that there is correlation between nonobservable individual effects and the explanatory variables. If we cannot reject the null hypothesis, the panel model assuming the existence of random nonobservable individual effects is seen to be more appropriate. If we reject the null hypothesis, given the existence of correlation between non-observable individual effects and explanatory variables, the panel model assuming the existence of fixed non-observable individual effects is more appropriate. We test for the existence of error autocorrelation. If autocorrelation exists, it is necessary to proceed to an assessment of the most appropriate model considering its existence. We used annual dummy variables so as to remove the impact of possible macroeconomic alterations on the financial performance of Portuguese firms. 4. Results In table 1 we present the results of the descriptive statistics to variables. (Insert Table 2 About Here) Results of the descriptive statistics of the variables indicate that companies‘ financial performance presents some volatility, since the Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 standard deviation is above the mean, the same occurring with the proxy measuring the level of risk. We present the results of applying the different panel models in the following table 2. (Insert Table 3 About Here) The results of the LM test indicate that we can reject the null hypothesis, at 1% significance, that non-observable individual effects are not relevant. This being so, we can conclude that regression by the ordinary least square method is not the most appropriate way of carrying out an assessment of the financial performance equation. From application of the Hausman test we can conclude that we reject the null hypothesis of absence of correlation between non-observable individual effects and the explanatory variables, and so the most appropriate method to evaluate the financial performance equation is the panel model assuming the existence of fixed non-observable individual effects. From application of the first order autocorrelation test, we find we reject the null hypothesis, at 1% significance, of absence of first order autocorrelation, and so we see to be appropriate assessment of the panel model of fixed nonobservable individual effects consistent with the existence of autocorrelation. We cannot reject the null hypothesis of absence of second order autocorrelation. Results of the Wald and F tests indicate we can reject the null hypothesis, at 1% significance, that explanatory variables are not relevant in explaining financial performance. Based on the results of the panel model of fixed non-observable individual effects, we can establish the following relationships: 1. there is a positive, and statistically significant, relationship between company size and financial performance; 2. there is a negative, and statistically significant, relationship between company debt and financial performance; 3. there is a negative, and statistically not significant, relationship between company liquidity and financial performance; 4. there is a positive, and statistically significant, relationship between companies‘ level of risk and financial performance. Agency costs resulting from the separation of management and ownership, as a consequence of greater company size, are not relevant in the Portuguese case, since company size influences financial performance positively, and so we reject hypothesis H1 of this study. We can conclude that the greater size of Portuguese firms does not necessarily mean increased agency costs resulting from the separation of management and ownership, and a consequent reduction of financial performance. The larger size of Portuguese companies does not contribute to managers, taking advantage of greater information asymmetry, investing in projects which increase their own utility and could contribute to reduced financial performance. The negative relationship between debt and financial performance does not allow us to accept as valid hypothesis H2. Increased debt does not contribute to improvement of companies‘ financial performance, a consequence of reduced agency costs resulting from the separation of management and ownership. We cannot conclude that debt is used as an instrument to discipline managers, preventing them from investing in projects which do not contribute to improving companies‘ financial performance. The statistically not significant relationship between the liquidity of Portuguese companies and their financial performance does not allow us to accept hypothesis H3 of this study as valid. Higher levels of liquidity do not necessarily mean increased agency costs resulting from the separation of management and ownership. Greater level of company liquidity, allowing managers to meet shortterm commitments more easily, does not contribute to reduced financial performance, as a consequence of the possibility of managers investing in projects that increase their own utility but which could have a current negative liquid value, contributing to reduced financial performance. The positive relationship between companies‘ level of risk and financial performance does not allow us to accept hypothesis H4 as valid. This result allows us to conclude that higher levels of risk do not necessarily mean increased agency costs resulting from the separation of management and ownership. Greater level of risk does not contribute to managers investing in projects that contribute to increasing their own utility, affecting financial performance. 5. Conclusion Using panel models, we show that the financial performance of Portuguese companies is influenced by size, by debt and by level of risk. We cannot conclude that the financial performance of Portuguese companies is influenced by liquidity. We do not find empirical evidence to prove the relevance of agency costs resulting from the separation of management and ownership in explaining the financial performance of Portuguese companies, since greater size, liquidity and risk do not influence financial performance negatively, and greater level of debt does not influence it positively. The results indicate the fact that managers have more information than owners about opportunities and specific characteristics of companies, does not necessarily mean managerial behaviour that contributes to diminished financial performance. References 1. Adams, M. (1996), ´Investment earnings and the Characteristics of Life Insurance Firms: New Zealand Evidance`, Australian Journal of Management, 21. 19 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 2. 3. 4. 5. 6. 7. 8. Adams, M. and Buckle, M. (2003), ´The Determinants of Corporate Financial Performance in the Bermuda Insurance Market`, Applied Financial Economics, 13. Berger, A., Herring, R. and Szego, G. (1995), ´The Role of Capital in Financial Institutions`, Journal of Banking and Finance, 19: 393-430. Cummins, J., Tennyson, S. and Weiss, M. (1999), ´Consolidated Efficiency in the US Life Insurance Industry`, Journal of Banking and Finance, 23. Fama, E. and Jensen, M. (1983), ´Agency Problems and Residual Claims`, Journal of Law and Economics, 26: 327-349. Galai, D. and Masulis, R. (1976), ´The Option Pricing Model and the Risk Factor of Stock`, Journal of Financial Economics, 3: 53-81. Gardner, L. and Grace, M. (1993), ´X-Efficiency in the US Life Insurance Industry`, Journal of Banking and Finance, 17: 497-540. Jensen, M. and Meckling, W. (1976), ´Theory of the Firm: Managerial Behaviour, Agency Costs and 9. 10. 11. 12. 13. 14. Ownership Structure`, Journal of Financial Economics, 3: 306-360. Jensen, M. (1986), ´Agency Costs of Free Cash Flow, Corporate Finance and Takeover`, American Economic Review: Papers and Proceedings, 76. Jensen, M. e Murphy, K. (1990), ´Performance Pay and Top-Management Incentives`, Journal of Political Economy, 98: 225-264. Lamm-Tennant, J. and Starks, L. (1993), ´Stock Versus Mutual Ownership Structures: the Risk Implications`, Journal of Business, 66: 29-46. Oppenheimer, H. and Schlarbaum, G. (1993), ´Investment Policies of Property-Liability Insurers and Pension Plans: a Lesson From Ben Graham`, The Journal of Accounting and Economics, 15: 485-508. Stulz, R. (1990), ´Managerial discretion an optimal financing policies`, Journal of Financial Economics, 26: 3-27. Wells, B., Cox, L. and Garver, K., (1995) ´Free Cash Flow in the Life Insurance Industry`, The Journal of Risk and Insurance, 62: 50-66. Appendices Table 1. Measurement of variables Variables Dependent variables Financial Performance (F. PERF) Independent variables Size (SIZE) Debt (LEV) Liquidity (LIQ) Risk (EVOL) Measurement Ratio between Operating Income and Total Assets Logarithm of Sales Ratio between Total Liabilities and Total Assets Ratio between Current Assets and Short-Term Liabilities Absolute Value of Percentage Change of Operating Income Table 2. Descriptive Statistics Variable F. PERF SIZE LEV LIQ EVOL Observations 705 705 705 705 705 Mean 0.059 4.876 0.552 1.798 2.910 S.D. 0.080 0.556 0.221 1.298 11.29 Minimum -0.236 3.876 0.084 0.061 0.001 Maximum 0.528 6.768 1.074 11.64 213.2 Table 3. Panel Models Dependent variable: F. PERF Independent Pooled OLS variables SIZE 0.04109*** (0.0054) LEV -0.10565*** (0.01589) LIQ 0.00881*** (0.00242) EVOL 0.00007 (0.00028) Observations 705 LM (2) Hausman (2) R2 0.1208 Wald (2) F statistic 26.17*** Sargan (2) m1 m2 20 Random Effects Fixed Effects Fixed Effects AR(1) 0.06192*** (0.00691) -0.11569*** (0.01712) 0.00471 (0.00498) 0.00042*** (0.00014) 705 684.63*** 29.13*** 0.1589 120.36*** 0.07054*** (0.00765) -0.12987*** (0.02198) 0.00192 (0.00241) 0.00041*** (0.00010) 705 0.08001*** (0.00965) -0.15897*** (0.02382) -0.00401 (0.00345) 0.00052*** (0.00012) 705 0.1675 0.1698 28.02*** 20.41*** -5.78*** -0.39 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 1. 2. 3. Heteroskedasticity consistent and asymptotic robust standard deviations are reported in brackets. *** indicates significance at the 1% level, ** indicates significance at the 5% level, and * indicates significance at the 10% level. The LM test the statistical significance of the individual effects, are asymptotically distributed as 2 , under the null hypothesis of no significance. 4. The Hausman test the correlation between individual effects and independent variables, are 5. asymptotically distributed as , under the null hypothesis of no correlation. Wald is a test of the joint significance of the estimated firm specific coefficients, are asymptotically 2 distributed as under the null hypothesis of no relationship. F is a test of the joint significance of the estimated firm specific coefficients, are asymptotically distributed as N(0,1), under the null hypothesis of no relationship. The m1 test is a test for first order autocorrelation of residuals and is distributed as N(0,1), under null hypothesis of no first order autocorrelation. The m2 test is a test for second order autocorrelation of residuals and is distributed as N(0,1), under null hypothesis of no second order autocorrelation. Estimations include constant and time dummy variables. 2 6. 7. 8. 9. 21 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 THE DETERMINANTS OF CAPITAL STRUCTURE: THE CASE OF LONGTERM DEBT CONSTRAINT FOR JORDANIAN FIRMS Rami Zeitun*, Gary Tian** Abstract This paper contributes to the capital structure literature by investigating the determinants of capital structure of Jordanian companies with the constraint of inadequate long-term debt as their source of financing and regional risk. We firstly document that Jordanian companies mostly depend on shortterm debt, as a result of the banking credit policy that promotes short-term debt. Our results suggest that the level of gearing in Jordanian firms is positively related to size, tangibility, and earning volatility, and negatively correlated to profitability, the level of growth opportunities, liquidity and stock market activities. The level of gearing measured by short-term debt is, however, negatively correlated to tangibility. The Gulf Crisis between 1990 and 1991 is also found to have a significant but positive impact on Jordanian corporate leverage. We conclude that the capital structure decision with inadequate long-term debt access is influenced more strongly by factors such as Stock‟s Market activity (SMA). Keywords: capital structure, determinants, Jordan *Assistant professor of finance in the Finance Discipline, Department of Finance and Economic, College of Business and economic, Qatar University. Emails: [email protected] and [email protected]. **Corresponding author Associate Professor Gary Tian is an associate professor of finance in the Finance Discipline, School of Accounting and Finance, University of Wollongong, Northfields Ave, 2522 Australia. Tel: +61 2 4221 4301. Email: [email protected]. We would also like to thank Steve Keen for his comments on the earlier draft of this paper. The authors remain responsible for all errors. 1. Introduction An ongoing debate in corporate finance concerns the question of a firm‘s optimal capital structure. Three major theories of capital structure have been proposed to explain the determinants of capital structure. These are: the trade-off theory (Modigliani and Miller, 1963, Baxter, 1967 and Ross, 1977), the pecking order theory (Myers and Majluf (1984)), and the agency theory (Jensen and Meckling (1976)). However, the results from the empirical evidence on capital structure were not conclusive and also most results were based on matured markets (Titman and Wessels (1988), Rajan and Zingales (1995), Bevan and Danbolt (2002) and Antoniou et al. (2002)). There are a small number of studies that provide evidence from developing countries including Booth et al. (2001), Pandey (2001), and Chen (2004). This paper examines the determinants of the capital structure in a representative sample of 167 Jordanian companies during 1989-2003. The Jordanian firms provide a unique case for studying this issue since most Jordanian firms are not able to borrow long-term debt as their source of financing. Only a few firms have long-term debt in their capital structure. Therefore, a large percentage of credit facilities are short term. According to Creane et al. 22 (2003) financial intermediation through the banking system in Jordan is mostly short-term. The reason why bank credit is short-term is that the banks seek to match maturities of deposits. Also, banks‘ credit policies may be more conservative since the Jordanian market is very small, and as Jordanian exports depend on Arabic countries which have a high level of political risk (For more details see Zeitun, 2006). For example, in 2002 Jordanian exports to the Arabic countries amounted to JD 740.8 million out of total exports of JD 1556.7 million to other countries, which is about 47.6 percent of total exports. A potent example of the political risk that affects these markets is the first Gulf War in 1991, when Jordanian exports to the Arab countries decreased by 33.12 percent (Zeitun, 2006). This study extends the existing empirical work on this special market in three ways. Firstly, it examines a much broader set of explanatory variables such as stock market‘s activity, in order to investigate the firm‘s financing behaviour under the constraint of inadequate long-term debt. Secondly, the firm sample used in this study is much larger than those previously analysed. Compared with the six year data used in the very limited previous studies, this study used a much longer period of data. Thirdly, this study provides more robust results since, in this study, we used Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 dummy variables to control for the effect of industrial sectors and years on firms' capital structure. The Jordanian economy is vulnerable to external shocks especially those occurring within the Middle East region such as the Gulf Crisis 1990-1991. There is very little known about the possible effect of the regional risk such as Gulf Crisis 1990-1991 and the outbreak of Intifadah in September 2000 on corporate decision making and bankruptcy costs. This study examines the impact of the Gulf Crisis and the outbreak of Intifadah on the performance of corporations. Therefore there are two important and interest questions we will explore in this article. First what are the determinants of capital structure in the case of long-term debt constraint for Jordanian firms? Secondly, are political risks the major factors influence the capital structure for Jordanian firms? The remainder of the paper is organized as follows. Section 2 examines the debt structure of Jordanian companies during the period 1989-2003. Section 3 discusses the determinants of capital structure. Section 4 discusses the methodology and the empirical model used in this study. Section 5 presents the analysis and discussion of results. Section 6 concludes the paper. 2. Capital Structure in Jordan Heavy reliance on debt finance, mainly from the domestic banking system, is a major feature of developing countries and is reflected in the high leverage of Jordanian firms. Table 1 depicts the annual average leverage ratios for non-financial listed companies on the Amman Stock Exchange (ASE) over the period 1989-2003. This set of figures reveals that Jordanian firms were more heavily leveraged in terms of short-term debt compared with long-term debt. For example, in 2000 the reported mean ratio for the short-term debt to total assets (STDTA) is 0.33, which is very high compared with the third measure of leverage, long-term debt to total assets (LTDTA), which is 6 percent. The mean ratio for LTDTA is extremely low compared with developed nations such as Germany (55%) and the US (67%). This long-term debt is also much lower than the emerging markets in East Asia with an average of approximately 30% in Malaysia, Taiwan, and Thailand (Claessens et al., 1998, p11). The average ratio of the total debt over total capital (TDTC)10 is about 127.44%, with the highest ratio being 170% observed during the Gulf Crisis of 1990-1991. The ratios of short-term debt (STD) and long-term debt (LTD) to total equity (TE)11 show similar results compared with long-term debt (LTD) and short-term debt (STD) to total assets (TA). For example, in 2000 the STDTE was about 121%, which is very high compared with 16% for the LTDTE. Insert Table 1 Here It was argued that a firm‘s capital structure could affect the firm‘s health and affect the default risk, so the capital structure of defaulted firms and nondefaulted firms should be different. Figure 1 shows the average of the leverage ratio in both default and non-defaulted firms over the period 1989-2002. Moreover, Figure 1 shows that defaulted firms have a high leverage ratio of total debt to total assets (TDTA) over the period 1989-2002. The leverage ratio TDTA increased sharply over the periods 1989-1993 and 1998-2001. Both defaulted and non-defaulted firms have their lowest leverage ratio over the period 19941997. Furthermore, Figure 1 shows that the Gulf Crisis of 1990-1991 had a strong impact on the defaulted firms as a result of an increase in the demand for debt finance. The highest leverage ratio for distressed firms over the period 1998-2001 could be explained by the growth in banks' credit facilities over the period 1997-1999, which encouraged distressed firms to borrow more and more. Due to the high economic growth rate during the period 19921995 (boom period), the leverage ratio for defaulted firms continued to decrease, while it started to increase in 1996 due to the poor economic performance. Insert Figure 1 Table 2 shows the leverage ratios in both defaulted and non-defaulted firms. Both defaulted and nondefaulted firms have a low long-term debt to total assets (LTDTA) ratio, while short-term debt to total assets (STDTA) is more prevalent in defaulted firms. For example, in 2002 the LTDTA and STDTA ratios for the defaulted firms were 16% and 63%, respectively, compared with 7% and 44%, respectively, for the non-defaulted firms. However, the long-term debt to total assets (LTDTA) ratio is lower for the defaulted firms over the period 19901992 which means the defaulted firms were unable to borrow long-term debt, while they borrowed more in the short-term to pay their short-term obligations. Insert Table 2 Here The total debt to total capital (TDTC) ratio is higher in the non-defaulted firms compared with the defaulted firms. The reason could be that non- 10 The total capital (TC) is defined as the paid capital. The choice of total debt to total capital ratio instead of debt to equity ratio is because our sample includes some firms that had negative equity during 1989-2003, when equity values fell as a result of the Gulf Crisis, the outbreak of Intifadah 2000, or distress and default. 11 The purpose of including different measures of capital structure is to provide a comprehensive explanation of the Jordanian firms‘ capital structure, as some firms have a high debt to equity ratio and lower debt to assets ratio. 23 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 defaulted firms are able to borrow as a result of a high profitability ratio which gives them the ability to access external sources of funds, while the defaulted firms are unable to do so as a result of decreasing assets. Total debt to total equity (TDTE) is higher in the defaulted firms as a result of financial distress, but it is still high in the non-defaulted firms. Defaulted firms have a negative value for the TDTE as a result of distress and of facing a level of leverage that exceeds their shareholders' equity. 3. Determinants of Capital Structure and Hypotheses Development To assess the determinants of capital structure in Jordan, the individual firm‘s leverage ratios are modelled as a function of several firm-specific factors in a cross-sectional framework. The theoretical literature on capital structure suggests a number of factors that may influence the capital structure of companies based on the agency cost of debt and equity and other costs associated with asymmetric information (Jensen and Meckling, 1976; Myers and Majluf, 1984: Harris and Raviv, 1991)12. The vector of firm-specific variables incorporates the following factors: 1. Tangibility Agency theory suggests that firms with a high leverage ratio tend to under-invest as the cost of debt increases and, thus, transfer wealth away from debt holders to equity holders. So, the more tangible assets a firm has, the greater the ability of that firm to secure its debt. Firms unable to provide collateral value (fixed assets to total assets) have to pay a higher interest rate as a result of increased agency costs, or will encourage investors to issue equity instead of debt (Scott, 1977). Furthermore, the tangibility of assets decreases the bankruptcy costs and increases the liquidation value of the firm. Thus, a positive relationship between tangibility of assets and leverage is expected and a negative relationship between tangibility and short-term debt. In Jordan, the banks‘ credit policies are more conservative as the Jordanian market is very small. Therefore, the tangible assets increase a firm‘s ability to access to more debt. Based on the theoretical and empirical evidence, the Hypothesis to be tested is as follows: H1a : There is a positive relationship between leverage ratio total debt to total assets (TDTA) and tangibility. H1b : There is a negative relationship between leverage ratio short-term debt to total assets (STDTA) and tangibility. 2. Profitability It is argued that firms with a high profitability ratio tend to have a high level of debt, as a result of the tax deductibility of interest payments (Modigliani and Miller, 1963). The high profitability also implies potential lower probability of bankruptcy (default). Zeitun (2006) showed that the average profitability of Jordanian companies has increased considerably over the period 1988-2004. He also suggested that the majority of Jordanian firms do not realise a profit which could be used as internal sources of fund. Therefore, profitable Jordanian firms will depend less on leverage. Based on the theoretical and empirical evidence, the Hypothesis to be tested is as follows: H2 : leverage ratios and profitability. 3. Firm Size Trade-off theory suggested a positive relationship between firm size and leverage, since large firms tend to be more diversified and have been shown to have lower bankruptcy risk and lower bankruptcy cost (Rajan and Zingales, 1995). Furthermore, large firms are expected to incur lower agency costs for issuing debt or equity, less cash flow volatility, and have easier access to the credit market. Therefore, large companies are expected to hold more debt in their capital structures than small firms to get the benefit of the tax shield. Also, it is argued that smaller firms tend to have large short-term debt and less long-term debt due to the conflict between shareholders and debtholders (Titman and Wessels, 1988; Michaelas et al., 1999). The Jordanian banks have restricted credit policies which make it is difficult for small firms to borrow money compared with large firms. Therefore, firm size affects leverage ratio for the Jordanian companies. Based on the theoretical and empirical evidence, the Hypothesis to be tested is as follows: H3 For an extensive review of the theoretical literature on the determinants of capital structure see Harris and Raviv (1991). 24 : There is a positive relationship between leverage ratios and firm size 4. Growth Opportunities Growth opportunity can be defined as a firm‘s opportunity to invest in profitable projects. The growth opportunity can be measured by the annual growth of the firm‘s total assets. Myers (1977) argued that, due to information asymmetries between insiders and outsiders, companies with high leverage ratios might have the propensity to undertake activities contrary to the interests of debtholders or to invest in risky projects that expropriate wealth from debtholders13. Based on the above theoretical argument, the Hypothesis to be tested is as follows: 13 12 There is a negative relationship between Myers (1984) refers to this as a pecking order theory, which states that firms prefer the internal sources of funds to finance projects rather than debt. Therefore, it can be argued that firms with higher growth opportunities tend to Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 H4 : There is a negative relationship between leverage ratios and growth opportunities. 5. Corporate Tax (Non-debt Tax Shield) Modigliani and Miller (1963) argued that, as interest payments on debt are tax-deductible, firms with enough taxable income have an incentive to issue more debt to get the benefit from the tax deduction. However, a non-debt tax shield, such as depreciation, can be used to reduce the corporate tax. Thus, higher taxes might increase the demand for debt and reduce the benefit of the non-debt tax shield (Kremp et al., 1999). Jordanian companies are subject to tax on income generated in Jordan. The tax rates vary depending on the nature of the business activities. For example, the tax rate on Mining, Industry, Hotels, and Transportation is 15 %, while on other firms it is about 35%. 6. Liquidity According to Pecking Order Theory, firms with high liquidity will borrow less as they prefer to use their internal sources of funds. Thus, a negative relationship between liquidity and leverage is expected and, therefore, a lower risk of default. This argument is supported by the empirical findings of Ozkan (2001), Antoniou et al. (2002), Deesomsak et al. (2004), and others. Based on the above theoretical and empirical evidence, the Hypothesis to be tested is as follows: H5 : There is a negative relationship between liquidity and leverage ratios. 7. Earnings Volatility According to Pecking Order Theory, the volatility of earnings decreases the firm‘s debt capacity. So, a higher volatility of earning increases the firm‘s failure (default), as a firm may not be able to fulfil its obligations according to the distress theory (Deesomsak et al., 2004). The volatility of earnings is defined as the absolute difference between the annual changes in the earnings before interest and tax (EBIT) and the average of the change in earnings before interest and tax over the sample study. Thus, a negative relationship is expected between earnings volatility and the leverage ratio, and a positive relationship with the firm‘s default (failure). Thus, the Hypothesis to be tested is as follow: H6 : There is a negative relationship between the rather than debt when their share prices increase. So, the history of share prices has an impact on the firms‘ capital structure, firms‘ health, and their default or failure. Thus, the Hypothesis to be tested is as follows: H7 : There is a negative relationship between leverage ratios and share price performance. 9. Stock Market Developments Another important variable to be considered in this study is the Stock‘s Market activity. According to Demirguc-Kunt and Maksimovic (1996), financial market development plays a significant role in a firm's financing decision. Firms‘ preference for debt over equity decreases as the stock market‘s activity increases. Amman Stock Exchange (ASE) was considered to be the most efficient stock exchange in the Arab world, as well as the largest and fastest growing market in the region open to investors (JIB, 2005). The efficiency of the ASE could affect the firm‘s leverage ratio as it provides liquidity to the firm's. Thus, the Hypothesis to be tested is as follows: H8 : There is a negative relationship between the leverage ratios and Stock Market capitalisation. 10. Regional Crises (Gulf Crisis) During our sampling period of 1989-2003, Jordanian macroeconomic factors such as interest rates, political instability around Jordan, or regional crises such as the Gulf Crisis in 1990-1991 and Intifadah in 2000 affect the Jordanian economy. The Gulf Crisis in 1990-1991 and Intifadah in 2000 severely affected the capital market in Jordan as the Jordan market depends on Iraq, the Gulf States, and Palestine to export its production. For example, market capitalisation fell by about 14% in 1990 and 20.5% in 2000. Following 1990, the Jordanian capital market experienced a significant growth of investment as a refuge from the Gulf States and Iraq. Also, the outbreak of the Intifadah in September 2000 affected the Jordanian capital market negatively, which also had an impact on the increasing number of defaulted and distressed firms in Jordan. Raising capital during the Gulf Crisis 1990-1991 and the Intifadah became costly, and yet necessary, for most Jordanian companies that depended on the Iraqi, Gulf States, and Palestinian markets. Therefore, these regional crises may cause time-series effects on corporate leverage. Based on the above argument, the Hypothesis to be tested is as follows: volatility of earnings and leverage ratios. H9 : 8. Share Price Performance or Market Performance According to market timing theory, the share price performance negatively affects the leverage ratios (Baker and Wurgler, 2002), as firms prefer equity crises) affects leverage ratios have low leverage ratios, as they tend to use the internal sources of funds rather than debt. Political Instability around Jordan (regional 11. Uniqueness (Industry Effect) Each industry may have specific features that affect the debt structure of firms in that industry (see Hovakimian et al. (2001). These may arise from the 25 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 different business environments of industries, the degree of competition in product markets, the capital required in these industries, and the skill composition of the industries (See Wei, Xie and Zhang, 2005). Thus, the Hypothesis to be tested is as follows: H10 : Firm‟s Industrial Sectors Affect Corporate Leverage. The objectives of this paper are to examine the determinants of capital structure for Jordanian firms, to examine the effect of industrial sector, Gulf Crisis 1990-1991, and the outbreak of Intifadah in September 2000 on the firm's capital structure. The next section introduces the research method. 4. Data and Methodology profitability (PROF), we use earnings before interest, tax, and depreciation (EBITD), divided by total assets. Tangibility (TANGB) is measured by the ratio of net fixed assets to total assets. The growth is proxied by the annual growth of the firm‘s total assets (Growth)18. The liquidity (LIQ) is measured by the ratio of current assets to current liabilities. The volatility of earnings (VOE) is measured by the absolute difference between the annual percentage change in earnings before interest and tax (EBIT) and the average of this change over the sample period. The share price performance (SPPR) is measured by the difference of the logs of annual share prices. The stock market activity (SMA) is measured by the ratio of the market value of a firm's traded shares to market capitalisation (See Table 3 for variables definitions). 4.1. Data Annual data were obtained from the Amman Stock Exchange (ASE) to cover the period 1989-2003. This resulted in a panel database of 1595 cases for 167 companies14. Appendix 1 depicts the Number of Listed Firms used in the Study by Sector over the period 1989-2003. The data used in the analysis is constructed from balance sheet and income statement information from the Amman Stock Exchange (ASE)15, and from the tax department. Furthermore, firms' annual share prices and capitalisation are constructed from the Amman Stock Exchange (ASE). The sample includes all non-financial firms listed on the Amman Stock Exchange (ASE). A sub-sample was extracted from the main sample that included healthy firms to check the effect of bankruptcy on the leverage ratio. Our main sample includes both financially sound companies and defaulted companies to avoid bias, as the probability of bankruptcy may have a significant effect on a firm‘s financing decisions. 4.2. Explanatory Variables The selection of the dependent and independent variables is guided by the previous empirical studies and the theoretical issues. In this study five variables are used to measure leverage. These are the ratio of total debt to total assets (TDTA), short-term debt to total assets (STDTA), long-term debt to total assets (LTDTA)16. The logarithm of total assets is used to measure a firm's size (SIZE)17. To measure a firm‘s 14 To have a list of the companies used in this study please contact the author. 15 It is worth noting that the data related to tax, depreciation, interest payments, and cash flow was collected manually with enormous effort. 16 It is worth noting that the total debt to total equity (TDTE) and total debt to total capital (TDTC) were tried in this study. 17 The logarithm of total sales and the logarithm of market capitalisation are tried in this study. 26 Insert Table 3 Here 4.3. Econometrics models To assess the determinants of capital structure and to investigate the effect of the default risk on the capital structure, an individual firm‘s leverage ratios are modelled as a function of several factors that affect the capital structure. We estimate the following model for the two samples of companies in a panel data approach: Leverage it 0 1TANGB it 2 PROFit 3SIZE it 4Growthit 5 LIQ it 6VOE it 7SPPR it 8SMC it 9TAX it i u it where Leverage it (1) denotes leverage and is computed as the ratio of total debt to total assets (TDTA), shortterm debt to total assets (STDTA),and long-term debt to total assets (LTDTA), in alternative estimations; TANGB refers to the firm‘s tangibility, PROF refers to the profitability measured by earnings before interest, tax and depreciation, divided by total assets, LIQ refers to the liquidity, VOE the volatility of earnings, SPPR refers to the share price performance, SIZE refers to the logarithm of total assets, Growth refers to the annual growth of the firm‘s total assets, and SMA refers to the stock market activity. i is used to capture the unobserved individual effects (either Fixed Effects model or Random Effects model), and uit is the error term, which represents the measurement errors in the independent variables and any explanatory variables that have been omitted. The non-debt tax shield was not included as there is a strong correlation with the profitability variable PROF. Pooled ordinary least squares (OLS) will be estimated to compare their results with the panel data 18 The annual growth of the firm‘s total sales and the book value of total assets less the book value of equity plus the market value of equity divided by the book value of total assets are used in this study. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 in order to decide whether the panel model is appropriated. 5. Empirical Results possible to include both of them. In this case, the PROF variable is used in the study as it is expected to have a more significant impact on a firm‘s capital structure. 5.1. Descriptive Statistics Insert Table 5 Here Table 4 reports the summary statistics of mean, standard deviation, maximum, minimum, coefficient of variation (CV)19, skewness, and kurtosis for all variables used in the analysis. Based on the first measure of leverage TDTA, the reported mean ratio is about 0.36 and it is relatively small and close to the ratio 0.377 reported by Omet and Mashharawe (2004) for Jordanian companies. Table 4, also shows that the leverage of ratio LTDTA has the lowest standard deviation. Note that there is a large difference in the variance of the dependent variables used in the analysis as measured by the standard deviation. For example, the variable TDTA has a standard deviation of 3.56, which is significantly higher than the 0.85 standard deviation of TDTE. Insert Table 4 Here 5.2. Diagnostic Tests In order to control for multicollinearity, a diagnostic test using the correlation matrix and the variance inflation factors was employed. Table 5 presents the correlation matrix of the explanatory variables. The low intercorrelations between the explanatory variables used in the regressions indicate that there is no reason to suspect serious multicollinearity20. However, there is a high intercorrelation between PROF and the non-debt tax shield (NTS), so it is not 19 The coefficient of variation CV is defined as the standard deviation over the mean. 20 The Breusch-Pagan Lagrange Multiplier test (1980) for a diagonal matrix (that is, no cross-section correlation) is N i 1 carried out. The statistic test is: LM T rij2 i 2 where r square ( ) distribution under the null hypothesis that all the exogenous variables are equal to zero. 2 5.3. Empirical Results The coefficient of variation indicates that there is a significant variation among the explanatory variables used in the study. The mean for the profitability (PROF) of the Jordanian companies is 9 percent, which is very low, the main reason being that the sample includes defaulted firms. The ratio of fixed assets to total assets (TANGB) is about 47 percent which is higher than other countries such as Thailand (0.44), Malaysia (0.38), and Australia (0.33) (Deesomsak, Paudyal and Pescetto, 2004). The growth opportunities measure for Jordanian companies is quite small at 0.66 compared to Oman for example, with 1.58, as reported by Omet and Mashharawe (2004). 2 ij is To ensure the robustness of the estimates, several diagnostic tests on the chosen estimations are performed. The Breusch-Pagan Lagrange Multiplier test (1980) for random effect is reported at the bottom of each table of the results for the determinants of capital structure. The Breusch-Pagan Lagrange Multiplier test is used to examine the suitability of the Random Effects model over the pooled Ordinary Least Square (OLS) estimation. STATA software allows the estimation of White‘s corrected covariance matrix for group-wise heteroskedasticity (Greene, 2003, p.315). The overall significance of the models was tested using the Wald test, which has a Chi- the ijth residual correlation coefficient. j 1 The analysis of the results is presented here in different sub-sections. It begins with an analysis of the determinants of capital structure for two samples using the leverage ratio TDTA, and then the results of different measures of leverage are presented. The analysis then moves on to examine the effect of the Gulf Crisis (1990-1991) on Jordanian firms‘ capital structure. This includes an analysis of the statistical significance of each variable. The pooled OLS regression and Random-Effects model are used in this analysis. Also, the results of the Fixed-Effects model are reported. The Random-Effects model and OLS are then used to examine the effect of the Industrial sectors on capital structure decisions. Specifically, the results of the five measures of leverage using the same explanatory variables are presented in this section. In order to explore the appropriateness of a Random-Effects model, a Breusch-Pagan Lagrange Multiplier test is conducted for the overall significance of these effects. According to the Breusch-Pagan test, the null hypothesis is that the random components are equal to zero. This test also provides support for the rejection of a pooled Ordinary Least Squares (OLS) over a Generalized Least Squares (GLS). The Breusch-Pagan test for the TDTA, STDTA, and LTDTA provides support for using the Random Effects model over a pooled OLS. Additional support for the Random-Effects model was further obtained from the Hausman test of model specification, given that the results failed to reject the null hypothesis of ―no difference‖ between the coefficients of the Random and Fixed-Effects models. Also, the Random-Effects model has an important advantage over the Fixed-Effects model, as it has the 27 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 ability to account for time–invariant predictors. As the industrial dummy variables are important in this analysis, the Random-Effects model may be more efficient and robust than the Fixed-Effects model. The overall significance of the models was tested using the Wald test, which has a Chi-square ( ) distribution under the null hypothesis that all the exogenous variables are equal to zero. The overall significance of the models is very high, significant at least at the 1% level in all estimations using the Random-Effects model. The overall goodness of fit 2 2 ( R ) for the Random-Effects model is greater than the goodness of fit of the Fixed-Effect model in all estimations. For example, the goodness of fit for TDTA for the full sample using the Random-Effects model is about 33% while it is 28% using the FixedEffects model. The estimation results of Equation (1) using two samples are presented in Table 6 using the OLS, Random-Effects model, and Fixed-Effects model. Table 6 reports the determinants of TDTA for two samples with defaulted firms and without defaulted firms. Table 7 reports the determinants of short-term debt to total assets (STDTA) and long-term debt to total assets (LTDTA). The results of the heteroskedasticity test show that our models do not suffer from a heteroskedasticity problem21. The observed Chi-squared value is not significant at the 5 percent level in our estimations. Insert Table 6 Here Insert Table 7 Here From hypothesis 1, the variable representing the tangible assets is expected to have a positive and significant impact on a firm‘s leverage TDTA and LTDTA, while a negative and significant relationship between STDTA and tangibility is expected. Based on the reported results in Table 6, the relationship between leverage (TDTA) and tangibility (TANGB) 22 is positive and significant at the 1 percent level. The result of the tangibility is consistent with the agency theory proposition that there are agency costs associated with the use of debt. It is also consistent with the hypothesis that there is a positive relationship between debt and the cost of bankruptcy which causes financial distress and increases the firm‘s likelihood of default. In other words, tangible assets increase the firm‘s ability to raise debt and reduce the likelihood of default. As predicted, Table 7 shows that there is a negative and significant relationship between tangibility and short-term debt. Table 7 also shows that there is a positive and significant relationship between long-term debt and tangibility. The finding of a positive relationship between tangible assets and leverage is consistent with the prior research based on developed country capital markets, including Titman and Wessels (1988), Rajan and Zingales (1995), among others. The results also similar to those of Wiwattanakantang (1999) and Omet and Mashharrawe (2004), who examined firms, traded on emerging markets. However, for Thailand firms, Booth et al. (2001) reported different results. They found a negative and significant relationship between tangibility and leverage. The findings of a negative relationship between tangible assets and short-term debt and a positive and significant relationship between long-term debt and tangibility are consistent with those of Bevan and Danbolt (2002). Hypothesis 2 predicts that firms with a high profitability ratio tend to decrease their leverage ratio, thus the coefficient of PROF is expected to be negatively related to leverage. From the regression results in Table 6 and Table 7, as predicted, profitability (PROF) is found to have a negative and significant effect on the firm‘s leverage ratios TDTA, STDTA, and LTDTA, with a high level of significance23. This result is consistent with, and supports, the pecking order theory, which argues that external finance is costly and firms prefer internal sources of finance. It is also consistent with the Trade-off theory hypothesis that high profitability increases the firm‘s debt financing capacity and the strength of the accompanying tax shield and, hence, decreases the firm‘s likelihood of default. These results, reported in Table 6 and Table 7, are consistent with most of the prior research based on developed capital markets including Titman and Wessels (1988), Rajan and Zingales (1995), Bevan and Danbolt (2002), Zoppa and McMahon (2002), and Cassar and Holmes (2003), among others. The results are also similar to those of Wiwattanakantang (1999), Booth et al. (2001), Chen (2004) from emerging markets, which is notable since our study includes additional firm specific variables. It is worth noting that NTS is used instead of PROF and found to be negative, but not significant, at any level of significance, which is not consistent with the previous findings such as Wiwattanakantang (1999) and Deesomsak et al. (2004), among others. From hypothesis 3, the firm‘s size is expected to have a positive impact on the firm‘s leverage. From the regression results in Table 6 and Table 7, as predicted, firm size (SIZE) is found to have a positive and statistically significant impact on a firm's leverage ratios TDTA, STDTA, and LTDTA at the 1 percent level24. The positive and significant relationship 21 The heteroskedasticity test for across panels can be run using the xtgls command in Stata 8. 22 It is worth noting that TANGB is found to have a positive and significant impact on total debt to total equity (TDTE) but insignificant impact on total debt to total capital (TDTC). 28 23 It is worth noting that PROF is found to have a negative but insignificant impact on TDTE and TDTC. 24 It is worth noting that a firm‘s size is found to have a significant impact on TDTE and TDTC. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 between leverage and size indicates that large firms have a lower risk of default as they have access to external sources of funds. This finding is consistent with the trade-off theory, that larger firms might be more diversified and tends to have better borrowing capacity compared with smaller firms. Also, large firms tend to have a lower bankruptcy cost and are less likely to default (Bevan and Danbolt, 2002). So small firms are expected to borrow less than large firms and tend to have a high likelihood of default. The finding of a positive relationship between size and leverage is consistent with the prior research based on developing countries including Wiwattanakantang (1999) and Booth et al. (2001). The result is also consistent with research based on developed countries including Titman and Wessels (1988) and Rajan and Zingales (1995). On the other hand, the result for long-term debt is inconsistent with Bevan and Danbolt (2002) who report that size is found to be positively related to the long-term debt and negatively related to the short-term debt. From Hypothesis 4, growth opportunity is expected to have a negative impact on leverage. The regression result in Table 6 and Table 7 shows that the impact of growth opportunity (Growth) 25 on leverage is positive, but is not significant using the Random-Effects model. This result does not give statistically significant support to the prediction of the pecking order theory that growing firms are likely to choose debt rather than equity. Our result is consistent with that of Omit and Mashharawe (2004) which finds that growth opportunity does not affect the leverage ratio for Jordanian firms. It is also inconsistent with other previous studies (e.g. Pandey (2001), and Buferna, Bangassa and Hodgkinson (2005)). This result is also not consistent with the prediction of agency theory that high growth firms use less debt since they do not wish to expose themselves to possible restrictions imposed by lenders. Another variable found to be a determinant of corporate leverage in Jordan is the liquidity ( H 5 ). The results reported in Table 6 and Table 7 show that liquidity (LIQ) has a negative and significant impact on the leverage ratios TDTA and STDTA, while it has a negative but not significant effect on the leverage ratio LTDTA. The negative and insignificant effect between the LDTTA and liquidity could be because most Jordanian firms depend on short-term debt rather than long-term debt as a result of the banks credit policy. This finding is consistent with agency theory and pecking order theory propositions that firms prefer to use their internal sources of funds to finance their investment26. It is also consistent with the free cash flow theory as firms prefer the internal source of funds since it decreases the risk of default. The higher liquidity ratio increases the firm‘s ability to meet its short-term obligations and, hence, decreases the risk of default (failure). This finding is consistent with prior empirical research such Ozkan (2001), Antoniou et al. (2002), and Deesomsak et al. (2004), among others. Hypothesis 6 predicts that volatility of earnings is negatively related to leverage. From the regression results in Table 6 and Table 7, VOE is found to have a positive but not significant effect on all measures of leverage, and this result is consistent with other studies such as Wiwattanakantang (1999) and Deesomsak et al. (2004). The finding is not consistent with the trade-off theory that firms with a high volatility of earning have a high risk of default and a lower debt capacity. Hypothesis 7 tests whether share price performance can be a significant determinant of corporate leverage in Jordan. From the regression results in Table 6 and Table 7, the coefficient of share price performance (SPPR) is negative, as expected, but does not have a significant effect on TDTA and LTDTA27. The finding does not support the market timing theory that firms prefer equity to debt when share prices increase. This result could reflect the view that most of Jordanian firms depend on banks as a source of funds rather than using the equity market, or it could be that firms ignore the volatility of earnings if the cost of entering into liquidation is low (Deesomsak et al., 2004). Hypothesis 8 predicted a negative relationship between SMC and leverage. From the regression results in Table 6 and Table 7, the relationship between stock market activity (SMC) and the leverage ratios TDTA and LTDTA is found to be significant and negative28. This result is consistent with the Demirguc-Kunt and Maksimovic (1996) argument, that financial market development plays an important role in firms‘ financing choice. However, the SMC is found not to have a significant impact on STDTA. It also shows that the activity of the Amman Stock Exchange (ASE) decreases the demand for debt. Therefore, as the ASE activity increased as companies' preference for equity over debt increased. 5.4. Regional Crises (Gulf Crisis) From Hypothesis 9, regional crises; Gulf Crisis 90-91 and outbreak of the Intifadah in September 2000, are 26 25 The other two measures of growth were used in the study and found to have a positive effect on firm‘s leverage. Growth in sales is found to be not significant, while the growth ratio (Growth3) measured by book value of total assets minus book value of equity divided by the book value of total assets has a positive and significant impact on the leverage ratio, at the 1% level of significance. Due to the high correlation between Growth3 and PROF we used Growth is assets in our analysis. It is worth noting that LIQ is found to have a negative and significant impact on TDTC, while it has a negative but insignificant impact on TDTE. 27 27 It is worth noting that SPPR is found to have a positive and significant impact on TDTC, while it does not have any significant impact on TDTE. 28 28 It is worth noting that SMC is also found to have a negative and significant impact on TDTC and TDTE reflecting the importance of stock market activity on corporate finance decisions. 29 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 expected to have a significant impact on corporate leverage. The results for the estimated effect of the Gulf Crisis of 1990-1991 and Intifadah and the macroeconomic factors are presented in Table 6 and Table 7. The estimated coefficients on time dummies suggest significant effects of macroeconomic variables on firms' leverage, implying that major changes to the overall economic environment may significantly affect a firm's choice of capital structure. From 1990 to 1993, time dummies almost had a significant effect on the firm‘s leverage ratios TDTA and LTDTA. The significance of the time dummies DUM1990, DUM1991, DUM1992 and DUM1993 show that the Gulf Crisis 1990-1991 had a positive impact on the leverage ratio as firms' demand for debt to finance short-term obligations increased. Another reason that could have lead to an increase in the leverage ratios during the Gulf Crisis is that banks‘ credit policies may have encouraged firms to borrow and invest. The time dummy variable DUM1995 had a significant effect on the capital structure. The time dummies DUM1994, DUM1996, DUM1997, DUM1998, DUM1999, DUM2000, DUM2001, and DUM2002 had no significant effect on the firm leverage ratios TDTA and LTDTA. The outbreak of the Intifadah in September 2000 is found to have had no significant impact on the firm leverage ratios TDTA and LTDTA29. From Hypothesis 10, industrial sectors are expected to have a significant impact on corporate leverage. The results of including dummy variables for industries are reported in Table 8. This Table shows that the results have changed very little. For example, the growth (Growth)30 becomes highly significant as we control for industrial sectors in the Random Effects model. In this study, 16 dummy variables are included in the regression. It is worth noting that the Hotels and Tourism, Transportation, and Educational services are dropped from the regression; therefore, they are excluded from the analysis. The dummy variables for the Foods sector, Paper, Glass, and Packaging sector, Steel, Mining and Heavy Engineering sector, Chemical and Petroleum sector, Textiles and Clothing sector, Utilities and Energy sector, Construction and Engineering sector, Real Estate sector, and Trade, 29 It is worth noting that, the outbreak of the Intifadah in September 2000 had a significant impact on other measures of leverage, such as TDTE and TDTC, at a high level of significance. The significance impact of DUM2000 on TDTE and TDTC shows that most Jordanian firms increased their debt to equity and capital during 2000 as a result of the impact of Intifadah. 30 The growth ratio measured by book value of total assets minus book value of equity divided by the book value of total assets is also found to be significant and positive in both the Random Effects model and the OLS, while the growth in sales is found to have a positive but not significant effect in the three models. 30 Commercial services, Rental, and Communication sectors, have a positive and significant impact on the financial leverage. This indicates that these sectors have a high demand for debt and have high leverage ratios in capital structure compared with other sectors. It also shows that firms in these sectors have the ability to borrow more, which increases their ability to manage debt in their capital structure. The dummy variable for the Medical services sector has a negative and significant impact on the leverage ratio. The negative coefficient of Medical services indicates that these firms have a lower ability to increase their leverage. It may also indicate that these firms have a lower demand for debt. The other industrial dummy variables for Medical and Pharmaceutical services, Tobacco, and Media sectors do not have a significant impact on firms' leverage TDTA. The finding is consistent with prior empirical research such as Titman (1984) and Bradley, Jarrell and Kim (1984), that that firm industry sectors affect corporate leverage. It is worth noting that the other two measures of size, the logarithm of total sales (SAL) and the logarithm of market capitalization (CAP) are significant. Regarding the other two measures of growth, the book value of total assets less the book value of equity plus the market value of equity divided by the book value of total assets had a positive and significant impact on leverage in the three models, while the annual growth of the firm‘s total sales had a positive but not significant effect in the three models. 6. Conclusion This paper analyses the capital structure of the listed firms on the Amman Stock Exchange (ASE) from 1989 to 2003. The issue of how firms in developing countries finance their activities attracts considerable interest since most of the theoretical and empirical work on capital structure considers only developed countries. Hypotheses were developed to test which capital structure theories best explained the Jordanian companies‘ capital structure, by comparing the relationships between long-term debt, short-term debt, total debt to total assets, total debt to total capital, and total debt to shareholders equity and eight explanatory variables that represent profitability, growth, tangibility, liquidity, size, volatility, market performance, and financial market development. Based on the time period 1989-2003, our results indicate that Jordanian companies mostly depend on short-term debt, as a result of the banking credit policy that promotes on short-term debt. Our results suggest that the level of gearing in Jordanian firms is positively related to size, tangibility, volatility of earnings, and negatively correlated with profitability, the level of growth opportunities, liquidity and stock market activities. The level of gearing measured by short-term debt is, however, negatively correlated with tangibility. The Gulf Crisis between 1990 and Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 1991 is also found to have a significant and positive impact on Jordanian corporate leverage. The rationale behind this finding is that most Jordanian companies export their products to Gulf markets, and the demand for the exporting product increased, leading to many not having enough liquidity to finance their expansion. The outbreak of Intifadah in September 2000, however, does not have a significant impact on the firms' leverage ratios, measured by TDTA, LTDTA, and STDTA. The finding of a strong positive relationship between size and leverage, as well as between the size and the leverage measured by short-term debt, suggests that the capital structure decision with inadequate long-term debt access is influenced more strongly and positively by factors such as the bankruptcy cost which is represented by SIZE. Furthermore, the finding of a very strong negative relationship between market activity and gearing further supports our previous finding that Jordanian firms have inadequate long-term debt access as their source of financing. Once the ASE activity increased, companies' preference for equity over debt increased substantially due to their inadequate long-term debt access and the high cost of short-term debt. We conclude that the capital structure decision with inadequate long-term debt access is influenced more strongly by factors such as bankruptcy costs and Stock Market Activity (SMA). References 1. Antoniou, A., Y. Guney, and K. 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The Average of Leverage Ratios for Jordanian Listed Firms 1989-2003 Year STDTA LTDTA TDTA STDTE LTDTE TDTE TDTC 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 0.389 0.433 0.429 0.344 0.329 0.261 0.250 0.248 0.249 0.255 0.249 0.327 0.238 0.101 0.075 0.065 0.058 0.054 0.043 0.042 0.046 0.057 0.073 0.071 0.062 0.068 0.508 0.523 0.518 0.423 0.401 0.314 0.305 0.313 0.328 0.353 0.357 0.365 0.345 0.966 1.708 1.674 0.957 0.262 0.437 0.468 0.504 0.691 0.506 1.213 1.209 0.542 0.3242 0.471 0.182 0.143 0.129 0.096 0.098 0.109 0.082 0.117 0.367 0.163 0.216 1.359 2.279 1.983 1.200 0.471 0.595 0.636 0.690 0.857 0.725 1.670 1.572 0.876 1.634 1.691 1.630 1.409 1.345 1.194 1.227 1.287 1.224 1.055 1.039 1.144 1.087 2002 2003 0.226 0.214 0.069 0.057 0.338 0.309 0.331 0.324 0.165 0.123 0.643 0.625 1.096 1.056 Average 0.296 0.063 0.380 0.786 0.186 1.079 1.274 Source: Amman Stock Exchange and author's calculation based on data from annual reports. 32 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Default Non-default Figure 1. Average Leverage Ratio TDTA in Defaulted and Non-Defaulted Firms: 1989-2002 Source: Amman Stock Exchange and author's calculation based on data from annual reports. Table 2. Average Leverage Ratios in both Defaulted and Non-Defaulted Firms over 1989-2002 LTDTA Year STDTA TDTE TDTC 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Default 0.11 0.05 0.04 0.04 0.05 0.05 0.04 0.07 0.12 0.16 0.09 0.06 0.24 0.16 Non-default 0.10 0.09 0.07 0.07 0.05 0.04 0.04 0.04 0.04 0.05 0.07 0.06 0.06 0.07 Default 0.47 0.64 0.66 0.48 0.42 0.29 0.26 0.27 0.25 0.29 0.32 0.40 0.48 0.63 Non-default 0.35 0.34 0.33 0.29 0.29 0.25 0.25 0.24 0.25 0.25 0.23 0.31 0.36 0.44 Default 1.40 2.66 3.16 2.22 -0.27 0.59 0.66 0.88 0.46 0.74 6.49 4.97 2.62 4.89 Non-default 1.34 2.11 1.45 0.82 0.74 0.60 0.63 0.63 0.94 0.72 0.66 0.98 0.77 0.57 Default 1.51 1.62 1.70 1.24 1.07 1.32 1.05 1.11 0.57 0.67 1.01 1.44 1.46 0.93 Non-default 1.69 1.72 1.60 1.47 1.44 1.15 1.28 1.34 1.37 1.14 1.05 1.09 1.06 1.10 Average 0.09 0.06 0.42 0.30 2.25 0.93 1.19 1.32 Source: Amman Stock Exchange and author's calculation based on data from annual reports. Table 3. Variables Definitions Variable TDTA TDTE TDTC STDTE LTDTA TANGB PROF LIQ SIZE Growth NTS SPPR VOE SMC Variable Definition Total debt/Total assets Total debt/Total equity Total debt/Total capital Short-term debt/Total equity Long term debt/ Total assets Total Fixed assets/Total assets (Earnings before interest and tax plus Depreciation)/Total assets Current liabilities/Total assets Logarithm of Assets Changes in Total Assets Depreciation/Total assets Share Price Performance (log P1 - log P0 ) Volatility of Earnings (EBIT EBIT Average) 1 0 Stock Market Activity (Market value of traded shares/market value of stock market capitalisation 33 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 4. Description Statistics for the Dependent (s) and Independent Variables Variable TDTA Mean 0.366 Std. Dev. 3.56 Minimum 0 STDTA 0.311 0.85 0 LTDTA 0.062 0.115 TDTE 1.899 SIZE CV 9.73 Skewness 2.95 Kurtosis 18.31 26.71 2.73 23.97 673.52 0 2.023 1.85 5.005 62.428 35.28 -15.67 1407.99 18.58 39.21 1562.01 6.9 0.6 5.07 9.04 0.09 0.73 4.24 PROF 0.09 0.25 -6.25 0.7 2.78 -15.46 349.14 TANGB 0.47 0.26 0 0.98 0.55 0.03 2 Growth 0.33 8.68 -0.87 328.61 26.30 37.71 1427.29 NTS 0.12 2.05 0 76.86 17.08 34.28 1236.87 LIQ 17.72 127.06 0.02 3331.44 7.17 16.83 362.16 VOE 0.68 11.96 -278.85 53.58 17.59 -16.77 371.72 SPPR -0.01 0.18 -1.58 0.88 -18.00 -0.14 10.86 0 0.23 2.00 8.23 89.63 SMC 0.01 0.02 Note: See Table 3 for variable definitions. Maximum 3.555 Table 5. Correlation Matrix for the Explanatory Variables SIZE PROF TANG Growth1 NTS LIQ VOE SPP SIZE 1 PROF 0.057 1.000 TANGB 0.078 0.041 1.000 Growth -0.022 0.018 -0.067 1.000 NTS -0.029 -0.911 -0.081 -0.002 1.000 LIQ -0.176 -0.070 -0.096 0.022 0.031 1.000 VOE -0.025 0.001 0.007 0.001 -0.001 0.040 1.000 SPPR 0.022 0.086 -0.024 0.044 -0.002 -0.034 -0.025 1.000 SMC 0.571 0.078 0.066 -0.012 -0.014 -0.056 -0.021 0.034 SMC 1.000 Note: Annual growth of total assets SMC (Stock market capitalisation) is the ratio of traded value to the market capitalisation. See Table 3 for variable definitions. Table 6. Regression Results for Total Debt to Total Assets (TDTA) Independent Variables Constant TANGB PROF SIZE LIQ VOE SPPR Growth SMC 34 Full Sample (defaulted and non-defaulted Firms) Sample without defaulted Firms OLS Random Effect Fixed effect OLS Random Effect Fixed Effect -1.0873 (-11.21)*** 0.156 (5.63)*** -0.0459 (-1.97)** 0.1938 (14.52)*** -0.0051 (-7.03)*** 0.0003 (0.6) -0.0669 (-1.58) -0.0002 (-0.45) -3.0248 (-7.06)*** -0.7158 (-4.34)*** 0.2010 (5.53)*** -0.0623 (-2.38)** 0.1386 (6.06)*** -0.0060 -6.95)*** 0.0003 (0.71) -0.0304 (-1.04) 0.0007 (1.39) -1.4483 (-3.01)*** -0.7950 (-2.79)*** 0.2238 (4.88)*** -0.1740 (-4.23)*** 0.1519 (3.84)*** -0.0075 (-6.29)*** 0.0003 (0.80) -0.0163 (-0.55) 0.0027 (3.6)*** -1.0426 (-2.02)** -1.1255 (-11.27)*** 0.1448 (5.07)*** -0.0254 (-1.09) 0.2015 (14.66)*** -0.0048 (-6.48)*** 0.0004 (0.62) -0.0472 (-1.09) -0.0003 (-0.61) -3.0266 (-7.09)*** -0.6461 (-3.78)*** 0.1931 (5.00)*** -0.0253 -(0.97) 0.1308 (5.55)*** -0.0062 (-7.09)*** 0.0003 (0.71) -0.0318 (-1.09) 0.0002 (0.46) -1.3493 (-2.88)*** -0.5765 (-1.98)** 0.2081 (4.12)*** -0.0822 (-1.98)** 0.1237 (3.09)*** -0.0078 (-6.52)*** 0.0003 (0.73) -0.0275 (-0.93) 0.0013 (1.670)* -1.0476 (-2.090)** Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 6 continued DUM1990 DUM1991 DUM1992 DUM1993 DUM1994 DUM1995 DUM1996 DUM1997 DUM1998 DUM1999 DUM2000 DUM2001 DUM2002 Observation Adjusted R-square Wald-test 0.1744 (5.02)*** 0.1646 (5.05)*** 0.1606 (4.94)*** 0.1335 (4.08)*** 0.0619 (1.87)* 0.0630 (1.93)** 0.0427 (1.31) 0.0552 (1.71)* 0.0443 (1.35) 0.0355 (1.11) 0.0504 (1.55) -0.0027 (-0.1) 0.0010 (0.04) 0.1407 (5.69)*** 0.1253 (5.43)*** 0.1172 (5.11)*** 0.1007 (4.39)*** 0.0370 (1.61) 0.0395 (1.75)*** 0.0158 (0.7) 0.0315 (1.41) 0.0265 1.17 0.0115 (0.52) 0.0226 (1.00) -0.0001 (0) 0.0022 (0.13) 0.1453 (5.62)*** 0.1254 (5.27)*** 0.1160 (4.94)*** 0.1000 (4.29)*** 0.0363 (1.56) 0.0361 (1.58) 0.0089 (0.39) 0.0259 (1.15) 0.0218 (0.96) 0.0045 (0.20) 0.0164 (0.72) 0.0022 (0.12) -0.0008 (-0.05) 0.1548 (4.33)*** 0.1376 (4.1)*** 0.1280 (3.8)*** 0.1059 (3.14)*** 0.0479 (1.39) 0.0429 (1.27) 0.0177 (0.52) 0.0312 (0.93) 0.0200 (0.59) 0.0028 (0.08) 0.0070 (0.21) -0.0166 (-0.62) -0.0129 (-0.5) 0.1115 (4.51)*** 0.0951 (4.13)*** 0.0817 (3.55)*** 0.0672 (2.93)*** 0.0151 (0.65) 0.0125 (0.55) -0.0108 (-0.48) 0.0061 (0.27) 0.0023 (0.1) -0.0188 (-0.85) -0.0194 (-0.86) -0.0186 (-1.09) -0.0147 (-0.88) 0.1055 (4.08)*** 0.0882 (3.71)*** 0.0751 (3.18)*** 0.0605 (2.59)*** 0.0090 (0.38) 0.0053 (0.23) -0.0190 (-0.83) -0.0016 (-0.07) -0.0037 (-0.16) -0.0253 (-1.14) -0.0252 (-1.1) -0.0186 (-1.09) -0.0176 (-1.06) 834 834 834 763 763 763 0.3344 0.3283 0.2835 0.3413 0.3294 0.2955 F= 8.31 (0.00)*** F= 19.34 (0.00)*** F= 20.92 (0.00)*** 2 = 212.12 (0.00)*** 2 = 191.79 (0.00)*** 2 = 23.56 Huasman Test F= 7.16 (0.00)*** 2 = 23.51 (0.3149) (0.318) 2 = 1190.59 2 = 1188.96 Breusch and Pagan Lagrangian (0.00)*** (0.00)*** Notes: *** Significant at 1% level, ** Significant at 5% level, and **Significant at 10% level. TANGB (tangibility) is the ratio of total fixed assets to total assets. PROF (profitability) is the ratio of earnings before interest, tax and depreciation to total assets. NTS (non-debt tax shield) is the ratio of depreciation to total assets. LIQ (liquidity) is the ratio of current assets to current liabilities. VOE (volatility of earnings) is the absolute difference between annual change in earnings before interest and tax and the average of this change. SPPR (share price performance) is measured as the first difference of logs of annual share prices. SIZE is the natural logarithm of total assets. Growth (growth opportunity) is the annual growth of total assets. SMC (Stock market capitalization) is the ratio of traded value to the market. See Table 3 for variable definitions. Table 7. Regression Results for Short-term Debt to Total Assets (STDTA) and Long-term Debt to Total Assets (LTDTA) ratio, 1989-2003 Constant TANGB PROF SIZE LIQ VOE SPPR Growth SMC DUM1990 OLS 0.0768 (0.36) STDTA Random-effect Model 0.0293 (0.12) Fixed-effect Model -0.0043 (-0.01) -0.2623 (-4.26)*** -3.7320 (-72.4)*** 0.0828 (2.8)*** -0.0076 (-4.74)*** 0.0012 (0.96) 0.4522 (4.83)*** 0.0009 (0.74) 0.3040 (0.32) 0.5744 (7.46)*** -0.2346 (-3.54)*** -3.7716 (-75.39)*** 0.0875 (2.63)*** -0.0069 (-4.34)*** 0.0012 (1.04) 0.4380 (5.05)*** 0.0001 (0.11) 0.6271 (0.61) 0.5771 (8.09)*** 0.1004 (1.13) -2.0239 (-25.5)*** 0.0600 (0.79) -0.0069 (-3.02)*** 0.0008 1.14 0.2018 (3.56)*** -0.0334 (-22.8)*** 1.2602 (1.27) 0.3375 (6.77)*** OLS -0.4327 (-11.76)*** LTDTA Random-effects model -0.3802 (-5.55)*** Fixed-Effects Model -0.389 (-3.18)*** 0.1062 (10.08)*** -0.0167 (-1.89)* 0.0625 (12.34)*** -0.0003 (-1.06) 0.0002 (0.84) -0.0153 (-0.96) 0.0001 (0.43) -0.1499 (-0.92) 0.0387 (2.94)*** 0.0976 (6.42)*** -0.0204 (-1.87)* 0.0560 (5.89)*** -0.0003 (-0.87) 0.0001 (0.52) -0.0122 (-0.99) 0.0003 (1.19) -0.3375 (-1.66)* 0.0393 (3.77)*** 0.096 (4.89)*** -0.042 (-2.38)** 0.057 (3.36)*** 0.000 (-0.21) 0.000 (0.46) -0.011 (-0.85) 0.001 (2.01)** -0.354 (-1.6) 0.043 3.86 35 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 7 continued DUM1991 DUM1992 DUM1993 DUM1994 DUM1995 DUM1996 DUM1997 DUM1998 DUM1999 DUM2000 DUM2001 DUM2002 No. of Observations Adj R-squared Wald-test 0.3883 (5.37)*** 0.3856 (5.35)*** 0.4200 (5.79)*** 0.3499 (4.76)*** 0.3047 (4.21)*** 0.1642 (2.27)** 0.1783 (2.5)** 0.1308 (1.8)* 0.0529 (0.75) 0.0564 (0.78) 0.0618 (1.04) 0.0137 (0.24) 834 0.8644 F=253.92 (0.00)*** 0.3909 (5.84)*** 0.3886 (5.82)*** 0.4201 (6.26)*** 0.3559 (5.24)*** 0.3108 (4.65)*** 0.1683 (2.52)** 0.1834 (2.78)*** 0.1345 (2.01)** 0.0564 (0.87) 0.0611 (0.92) 0.0544 (1.00) 0.0060 (0.11) 834 0.8676 2 =5838.5 0.00)*** 0.2373 (5.17)*** 0.2345 (5.17)*** 0.2532 (5.63)*** 0.2012 (4.47)*** 0.1778 (4.03)*** 0.0892 (2.03)** 0.1093 (2.52)** 0.0807 (1.84)* 0.0261 (0.61) 0.0343 (0.78) -0.0184 (-0.54) 0.0054 (0.16) 834 0.5635 0.0376 (3.04)*** 0.0277 (2.24)** 0.0101 (0.81) -0.0001 (0.00) -0.0046 (-0.37) -0.0063 (-0.51) -0.0046 (-0.38) 0.0009 (0.07) 0.0024 (0.2) 0.0011 (0.09) -0.0034 (-0.34) 0.0057 (0.57) 834 0.2998 F= 321.14 (0.00)*** F=17.99 (0.00)*** 2 = 732.32 Huasman Test 0.0386 (3.96)*** 0.0275 (2.83)*** 0.0114 (1.18) 0.0018 (0.18) -0.0032 (-0.34) -0.0053 (-0.56) -0.0032 (-0.34) 0.0020 (0.21) 0.0029 (0.31) 0.0005 (0.05) -0.0037 (-0.5) 0.0047 (0.64) 834 0.3144 2 =105.930 (0.00)*** 0.041 (4.04)*** 0.030 (2.99)*** 0.014 (1.41) 0.004 (0.42) -0.001 (-0.1) -0.004 (-0.39) -0.002 (-0.17) 0.003 (0.31) 0.004 (0.37) 0.001 (0.09) -0.004 (-0.49) 0.004 (0.49) 834 0.296 F= 3.250 (0.00)*** 2 = 6.60 (0.00)*** (0.9988) = 2 = 537.68 Breusch and Pagan 469.49 Lagrangian (0.00)*** (0.00)*** Notes: *** Significant at 1% level, ** Significant at 5% level, and *Significant at 10% level. See Table 3 for variable definitions. 2 Table 8. Regression Results for Total Debt to Total Assets (TDTA) with Industry Dummies Independent Variables Constant TANGB PROF SIZE LIQ VOE SPPR Growth SMC Dummy for Food Sector Dummy for Paper, Glass, and Packaging Dummy for Steel, Mining and Heavy Engineering Dummy for Medical Pharmacy Dummy for Chemical and Petroleum Dummy for Textiles and Clothing Dummy for Utilities and Energy Dummy for Tobacco 36 Pooled OLS regression -1.0724 (-10.42)*** 0.1969 (7.35)*** -0.0717 (-2.89)*** 0.1742 (12.44)*** -0.0038 (-5.65)*** 0.0004 (0.82) -0.0383 (-1.04) 0.0005 (0.97) -2.0820 (-5.16)*** 0.0935 (4.24)*** 0.1128 (4.79)*** 0.0667 (3.14)*** 0.0015 (0.05) 0.2308 (10.75)*** 0.1467 (4.94)*** 0.2938 (10.78)*** 0.0582 (0.88) Random-effect Model -0.8978 (-5.07)*** 0.2264 (6.22)*** -0.0999 (-3.38)*** 0.1467 (6.19)*** -0.0058 (-6.6)*** 0.0003 (0.73) -0.0272 (-0.94) 0.0014 (2.43)** -1.3090 (-2.75)*** 0.1368 (2.72)*** 0.1181 (2.13)** 0.0870 (1.79)* 0.0345 (0.53) 0.2299 (4.19)*** 0.1750 (2.27)** 0.2907 (4.42)*** 0.0808 (0.75) Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 8 continued Dummy for Construction and Engineering Dummy for Real Estate Dummy for Media Sector Dummy for Medical Services Dummy for Trade, Commercial Services, and Rental DUM1990 DUM1991 DUM1992 DUM1993 DUM1994 DUM1995 DUM1996 DUM1997 DUM1998 DUM1999 DUM2000 DUM2001 DUM2002 Adjusted R-square Wald-test 0.2151 (7.37)*** 0.0228 (0.65) 0.0171 (0.51) -0.1482 (-1.71)* 0.1343 (4.52)*** 0.1519 (5.00)*** 0.1349 (4.73)*** 0.1285 (4.52)*** 0.1071 (3.75)*** 0.0384 (1.33) 0.0426 (1.5) 0.0225 (0.79) 0.0362 (1.29) 0.0271 (0.95) 0.0130 (0.47) 0.0249 (0.88) -0.0020 (-0.08) 0.0033 (0.15) 0.53 F= 27.72 (0.00)*** Huasman Test Breusch and Pagan Lagrangian 0.2287 (3.02)*** 0.1735 (2.43)** 0.0343 (0.35) -0.2257 (-1.75)* 0.1385 (2.22)** 0.1412 (5.73)*** 0.1245 (5.42)*** 0.1157 (5.06)*** 0.0990 (4.34)*** 0.0345 (1.51) 0.0366 (1.63) 0.0117 (0.52) 0.0277 (1.25) 0.0222 (0.99) 0.0062 (0.28) 0.0171 (0.76) 0.0001 (0.01) 0.0016 (0.09) 0.53 2 = 284.53 (0.00)*** 11.53 (0.9515) 436.26 (0.00)*** Notes: *** Significant at 1% level, ** Significant at 5% level, and *Significant at 10% level. t-statistics are in parentheses. See Table 3 for variable definitions. 16 industrial dummy variables are included in the regression. The Hotels and Tourism, Transportation, and Educational Services are dropped from the regression, therefore not reported Appendix 1. Number of Listed Firms used in the Study by Sector over the Period 1989-2003 Sector No. of Firms Foods 19 Paper, Glass, and Packaging 12 Steel, Mining and Heavy Engineering 20 Medical Pharmacy 11 Chemical and Petroleum 11 Textiles and Clothing 8 Utilities and Energy 11 Tobacco 3 Construction and Engineering 10 Hotels and Tourism 11 Real Estate 10 Media 6 Medical Services 5 Trade and Commercial Services and Rental, Communication 17 Educational Services 3 Total 167 37 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 DIVIDENDS AND INSTITUTIONAL INVESTORS ACTIVISM: PRESSURE RESISTANT OR PRESSURE SENSITIVE? José María Diez Esteban*, Óscar López-de-Foronda** Abstract This paper provides new international evidence on the relationship between dividend policy and institutional ownership by analysing a sample of US and UK and Irish firms characterised by an AngloSaxon tradition and a matching sample of other EU companies from Civil Law legal systems. We hypothesize that, due to the different characteristics of both the legal system and the nature of agency conflicts in firms from those countries, the type of institutional investors and their role in corporate governance is different and so the use of dividend policy to solve the conflict of corporate governance problem differs in each legal system. We find that while in firms from Anglo-Saxon tradition the relation between dividends and institutional investors, pension and investment funds, is possitive, in Civil Law countries the relation is negative where investors are banks or insurance companies with other private interest inside the firm. These results are consistent with our hypotheses and breed new insights into the role of dividend policy as a disciplining mechanism in firms from different legal system with an important presence of institutional investors. Keywords: dividend policy, corporate governance, institutional investor activism, pressure and pressure insensitive, international financial markets * Departamento de Economía y Administración de Empresas, Área de Economía Financiera y Contabilidad, Universidad de Burgos, Plaza Infanta Elena, 09001 Burgos s/n, España. ** Corresponding author. Departamento de Economía y Administración de Empresas, Área de Economía Financiera y Contabilidad, Universidad de Burgos, Plaza Infanta Elena, 09001 Burgos s/n, España. Tel (34)-947259040, Fax (34)947258960. E-mail: [email protected] 1. Introduction Financial institutions' aggregate investments have grown substantially across world equity markets, and they have incentives to monitor managers when institutions are large shareholders. So, institutions may demand more dividends to avoid managerial discretion in the use of free cash flow ( Jensen; 1986) and to force firms to obtain external funds and be subject to monitoring by external capital markets (Short et al., 2002). In anglosaxon countries, institutional investors as pension and investments funds pension are frequent owners of important shareholdings and they can use the payout policies to play an active role in the corporate governance problems. But activities of institutional investors differs both across types of investors and across countries. Recent studies have focused on the different objectives of different institutional investors in corporate governance such as pension funds, banks, or insurance companies. Pound (1988) and Bhattacharya and Graham ( 2007) distinguish two types of institutional holdings: pressure sensitive investors when they are more sensitive to pressure from corporate management and pressure insensitive when they are not sensitive to pressure from corporate 38 management. Pressure sensitive investors are banks and insurance companies because they have frequently other business relations with companies. This type of investors is more frequent in countries where investors protection are weaker, the ownership concentration is higher and firms use more debt to finance their investments. It is the case of civil law countries where investors as banks and insurance companies with other private interest in firms try to reduce dividends to get their private interests inside firms contrary to the attitude of pressure resistant investors, pension and investment funds, which are more frequent in anglosaxon firms. The objective of our paper is to demonstrate that, due to the distinct characteristics of anglosaxon and civil law firms, the type of institutional investors and their role in corporate governance is different and so, the use of dividend policy to solve the agency problems differs in each legal system. Our results suggest that while in firms from Anglo-Saxon tradition the relation between dividends and institutional investors, pension and investment funds, is possitive, in Civil Law countries the relation is negative where investors are banks or insurance companies with other private interest inside the firm. So, different institutional investors can have a distinct impact on dividend policies according to the Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 particularities of corporate governance environments of each legal system. The paper proceeds as follows. Section 2 provides the arguments to link dividends and institutional shareholders in different legal system with the hypotheses to be tested, while the following section describes the data and methodology. Section 4 presents and discusses the major results. The final section summarizes and discusses the paper‘s contribution to the literature. impact of these investors on dividends policy could be negative or positive. Therefore, we set two different hypotheses for firms from anglo and civil law system respectively. Hypothesis 1: In anglosaxon firms, dividends increase when the ownership of institutional investor is higher. Hypothesis 2: In civil law firms, dividends decrease when the ownership of institutional investor is higher. 2.The Link Between Institutional Investors Activism and Dividend Policy in Each Legal System 3. Methodology The relation between dividends and institutional investor can be influenced by the nature of each institutional investor and by the particular corporate governance problem existing in firms from different legal system. The so-called law and finance approach is based on the legal tradition of each country. According to which, the legal and institutional features are not unrelated to the agency problems within firms. There are two conflicts of interest to which most attention has been paid: the relationship between managers and firm owners and the relation between shareholders and creditors. Nevertheless, in recent years there is more concern with the conflict of interest between large and small minority shareholders. As stated by Becht and Röell (1999) and Bianco and Casavola (1999), in the Anglo-Saxon common law countries, the main agency problem arises from the dispersion of corporate ownership and from a certain lack of shareholder activism. On the contrary, the main problem in civil law countries is the too high concentration of ownership and, consequently, large shareholders may use their voting power to extract private benefits from small shareholders. These aspects have an influence on the participation and the nature of institutional investors in corporate governance. Bhattacharya and Graham (2007) suggest that an institutional investor with other profitable business relationships with the firm such as banks as lenders or insurance companies that act as primary insurers, can create conflicts of interest while other institutional investors can exert an effective monitoring on managers. Li and others (2007) find evidence that banks and insurance companies are frequent investors in civil law firms while pension funds are frequent owners of important shareholdings in anglosaxon countries. It is due to differences in the legal framework of civil law with a bank orientation of firms and anglosaxon firms with a market orientation to obtain funds respectively (Rajan and Zingales, 1995 and La Porta et al., 1998, 2000ab and 2002). As we mentioned, the authors distinguish pressure resistant versus pressure sensitive institutional investors according to whether these can reduce or increase corporate governance problems so that the The information required to test the two hypotheses that were advanced in the previous section has been gathered from different sources. The Compustat Database was used to obtain firm financial data. Information on US company ownership over the period 1996-2000, during which the research was conducted, was collected from Deloitte and Touch's Peerscope and Investor Insight's Market Guide databases. Amadeus, provided by the Bureau van Dijk, was used for ownership data on European companies. La Porta et al.'s (1997) international data on Shareholders and Creditors rights was also used. The final sample is shown in table 1. As can be seen from the table, the sample is composed of 931 companies over the period 1996-2000 and involves a total of 4,092 firm-year observations. Of the total number of companies, 462 are from the US and 469 are European. 3.1. Sample and Variables INSERT TABLE 1 3.2. Empirical Model The extended model that we use in our empirical analysis is as follows: DIVit=0 +1DIVi(t-1)+(2+ 2ANGLOi) INSTIit +(3+3ANGLOi) INSIit +(6+6ANGLOi) DRit +(7+7ANGLO) MBit+ 1 SRi+ 2 CRi+ (7+7ANGLOi) LOGACTit + i+ it (1) DIVit is defined as dividend yield (dividends divided by market capitalization of equity), or as dividend payout (dividends divided by earnings) or the ratio between dividends and total assets. This variable was previously censored using a TOBIT model given that one cannot directly include such in a Generalized Method of Moments (GMM) panel without it being censored, as referred by Arellano and Bover (1997); INSTIit is the degree of institutional ownership; INSIit is the ownership by insider shareholders as a percentage of total shares; DR it represents the level of debt defined as the ratio between the book value of debt and total assets; MB it is the market-to book ratio; SR and CR are indexes for shareholders and creditors rights ,respectively, as taken from La Porta et al. (1997); LOGACT measures size, defined as the log of the book value of the assets. 39 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 ANGLO is a dummy variable where a value of 1 is assigned for firms from the US, United Kingdom or Ireland (Common Law countries), and a 0 for all other firms (Civil Law firms). We test this model with panel data to allow the values taken over time by a series of variables to be known on an individual basis (The panel data used is characterized as being incomplete or unbalanced. In particular, the variant chosen for this work is referred to a micropanel data, which is to say, a data group in which the dominant dimension corresponds to the number of individuals while the number of periods is significantly lower). The use of this methodology has a number of advantages when compared with a cross sectional data. The first is the so-called control of constant unobserved heterogeneity. In our case, the particular singularities of the firms can affect their dividend payment policies, as already stated, and such features can persist for long periods of time. The second is the dynamic dimension of our data panel that allows dividend policies to vary according to the proposed explanatory variables over a period of time and furthermore considers the impact on dividends in the light of changes in the model's other variables. The existence of individual as well as endogenous effects leads us to consider the variables in first differences and to estimate the parameters of the model using the generalized method of moments (The endogenous character of the ownership structure has been considered in recent studies as Villalonga and Amit (2006) for US firms, Short and Keasey (2002) for UK firms, De Miguel et al. (2002) and Alonso-Bonis and De AndrésAlonso (2007) for Spanish firms and López Iturriaga, and Saona Hoffman (2005) for Chilean firms among others). 4. Results Descriptive Results The results are shown in tables 2 and 3. In table 2, descriptive statistics on the most significant variables used in firms within each legal and institutional framework reveal the existence of important and significant differences between the two sets of firms. INSERT TABLE 2 Table 2 reveals that Anglo-Saxon firms on average pay out more dividends, carry less of a debt burden - with levels of debt that do not reach 30% of total liabilities, against 50% in firms from Civil Law countries -, display an ownership structure that is characterized by a much higher participation of institutional investors – reaching 40% of total ownership against a mere 7% for firms within the Civil Law tradition - and have greater opportunities for growth than firms in continental Europe (as measured by the market-to-book ratio). If a greater degree of shareholder protection is added to this already dissimilar model of financial architecture, a picture emerges of the different scope of agency problems in companies within the two legal and 40 institutional frameworks and, consequently, of the different dividend policies that are adopted. Regression Results Table 3 shows the estimated coefficients for the variables in our model, first for Anglo Saxon firms and then for Civil Law firms, followed by the coefficients for the institutional variables and the results of the statistic tests31. INSERT TABLE 2 We observe an important difference between our Anglo-Saxon and Continental European samples, which is the sign and magnitude of the coefficient estimate for INSTI. This coefficient is positive and significant for the Anglo-Saxon. So, we obtain evidence to confirm the hypothesis 1 of our study. In these firms, institutional investors as pension and investment funds are pressure sensitive to corporate governance problem and they are interested in increasing dividends to effective monitoring on managers. While the coefficient is negative and significant in the Civil Law sample (although not when we use the dividend payout ratio as the dependent variable). We also evidence to confirm the hypothesis 2 of our study. In this case, banks as lenders or insurance companies that act as primary insurers, can create conflicts of interest and they prefer reduce dividends to get their private interest in firms. From Table 3 one can also observe a statistically significant negative impact of the DIV variable from the previous period. Although, as referred earlier, one would expect, instead, a positive impact (Lintner, 1956), it should be kept in mind that the 1996-2000 sample period a dramatic fall in dividend payments was observed in many countries, as observed by Fama and French (2001), although in later years, particularly after 2003, this phenomena has somewhat reversed. Thus, it may be the case that the negative sign observed in Table 3 for the DIV variable may well reflect this particular feature of recent aggregate dividend behaviour. The values obtained by the Wald test, the Sargan test and the second order serial correlation allow us to confirm the validity of the instruments used and the absence of second order correlation. 5. Summary and Conclusions In summary, the results obtained from our empirical model show a relation between institutional ownership and dividend policy which is remarkably 31 Year dummies were included as explanatory variables but are not reported in Table 5 for simplicity. Only the coefficient for the 2000 year dummy showed some statistical significance at the 10% level. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 different between the two legal and institutional environments (Civil or Common Law). We evidence that the type of institutional investors and their role in corporate governance is different due to the different characteristics of both the legal system and the nature of agency conflicts in firms from those countries. And so, the use of dividend policy to solve the c1onflict of corporate governance problem differs in each legal system. We find that, in firms from Anglo-Saxon tradition, the relation between dividends and institutional investors as pension and investment funds is positive. In this case institutional investors try to force to increase dividend policy in order to reduce the agency problems between managers and shareholders. While, in Civil Law countries, the relation between dividends and institutional investors is negative due to the influence of banks or insurance companies with other private interest inside the firm. Therefore, we breed new insights into the role of dividend policy as a disciplining mechanism in presence of institutional investors in ownership structure of firms from different legal systems and distinct agency problems. But there is a significant scope for further investigating the relationship between this type of investors and different methods of payout, dividends and/or share repurchases, in an international context. 6. References 1. 2. 3. 4. 5. 6. 7. Aivazain, V., Booth, L. and Cleary, S. (2003): ―Dividend Policy And The Organization Of Capital Markets‖. Journal of Multinational Financial Management, vol. 13, No.2, pp. 101-121. Alonso-Bonis, S. And De Andrés-Alonso, P. 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Accounting, Economics and Finance, Faculty of Busbiess and Law, Deaking University, Melbourne. Chen, C.R. and Steiner, T.L. (1999): ―Managerial Ownership And Agency Conflicts: A Nonlinear Simultaneous Equation Analysis Of Managerial Ownership, Risk Taking, Debt Policy And Dividend Policy‖. Financial Review, vol. 34,No.1, pp. 119-136. Fama, E., and French, K. (2001): ―Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?‖, Journal of Financial Economics, vol. 60 (1), pp. 3-45. Jensen, M.C. (1986): ―Agency Costs Of Free Cash Flow, Corporate Finance, And Takeovers‖. American Economic Review, vol. 76, No.2, pp. 323-329. La Porta, R., López De Silanes, F., Shleifer, A. and Vishny, R. (1998): ―Law and Finance‖. Journal of Political Economy, vol. 106,. No.6, pp. 1113-1115. La Porta, R., López De Silanes, F., Shleifer, A. and Vishny, R. (1999): ―Corporate Ownership Around The World‖. Journal of Finance, vol. 54, No.2, pp. 471-517. La Porta, R., López De Silanes, F., Shleifer, A. and Vishny, R. (2000a): ―Investor Protection And Corporate Governance‖. Journal of Financial Economics, vol. 58, Nos.1&2, pp. 3-27. La Porta, R., López De Silanes, F., Shleifer, A. and Vishny, R. (2000b): ―Agency Problems And Dividends Policy Around The World‖. Journal of Finance, vol. 55, No.1, pp. 1-33. La Porta, R., López De Silanes, F., Shleifer, A. and Vishny, R. (2002): ―Investor Protection And Corporate Valuation‖. Journal of Political Economy, vol. 106, pp. 1113-1115. Li, D.; Moshirian, F.; Kien Pham, P. y Zein, J. (2006): ―When financial institutions ara large shareholders: the role of macro corporate governance environments‖. Journal of Finance, vol. LXI, nº6, pp. 2975-3007. López Iturriaga, F.J. and Saona Hoffman, P. (2005): ― Earnings management and internatl mechanism of corporate governance: Empirical evidence from Chilean firms‖. Corporate Ownership & Control, vol. 3, issue 1, pp. 17-29. Miguel, A. de; Pindado, J. (2001): ―Determinants Of Capital Structure: New Evidence Form Spanish Panel Data‖. Journal of Corporate Finance, vol. 7, pp. 7799. Pound, J. (1988): ―Proxi contest and the efficiency of shareholder oversight‖. Journal of Financial Economics, vol. 20, pp. 237-265. Rajan, R.G. and Zingales, L. (1995): ―What Do We Know About Capital Structure?. Some Evidence From International Data‖. Journal of Finance, vol. 50, No.5, pp. 1421-1460. Short, H.; Zhang, H. and Keasey, K. (2002): ―The Link Between Dividend Policy And Institutional Ownership‖. Journal of Corporate Finance, vol. 8, No.2, pp. 105-122. Villalonga, B. and Amit, R. (2006) ―How do family ownership, control, and management affect firm value?‖ Journal of Financial Economics, 80(2), 385– 417. 41 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Appendices Table 1. International distribution of the sample of firms by different origin legal and country Civil Law tradition Firms 71 44 29 12 6 2 2 1 167 Firms 71 8 79 Firms 33 23 56 11,94% Observations 350 212 151 63 33 10 10 5 834 Observations 341 38 379 Observations 158 70 228 USA United Kingdom Ireland Firms 462 165 2 Observations 1.830 811 10 Total Percentage 167 35,61% 821 French origin France Spain Netherlands Belgium Greece Italy Luxemburg Portugal Total German origin Germany Austria Total Scandinavian origin Denmark Sweden Total Percentage Common Law tradition Table 2. Summary statistics for Anglo Saxon firms and Civil Law firms Mean Median Variable Anglo Civil p value DIV 0.019 0.000 INSI INSTI DR MB LOGACT ROE ROA 0.309 0.469 0.277 1.866 3.835 0.146 0.073 0.019 0.524 0.079 0.492 1.022 2.715 0.142 0.069 0.000 0.000 0.000 0.000 0.000 0.427 0.019 Máximum St. Desv. Anglo Civil *** 0.014 0.007 *** 0.284 0.562 *** 0.493 0.024 *** 0.277 0.499 *** 1.113 0.569 *** 3.358 2.606 0.137 0.129 *** 0.066 0.060 Mínimum Anglo Civil Anglo Civil 0.029 0.052 0.885 0.782 0.207 0.232 0.189 2.236 1.684 0.120 0.068 0.235 0.120 0.189 1.873 0.913 0.793 0.870 0.884 13.360 7.527 0.2231 0.925 0.841 0.366 0.875 0.849 0.962 6.220 6.689 2.631 0.755 Anglo 0.000 0.000 0.000 0.000 0.016 0.912 -0.478 -0.262 Civil 0.000 0.000 0.000 0.000 0.551 1.106 -0.776 -0.2462 DIV is the dividend yield, measured as dividends divided by market capitalization of equity; INSI is the variable that measures ownership by insider shareholders, calculated as the total percentage of all shares owned by the members of the managerial team, both executive and non-executive board members, in addition to those owned by shareholders whose stake is over 5% of the total shares of the company; INST measures the degree of institutional ownership; Lit represents the level of debt, measured as the ratio between the book value of debt and of total assets; MB is the market to book ratio (market capitalization of equity plus book value of total assets less book value of equity, divided by the book value of total assets); LOGACT measures firm size as the log of total assets; ROE is the ratio between Net Income and Shareholders Equity; ROA is the ratio between Net Operating Profits and Total assets. 42 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 3. Results of a Tobit Regression estimated as a dynamic panel data analysis using GMM estimation Variable Anglo firms Civil law firms Constant -0.044 (0.070) -0.044 (0.070) DIVi(t-1) -1.828 (0.208) *** -1.828 (0.208) *** INSTIit 0.082 (0.027) *** -0.197 (0.069) ** INSIit -0.235 (0.276) 0.484 (0.319) * DRit -0.4993 (0.459) ** 1.088 (0.589) MBit -0.033 (0.010) *** -0.002 (0.028) LOGACTit 0.028 (0.014) SRi 0.038 (0.011) CRi 0.015 (0.013) Wald test m1 4180.75 (20) 3.67 m2 0 Hansen/Sargan test 13.67 (12) -0.314 (0.814) ** 0.038 (0.011) ** 0.015 (0.013) *** DIV is the dividend yield (dividends to market capitalization ratio); INSTI measures the degree of institutional ownership; INSI is the variable that measures ownership by insider shareholders, calculated as the total percentage of all shares owned by the members of the managerial team, both executive and non-executive board members, in addition to those owned by shareholders whose stake is over 5% of the total shares of the company; DR represents the level of debt, measured as the ratio between the book value of debt and of total assets; MB is the market to book ratio (market capitalization of equity plus book value of total assets less book value of equity, divided by the book value of total assets); LOGACT measures firm size as the log of total assets; SR and CR are indexes for shareholders and creditors rights, respectively, as taken from La Porta et al. (1998) ANGLO is a dummy variable where a value of 1 is assigned for firms from the US, the United Kingdom or Ireland (from Common Law countries) , and a 0 for all remaining firms (from Civil Law countries). The results are presented in two columns: In first column we present the coefficients obtained for anglosaxon firms and, in second column, we present the results for civil law firms of our sample. The constant, the coefficients for dummy variables SR and CR and the coefficient for previous dividends are the same for both samples of firms. *** for 99% confidence level, ** for 95% and * for 90%. 43 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 INFORMATION SIGNALING AND OWNERSHIP TRANSITION – VALUE EFFECTS OF SHARE ISSUE PRIVATIZATIONS Martin Ahnefeld*, Mark Mietzner**, Tobias Roediger***, Dirk Schiereck**** Abstract Privatizations are commonly associated with an increase in efficiency due to a stronger focus on profit maximization and less agency conflicts because the management does not have to serve political objectives anymore. This paper discusses whether SIPs generate positive announcement returns because of increased efficiency after the ownership transition. We apply a market model event-study methodology based on a sample of 134 SIPs in the 1979-2003 period. We identify significantly negative CAARs between -0.125% and -1.766% and find that firm and offering size, the proportion of secondary shares issued within the SIP as well as the market environment have a negative impact on announcement returns. In contrast, the negative CAARs are less distinctive for enterprises that had prior SIPs. Keywords: Share issue privatization, seasoned equity offerings, ownership structure, event study *Department of Finance, Accounting and Real Estate, European Business School (EBS) **Department of Finance, Accounting and Real Estate, European Business School (EBS) ***Department of Finance, Accounting and Real Estate, European Business School (EBS) ****Department of Finance, Accounting and Real Estate, European Business School (EBS), International University Schloss Reichartshausen, Rheingaustr. 1, D-65475 Oestrich-Winkel, Germany, Phone: +49 (0) 6723-991-212, Fax: +49 (0) 6723-991216, e-mail: [email protected] and [email protected]. I. Introduction A number of studies analyze the returns of initial public offerings of divested state-owned enterprises as well as returns to subsequent share issuances, 32 e.g., Dewenter and Malatesta (1997) or Jones, Megginson, Nash and Netter (1999). Prior research has found significant positive returns which are often attributed to substantial underpricing. These observations are reflected by Altinilic and Hansen (2003) or Laurin, Borardman and Vining (2004), who argue that governments deliberately underprice initial and subsequent share issue privatizations (SIP) in 32 Prior research distinguishes between two methods of privatization through a sale of ownership claims in state property for cash payments: On the one hand, the government may sell the state-owned enterprise to individual, strategic or groups of investors. On the other hand, some or all of a government‘s stake in a state-owned enterprise is sold to investors through a public share offering. We define this process as share issue privatizations (SIPs), whereas some or all of a government‘s stakes are sold via a public offering. Although this process is similar to IPOs of privately held enterprises, the government‘s motives are different. Megginson and Netter (2001) claim that the motivation for SIPs is to raise money and to respond to political objectives. By contrast, private offerings are structured primarily to raise proceeds. We refer to the offering of a government‘s stakes in a state-owned enterprise for the first time as initial share issue privatization, while subsequent equity offerings are defined as seasoned or subsequent share issue privatization. 44 order to signal that they do not intend to redistribute the value of shareholders‘ investments and to align shareholders‘ interests with those of the privatizing government. However, if underpricing is a reliable signal for stating that governments will not interfere in a firm‘s operating activities in the future, then, as suggested by Dewenter and Malatesta (1997), a SIPs should be underpriced more strongly compared to IPOs and seasoned equity offerings (SEO) of firms in the private sector. In turn, this expectation should be incorporated into stock prices at the day the information on a subsequent equity offering of a SEO becomes public. Several studies document that the announcement of an issuance of seasoned equity for non-state-owned enterprises is associated with average negative abnormal returns between -2.00% and -3.00%.33 Even though theses findings may not be strictly comparable with the announcements of a SIPs, because private-sector SEOs might be underpriced for different reasons, one may expect the announcement of a subsequent share issuance (of secondary or primary shares) during a privatization 33 See, for example, Asquith and Mullins (1986), Mikkelson and Partch (1986), Akhigbe and Harikumar (1996), Bayless and Chaplinsky (1996), Guo and Mech (2000), Clarke, Dunbar and Kahle (2001), Gajewski and Ginglinger (2002), Best, Payne and Howell (2003), D'Mello, Tawatnuntachai and Yaman (2003) and Byoun (2004). Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 process to result in negative market reactions. Asymmetric information is regarded as one reason for the negative market reaction as outside investors usually do not exhibit the same information about the firm‘s true value than inside investors. Furthermore, the government‘s motives to privatize are ambiguous. A rich body of literature on post-privatization performance has emerged over time providing evidence that profitability, operating efficiency, output as well as the financial performance increase after a reduction of state ownership.34 Barberis, Boycko, Shleifer, and Tsukanova (1996), Frydman, Gray, Hessel, and Rapaczynski (1999) and more recent Jelic, Briston, and Aussenegg (2003) demonstrate that the rationale behind these empirical findings is primarily to be found in changes in the ownership structure and the board of directors. Profit-oriented shareholders participating in SIPs processes encourage managers to the primary goal of shareholder value, whereas, in line with Moore (1992), purely state-owned enterprises (SOE) may pursue multiple aims related to diverse political objectives, for instance, job security. Hence, one can assume that the announcement of a SIP, and, more specifically, the direct (SIPs with secondary shares only) or indirect (SIPs with secondary and/or primary shares) reduction of state ownership, generate positive announcement returns. Overall, the valuation effects associated with an announcement of a SIP are ambiguous. To the extent that an intensified monitoring by capital markets result in performance improvements, announcements of SIPs should cause positive valuation effects. By contrast, a negative market reaction reflects the market's perception of the degree to which the government intends to redistribute firm value after privatization, i.e., affect the value of the firm through policy changes in regulation, taxation and so forth. Since the valuation effect of SIP announcements is ambiguous, we enlarge the body of research by analyzing the market reaction to announcements of SIPs. Consequently, two questions arise: First, do share prices react to SIP announcements? Second, if valuation effects are observable, are they caused by an expected increase of performance or by the market's perception of a government‘s motives for privatization? Our study design applies a market model eventstudy methodology based on a sample of 134 SIPs, which are conducted by 82 enterprises from 15 Western European countries between 1979 and 2003. We identify negative cumulated average abnormal 34 Studies documenting an improvement of profitability include Boubakri and Cosset (1998), Boycko, Shleifer and Vishny (1996), D'Souza and Megginson (1999), Megginson and Netter (2001) and D'Souza, Megginson and Nash (2005). However, Martin and Parker (1995) analyze eleven British enterprises privatized during the 1981-1988 period and observe decreasing values of both performance measures they applied. announcement returns between -0.125% and -1.766% which can largely be explained by firm and offering size as well as the market environment. In contrast, the negative CAARs are less distinctive for enterprises that had prior SIPs The remainder of this paper is organized as follows: First, we explore the manifold theoretical and empirical background against which our investigation is organized. Section III deals with the data and the methodology used in our event-study analysis. Subsequently, section IV describes the results of the univariate analysis. Section V discusses the results of our event-study, while section VI presents the results of the cross-sectional regression. Finally, section VII concludes with a summary and discussion of the results. II. Theoretical Framework and Hypotheses It is usually assumed that state-owned enterprises (SOEs) are less efficient compared to private ones due to the fact that they have to cater to the objectives of politicians and are not able to pursue the aim of maximizing efficiency. In line with Villalonga (2000), three distinct theoretical approaches (Agency and Property Rights Theory, Public Choice Theory and the Organizational Theory) can be made to explain why efficiency of SOEs is lower. Most important, as proposed in this analysis, managers of SOEs attempt to maximize their private benefits rather than the utility function of the government [De Alessi (1969)]. Furthermore, reducing ownership in SOEs is impossible for individuals prior to an equity offering. Therefore, in order to explain different levels of efficiency one has to consider the agency conflict between owners and managers as well as the absence of a market for corporate control. This leads to the objectives of the Agency and Property Rights Theory. However, the Public Choice Theory assumes that politicians are self-interested agents who aim at maximizing their own utility. Third, Villalonga (2000) suggests that the Organizational Theory explains differences between public and private firms with regard to efficiency by analyzing the SOE inherent organizational characteristics. The overviews of theoretical and empirical studies provided by Villalonga (2000) and Megginson and Netter (2001) show that considerable research energy has been invested into determining what factors may explain differences in efficiency between privately and stateowned firms. Overall evidence consistently shows that privately owned enterprises provide superior degrees of efficiency. Boycko, Shleifer and Vishny (1996) highlight the problem of inefficient state-owned enterprises and argue that efficiency could be enhanced after privatization. A privatization transfers several control rights over a firm‘s resources to managers who are willing to meet the interest of the shareholders. 45 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Therefore, vote maximizing politicians who have a fundamental interest in employment in order to gain support of trade-unions in elections have to compensate managers for excess employment via subsidies. Budget restrictions for politicians are the principle reasons why a reduction of excess employment and a restructuring of the firms will be achieved after a privatization [Boycko, Shleifer and Vishny (1996)]. A privatization will subject managers to profit maximization, since shareholders are profit-oriented, whereas, in line with Moore (1992), a state-owned enterprises pursues multiple objectives, such as keeping employment rates high. Moreover, a rich body of empirical studies on postprivatization performance has emerged over time, applying a broad set of sophisticated methods and indicators to measure possible performance variations of newly privatized firms. Empirical investigations of D'Souza, Megginson and Nash (2005) and the research pooled in Megginson and Netter (2001), document that firms experience significant increases in efficiency and profitability due to privatization because managers are monitored by the capital market [Boubakri and Cosset (1998)]. The basic idea of the performance improvement test is to compare the pre-privatization performance for enterprises with their post-privatization performance. Megginson, Nash and van Randenborgh (1994) were one of the first concerning performance changes after a divesture. Backed on a sample of 61 privatized firms of 18 countries during 1961-1989 they show that profitability, operating efficiency, output as well as the financial performance increases due to a SIP. Additionally, D'Souza and Megginson (1999) and Boubakri and Cosset (1998) offer similar results as Megginson, Nash and van Randenborgh (1994). In contrast, Martin and Parker (1995) analyze eleven British enterprises during the 1981-1988 time period and find decreasing values for their performance measures applied. They assume that privatization does not result in an enhancement of performance, as they concede that the management could have reorganized the firm prior to the privatization process with respect to capital market requirements. Frydman, Gray, Hessel and Rapaczynski (1999) report an improvement in performance after the government sold parts of their shares to outside or foreign owners. However, they show that there is no evidence for a beneficial effect on performance if ownership rights were transferred to insiders like managers or employees. Barberis, Boycko, Shleifer and Tsukanova (1996) analyze a sample of Russian shops which have been privatized during the 1990s and conclude that for an effective privatization the chief executive officer has to be changed. In a more recent study, Jelic, Briston and Aussenegg (2003) find for Polish privatized firms a significant effect of foreign ownership on the development of share prices. In sum, Megginson and Netter (2001) conclude that their review of 22 studies provides ‖[...] at least limited support for the proposition that 46 privatization is associated with improvements in the operating and financial performance of divested firms‖ [Megginson and Netter (2001)] and that almost ‖[...] all studies that examine postprivatization changes in output, efficiency, profitability, capital investment spending and leverage document significant increases in the first four and significant declines in leverage‖ [Megginson and Netter (2001)]. All studies mentioned poses insights into the impact of ownership transition, and provide guidance for an effective privatization. In this context, a reduction of state ownership seems to be value enhancing and should result in a positive market reaction. One commonly applied methodology to privatize state-owned enterprises is a share issue privatization. Many studies, e.g., Dewenter and Malatesta (1997) or Jones, Megginson, Nash and Netter (1999), analyze the returns of initial share issue privatizations and find significant positive returns which are often caused by substantial underpricing. Perotti (1995) and Biais and Perotti (2002) provide a theoretical foundation for underpricing, based on a government‘s ability to signal that they do not intend to redistribute the value of the shareholders‘ investment, i.e., affect the value of the firm through policy changes in regulation, taxation and so forth. Perotti (1995) categorizes governments as either populist or committed governments and only the latter can resist the politically valuable option of reallocating firm value to a specific constituency after a privatization. Since a populist government would also pretend to pursue the privatization process, a committed government requires a credible signal, whereas ‖[...] a partial sale and (possibly) its underpricing are signals of commitment‖ [Perotti (1995), p. 848)]. This approach implies that the consequences of subsequent interference also affect the government that is still the biggest shareholder after a gradual sale [Perotti (1995) and Jones, Megginson, Nash and Netter (1999)]. Furthermore, successive selling of small proportions of the governmental stake bears the risk that the motives of a populist governments become public, which reduces the proceeds achievable in subsequent share issuances. In contrast, divesting SOE via SIP leads to the problem that the government has to assure that it intends to transfer the right of disposal. However, underpricing is a reliable signal when it is used by a committed government in order to capture the economic benefits of a privatization. Hence, the level of underpricing necessary is related to the investors‘ expectations about future policy and ‖[...] the secondary market will place a higher value on a firm if the government credibly signals commitment‖ [Jones, Megginson, Nash and Netter (1999)]. In addition, to signal a government‘s identity with the privatization process and to overcome uncertainty about future policy, underpricing of an IPO or Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 subsequent SIPs may provide the opportunity to maximize the present value of the total net proceeds from all equity offerings [Laurin, Borardman and Vining (2004)]. Altinilic and Hansen (2003), argue that underpricing is important to compensate investors for the uncertainty about the firm‘s prospects and thus, the value of the firm. With respect to the uncertainty about the firm‘s value and the government‘s motives to privatize a SOE, Jones, Megginson, Nash and Netter (1999) analyze if political objectives and economic factors have an impact on initial returns. Using sample of 630 SIPs during 1977-1997, they find returns of 34.1% for initial and 9.4% for seasoned share issue privatizations and document that their results ‖[...] indicate that much of the underpricing of initial SIPs is a concession by governments designed to overcome the political obstacles that stand in the way of successful privatization and the economic benefits that might flow from it‖ [Jones, Megginson, Nash and Netter (1999), p. 234)]. The empirical studies reviewed provide evidence that returns of subsequent SIPs are positive and that the decision to privatize, i.e., the time pattern for later SIPs is made by politicians or managers who exhibit superior information of the firm. Assuming managers to act in the interest of their shareholders, a strong incentive exists to issue new equity, when the capital market evaluates shares above the value which would be justified by the firm‘s prospects. Consequently, the announcement of issuing stocks should result in a re-evaluation of the share price by the investors [Asquith and Mullins (1986)]. Therefore, stock prices of partially privatized firms should decline when the government is willing to sell its shares. Concluding from the arguments mentioned above, the transition of ownership should result in an improvement of operating and financial performance. Thus, the announcement of a further equity offering should cause a positive market reaction. In contrast, underpricing of initial or subsequent share issuances, information asymmetries as well as agency problems should have a negative impact on share prices. Hence, the question can be raised which effect will predominate: Question Do share prices react to seasoned 1: share issue privatization announcements? Question Second, if valuation effects are 2: observable, are they caused by an expected increase in performance (positive valuation effects) or by the market's perception of a populist government‟s motives for privatization (negative valuation effects)? The empirical research supports the existence of widespread negative returns related to SEO announcements of non state-owned enterprises. Prior research on non-state-owned enterprises provides evidence that an announcement of an equity issuance results in a decline of share prices between -0.82% and -3.56% within two days the information becomes public (see table 1).35 But to what extent are these findings transferable to SIPs and more generally, what affects announcement returns in a SIP process? Following the efficient market hypothesis (EMH), the announcement of an issuance will cause no price effect because arbitrage will equalize stock prices and the prices of stocks‘ close substitutes. Thus, sales of large blocks of shares will only cause a price reaction because the stock is priced relative to its substitutes. If close substitutes are not available, then, according to the price pressure hypothesis, an excess supply leads to a negative price movement [Akhigbe and Harikumar (1996)]. Hess and Frost (1982) provide empirical support for this theory. Allocating income rights to the capital market can result in an improvement of a firm‘s profitability because of a reduced likelihood of political interference. Faccio, Masulis and McConnell (2006) find empirical support that firms with small governmental influence outperform enterprises facing interference by politicians. In this context we assume governments to be at least one of the companies‘ biggest blockholders, who usually possess superior information about the companies‘ prospects. Therefore, a sale of shares conjectures the information that the government trades on an informational advantage. By selling a large proportion of shares, the government may communicate a negative signal about the firm‘s future cash flows. This argument corresponds to the one adduced by Fidrmuc, Goeren and Renneboog (2006) to explain negative market reactions to the announcement of insider stock sales. Furthermore, the government may be a populist government as defined by Jones, Megginson, Nash and Netter (1999) that faces the problem of liquidity needs for their redistributive policy. Thus, the negative signal of a government that sells its shares should be evaluated by the capital market with respect to the firm‘s cash flow [Jones, Megginson, Nash and Netter (1999)].36 Additionally, the findings of Loughran and Ritter (1995) and Loughran and Ritter (1997) provide empirical support that firms take advantage of a current overvaluation of their shares to issue equity; then, perceived overvaluation leads to a subsequent negative market reaction if a seasoned equity offering is announced. The reason for the ‖window of opportunity problem‖ can be found in an asymmetric 35 Most of the results correspond to an event-window starting one day prior the announcement day and ending one day thereafter. 36 Conversely, director‘s put their own wealth at stake and their signal of selling shares is therefore less informative, if they act also due to liquidity needs [Fidrmuc, Goeren and Renneboog (2006)]. 47 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 information problem which transfers into information costs. Thus, firms will issue new equity only if information costs are low [Myers and Majluf (1984)]. This leads to the following hypothesis: Question The valuation effect is more 3: detrimental for larger SIPs. Considering IPOs of private non-state-owned enterprises, Ritter (1991) suggest that firms go public at market peaks, when comparable companies are valued above their true value, and therefore the issuer can take advantage of a ―window of opportunity‖. Therefore, the question arises, whether abnormal returns are less negative in strong equity markets, i.e., in a market environment with substantial increases in the index return over 200 days prior to the issue as well as a low standard deviation in that period. A positive market assessment may force a clustering of equity (initially and seasoned) issuances and ‖[...] may induce information spillovers and hence lower adverse selection problems‖ [Huyghebaert and Van Hulle (2006), p. 302)]. An explanation for IPO clustering was provided by Bayless and Chaplinsky (1996) who asserted reduced discount rates and behavioral finance effects, e.g., herding, as possible reasons. Therefore, we would expect governments to increase the relative as well as the absolute number of shares during periods of high pre-issuance market conditions because of reduced information costs: Question Do abnormal returns associated with 4: sales of ownership claims depend on market conditions? Given the decision to sell parts of an enterprise, the level of information asymmetry as to politicians‘ intention to privatize should decrease in case of a seasoned SIP because the potential risk of redistribution of firm value by politicians will be reduced as described above. D'Mello, Tawatnuntachai and Yaman (2003) observe a relationship between the sequence of SEOs and the uncertainty about a firm‘s value. They provide evidence for less unfavorable announcement reactions because of declining level of asymmetric information. Here, the rationale is that prevalently issuers experience lower information costs due to the issuers heightened reputation of not taking advantage of new shareholders, i.e., not to pursue multiple aims related to diverse political objectives: Question The level of asymmetric information 5: associated with SIP depends on offering frequency. The market is less concerned about successive SIP announcements of firms. Conversely, the market is more concerned about the announcement of the first equity issuance after the IPO. Issuing equity provides the possibility of issuing not only secondary shares but also new equity which ceteris paribus improves the financial situation of the enterprise. In addition, this effect should be supported by an increase in profitability, which is to 48 be expected after privatization [Megginson, Nash and van Randenborgh (1994) and Alexandre and Charreaux (2004)]. However, the impact of the amount of secondary shares issued in a SIP process on announcement reactions may be of a dual nature: On the one hand, selling secondary shares only conveys the market‘s conviction of a reduction of political connection. This should be associated with a positive market reaction. Moreover, Alexandre and Charreaux (2004) argue that a retraction of the government and the issuance of new equity should also foster profitability due to the reduced likelihood of bankruptcy. However, a relative decrease in financial leverage due to a raise of new capital may cause declining monitoring activities of creditors [Jensen (1986)], which should result in negative announcement effects. On the other hand, the capital market may perceive a high amount of secondary shares as an indicator that the current stock price is high relative to managers‘ assessment of the firm's prospects, i.e., selling overpriced shares [Asquith and Mullins (1986)]. Consequently, this should results in a negative market reaction. Question The abnormal market reaction 6: associated with SIP announcements depends on the proportion of secondary shares issued. A high (low) proportion of secondary shares should be associated with a negative (positive) market reaction. Examining market reactions to subsequent equity offerings, Jensen (1986) draw the conclusion that managers act in their own interest by enhancing the assets under their management. The rationale is that managers even risk the consequence of a declining equity value, i.e., investment in projects with negative net present values, in order to increase the total assets controlled by them. In general, large free cash flows as well as lower financial constraints are mentioned as the origin of the over-investment problem in diversified firms [e.g., Berger and Ofek (1995)]. However, the negative market reaction caused by this agency conflict may be attenuated if the firm exhibits substantially growth opportunities. In line with previous research, the existence of growth opportunities induces less negative market reactions [e.g., Denis (1994)]. Interestingly, the study conducted by Denis (1994) does not detect any relationship between announcement effects and the profitability of new investment projects. Yet, firms with an optimistic assessment of their future prospects, as reflected in high market-to-book-ratios, should experience a less negative announcement effect: Question The market reaction to announcements 7: of share issue privatizations depends on the market‟s perception about a firm‟s investment opportunities. The market reaction to the announcement of firms with more (less) investment Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 opportunities is positive (negative). Changes in the number of employees prior to a SIP may be an important signal for the capital market perception of a firm's profitability. On the one hand, a remarkable reduction in the number of employees conveys that a firm has downsized its staff in order to become more profitable, e.g., indicates a reduction of overemployment. On the other hand, politicians may noticeably increase the number of employees as a means to gain support of trade-unions for increasing employment. Question A relative decrease (increase) in the 8: number of employees one year prior to a SIP announcement causes a positive (negative) market reaction. III. Data and Methodology A. Data and Methodology Our initial sample consists of 248 SIPs from 15 Western European countries and covers the period of 1979 through 2003. Announcement dates are obtained from the Securities Data Corporation (SDC) database and encompass information on the type of equity issue, e.g., primary, secondary or both types, the number of shares issued, the issue price, and the issue dates. Stock price data are obtained from Thomson Financial DataStream and the announcement dates come from Dow Jones, Reuters and the Lexis Nexis databases. For an inclusion in the final sample, we require a firm‘s announcement of a privatization via SIP to satisfy at least one of the following criteria: (1) the government announced an equity offering, (2) the enterprise announced a share issuance, (3) a state-owned holding company announced or accomplished a stock disposition, (4) the government authorized a further reduction in their stake, (5) the government actually sold a further stake or approved an offering of a further stake in the near future, (6) the shareholders agreed to a further SIPs or (7) an investment bank acknowledged that shares had been sold. For sample refinement purposes, initial public offerings and events of uncertain announcement days are excluded from the sample. As our research interest centers on examining the effects of seasoned share issue privatization announcements, we require all sample firms to have stock returns throughout all event and estimation periods. Since Thomson Financial DataStream does not provide share prices for every enterprise in the initial sample, our data set is reduced by 47 transactions. Moreover, in order to avoid confounding events within the event windows as well as defining different lengths of estimation periods, the final sample was pared down to 82 enterprises that conducted 134 SIPs. B. Control Variables We use the Thomson Financial DataStream INDC3 code to classify the firms of the final sample into ten industries: basic industry (BASIC), cyclical consumption industry (CYCGD), cyclical services (CYSER), general industry (GENIN), information technology (ITECH), non-cyclical consumption industry (NCYCG), non-cyclical services (NCYSR), resources (RESOR), financial services (TOTLF), and utilities (UTILS). As more than half of the SIPs originate from the non-cyclical consumption, the resource or the financial services industry, we construct the binary variables Financial Services and Utility to capture a firm‘s affiliation to the financial or utility industry. Firms that experience political interference, i.e due to changes in the regulatory environment, may also suffer from an increase in their systematic risks [Schwert (1981)]. In order to control for a company‘s risk, we include the systematic risk factor obtained from the market model regression in the estimation period. The probability to receive political attention seems to be greater for large firms. To control for firms‘ size, we include the company‘s market value at the announcement day, which is obtained from Thomson Financial DataStream. The absolute and the relative value of shares issued as well as the proportion of secondary shares offered comes also from Thomson Financial DataStream and is based on the information of the type of equity issuance. Furthermore, we include the proxy SIP-frequency to indicate whether the enterprise had prior SIPs (coded as zero) or if the firm conducts its first subsequent equity offering (coded as one).37 We use the relative change in the number of employees one year prior to the announcement to capture reorganization activities. Additionally, we include the market-tobook value at the announcement day to measure the market‘s perception of the firm‘s future prospects. Finally, we apply two measures to control for the overall market environment: the mean return and the standard deviation of the benchmark index during the estimation period. C. Event-Study Methodology The stock market reactions to seasoned equity offering announcements are measured using daily stock returns. One testing strategy is to consider SIP activities and to clarify whether prices adjust to this news immediately or over a long time period [Shleifer (2000)]. For that purpose, an event-study analysis is designed to identify abnormal returns within a well-specified event period.38 Abnormal returns are calculated as the ex post observable returns' deviations from those returns which had occurred in the absence of SIP announcements. Following the methodology of Armitage (1995), a market-adjusted model is used to isolate potential extraordinary effects associated with SIP announcements. We estimate abnormal returns for each security within our final sample by comparing 37 As mentioned above, we exclude IPOs of SOE. The term "event period" is a synonym for "event window" within this paper. 38 49 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 the security's returns which occurred around the announcement dates to the returns of a market index. Thereby, it is possible to estimate expected returns for given returns of the market index as follows: Ri ,t = i i Rm,t i ,t , where i and i , are estimates from an Ordinary Least Square regression, term, i,t denotes the disturbance Ri ,t is the logarithmic return of security i and Rm ,t is the logarithmic return of a market index for day t. Abnormal returns are calculated as prediction errors: ARi ,t = Ri ,t i i Rm,t , where ARi ,t is the excess return on security i for day t and t0 denotes the announcement day.39 We defined an estimation period of 200 days which ranges from [t220, t20 ] days prior to the event day in order to estimate the market model parameters. For each individual security, the calculated abnormal returns have to be aggregated in order to control for price adjustments over the time period. Therefore, cumulated abnormal returns (CAR) around the announcement day t0 are calculated as the sum of the prediction errors for each security within the event window of [t0 , t0 ] days: t t0 CARi ,[ t0 ,t0 ] = AR t t0 (3) i ,t Since our research scope is directed towards examining whether joint cumulated effects are different from zero, we construct a portfolio comprising all securities as well as subsample portfolios according to different categories of SIPs, e.g., the issuances of secondary shares only. For each portfolio we test the null hypotheses whether the cross-sectional cumulated average abnormal returns (CAAR) in the event period are different form zero. For a sample of N securities CAARs are calculated as defined by equation (4) : CAAR[ t0 ,t0 ] = 1 N N CAR i i =1 We draw statistical inferences for the different event-window cumulative average abnormal returns using a standard t-test statistic. However, Brown and Warner (1985) mention that an event might increase the variance, and as a consequence the null hypothesis is rejected too often. In order verify our test results, we implement the test statistic described by Böhmer, Masumeci and Poulsen (1991) and use the variance of the market model residuals to 39 In this paper, the terms "prediction error" and "abnormal return" are used as synonyms. 50 standardize cumulated abnormal returns. Finaly, we also apply a non-parametric rank test according to Corrado (1989), which is more powerful than the usual t-test. IV. Descriptive Statistics (1) The sequence of share issuances for the full sample, except 14 announcements for which further information was not available, is shown in table 2. The table provides evidence that most of the enterprises conduct up to three subsequent equity offerings. 79 firms offer shares at least once after their initial privatization step, whereas 16 out of 79 enterprises issue new shares within the first subsequent SIP only. Approximately 24% of (2) the firms (32 firms) issue conduct two equity offerings and about 17% (23 firms) are divested in three or more stages. Remarkably, in the majority of the SIPs (91 announcements or 67,91%) the government sells secondary shares only. We interpret this observation as an indication for limited growth opportunities because the companies obviously do not need additional equity. Around one of six SIPs is a primary share issuance. Table 3 shows the annual distribution of all equity offering announcements and the respective characteristics of the SIP: Most of the firms issue shares in the second half of our sample period, whereas many SIPs are conducted within a four-year time period (1996-1999). Regarding the combined equity offerings, Table 3 shows that almost all announcements have been conducted between 1997 and 2000. V. Market Reaction to Seasoned SIP Announcements An aggregated view on the results of the event-study reveals remarkable patterns with respect to the speed of stock price adjustments to announcements of SIPs (see Figure 1). The stock prices begin to decline prior to the announcement day and drop substantially at the day the information becomes public. In line with market efficiency hypothesis the CAARs remain stable thereafter. (4) Statistical inferences about these observations are provided by table 4. The CAARs for the full sample range between 1.766% to -0.125%. The results show that investors perceive the announcement of a SIP of seconday, primary and combined shares as unfavourable information.40 Nevertheless, compared to existing evidence provided for private companies‘ SEOs of up 40 See Akhigbe and Harikumar (1996) for a detailed discussion of stock price adjustments to SEO of all equity firms and D'Mello, Tawatnuntachai and Yaman (2003) for results for returns of firms that announced multiple primary SEOs. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 to -3.30% the capital markets seem to be less concerned about the announcement of a subsequent equity offering within a privatization process. The implication of this result may be of a dual nature: On the one hand, an average decline of -0.691% (CAAR) implies a predominance of the negative effects associated with an announcement of a successive equity offering. On the other hand, these results could support the theory that positive privatization effects attenuate the negative market reaction. A closer look at Table 5 reveals that omitting the announcements of primary and combined SIPs' the cumulated average market reaction for pure secondary SIPs is more negative. A pure sell-off of public ownership without proceeds for the listed comnpany to finance future growth signals at least to some extent an attractive share price level from the perspective of the seller. Yet, seasoned equity offerings, in general, are underpriced in order to compensate new shareholders for the uncertainty about the firm's value. Our results also indicate that the underpricing has already partially been incorporated into share prices the day the subsequent offering becomes public. Comparable studies report initial returns associated with an SEO ranging between 2.2% for private SEOs and 9.4% for seasoned SIP [Jones, Megginson, Nash and Netter (1999) and Corwin (2003)]. Moreover, Dewenter and Malatesta (1997) provide evidence for the United Kingdom that IPOs of private enterprises are less underpriced compared with the degrees of underpricing within a SIP. Jones, Megginson, Nash and Netter (1999) find mixed evidence for a greater underpricing of initial SIPs compared with IPOs. However, when we compare the difference between the negative market reaction associated with a SIP announcement and the degree of underpricing of IPOs with the differences observed for SIPs, we find some indication that SIPs are more detrimentally affected than equity offerings of private firms. VI. Regression Results Table 6 provides the results of our regression analysis. The four models are estimated using ordinary least squares, whereas White (1980) Heteroskedasticity-Consistent Standard Errors and Covariances are applied to calculate t-statistics. The third question addresses that the market reaction to an announcement of a further SIP to be more negative for large SIPs. Previous research uses the relative offering size as a proxy for the price pressure hypothesis and finds a negative relationship between the relative offering size and the announcement reaction [Asquith and Mullins (1986) and Akhigbe and Harikumar (1996)]. Accordingly, our two proxies for offer size (absolute and relative value of shares issued) have a negative sign and are significant on a 1% level. Beyond the potential price pressure we interpret this result as being consistent with the hypothesis that the issuer trades on superior information and sells shares at attractive price levels. However, the capital market may also perceive an announcement of an issuance of a large proportion of the enterprises‘ equity as a signal of a populist oriented government. A populist government may prefer to achieve privatization proceeds in the short term, because their underlying motives may become public. In contrast, the regression results indicate a weak relation between the proportion of secondary shares issued and the announcements effects. In one of four models, the variable is significantly related to CARs only. While our above mentioned results show that the capital market is more concerned about a solely secondary share offering, the regression analysis provide at most weak evidence. In line with the results of previous research, but conversely to Masulis and Korwar (1986) and Denis (1994) strong equity markets, i.e., stock market runups prior to the announcement date, are negatively related to announcement period CARs. In all four models, the proxy for market environment (Mean Return Ri,(t-220;t-20)) is significant, which confirms our hypothesis that the market reaction depends on market conditions. Furthermore, our second measure for hot equity markets, the standard deviation of the benchmark index during the estimation period, provides further support for this view. In contrast to our previous assumption, the sign of our two measures (Mean Return Ri,(t-220;t-20) and the standard deviation of the benchmark index) do not indicate, that the market environment may reduce information costs. This observation, combined with the negative impact of selling a high proportion of secondary shares, supports the hypothesis that market participants are aware that the government may take advantage of a window of opportunity. Focusing on the possible allocation of the issuance proceeds, we suggest that issuing firms with less growth opportunities are more likely to undertake investment projects with negative net present values. Therefore, we previously concluded that the existence of growth opportunities should attenuate the negative market reaction. As our proxy for growth opportunities, the market-to-book-ratio at the announcement date, is not significant, we are not able to support this hypothesis. Thus, the short-term market reaction seems to be independent from the existence of future growth opportunities. If we take the SIP frequency into account, we find that the negative market reaction is less distinctive for enterprises that had prior equity offerings. This supports the view of D'Mello, Tawatnuntachai and Yaman (2003) that prevalently issuers experience lower information costs. Therefore, the advantageousness of conducting more SIPs, expressed in less pronounced negative abnormal returns, confirms the hypothesis that a higher information flow to the capital market via subsequent equity offerings reduces the uncertainty regarding a government‘s future policy as to 51 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 interference. Because politicians may perceive seasoned equity offerings as a means to obtain votes for subsequent elections, e.g., due to preferential allocations of stock at discounted prices, we suggest that companies which have experienced an increase in employees one year prior to the announcement of a SIP, may be subjected to governmental interests. The results of table 6 show that the coefficient of a percentage change in the number of employees is negative and significant at the 10% level in Model I and II. We interpret this observations as an only minor support for the hypothesis that politicians take advantage of a subsequent SIPs by increasing staff. Following research by Best, Payne and Howell (2003) we controlled for a firm‘s affiliation to selected industries, systematic risk and size. We find the coefficient for utilities to be significantly positive, whereas for firms of the financial services sector no relationship is observable. In accordance with D'Mello, Tawatnuntachai and Yaman (2003), regulated industries are characterized by less information asymmetry and utility firms can reduce adverse selection costs due to an information improvement at subsequent offerings. Given a revealing base of information, our result suggests that firms in the utility sector exhibit lower negative abnormal market reactions, which is in line with reduced information asymmetries. Following previous research, we include the market value at the announcement day as a proxy for uncertainty and asymmetric information [Corwin (2003) and Laurin, Borardman and Vining (2004)]. We assume that small firms experience more information asymmetries and greater uncertainty. However, given the coefficient‘s sign these firmspecific characteristics appear to have a negative influence on market reactions indicating that large firms are associated with larger information asymmetries. One possible explanation for this result might be that governmental interference is more likely in larger firms since a populist politician‘s intention is to raise privatization proceeds and to obtain the opportunity to redistribute firm value after privatization. Since the risk coefficients are statistically insignificant in both models, our analysis provides only weak evidence that announcement returns are dependent on a firm‘s systematic risk. European countries during the 1979-2003 period we identify negative cumulated average abnormal announcement returns between -0.125% and 1.766%. Using different event-windows and comparing offerings of secondary shares with our full sample we find abnormal returns to be pronounced more negative. Relating our results to prior evidence form non-state-owned enterprises, our results show that the capital market seems to be less concerned of the announcement of a subsequent equity offering within a privatization process. However, these univariate comparisons do not account for firm, issue and market environment specific effects. The regression results reveal that offering size has a significant negative impact on the cumulated abnormal returns indicating that the capital market perceives a high proportion of the company to be sold in a SIP as consistent with a signal for a populist government. Regarding subsequent equity offerings we find that the negative abnormal returns are less distinctive indicating that each equity issue is not an independent SIP. Moreover, the results for the market environment proxies are difficult to reconcile with existing theoretical explanations. Contrary to theoretical predictions, the market environment does not seem to reduce information costs. However, we assume this finding to be in line with the idea of a window of opportunity.Finally, we control for a firm‘s affiliation to selected industries, systematic risk and size. In addition to previous research, we can conclude that firms in the utility sector exhibit lower negative abnormal market reactions. This might be attributed to lower information asymmetries. Our findings have implications for the privatization process as a gradual sale of state-owned enterprises via several steps that mitigate negative valuation effects and therefore preserve shareholder value. References 1. 2. 3. 4. VII. Summary and Concluding Remarks This paper examines the market reaction to announcements of subsequent equity offerings within a share issue privatization process. While previous research has shown a positive impact of privatization on performance due to transition of ownership, numerous studies document that the announcement of SEOs of non-state-owned enterprises is associated with substantial negative abnormal returns. Analyzing a sample of 134 SIPs, which are conducted by 82 enterprises from 15 Western 52 5. 6. 7. Akhigbe, Aigbe, and T. 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White, Halbert, 1980, A HeteroskedasticityConsistent Covariance Matrix and a Direct Test for Heteroskedasticity, Econometrica 48, 817-838. Appendices Cumulative Average Abnormal Returns 1.00% t-20 t-15 t-10 t-5 t-0 t+5 t+10 t+15 t+20 t+25 t+30 t+35 t+40 t+45 t+50 -1.00% -3.00% Days relative to announcement day Figure 1. Cumulative average abnormal returns around a SIP announcement Cumulative average abnormal returns for the entire sample Table 1. Overview of selected studies on market reactions to SEO announcements Research provided by… Byoun (2004) Clarke, Dunbar and Kahle (2004) Bayless (1994) Bayless and Chaplinsky (1996) Akhigbe and Harikumar (1996) Best, Payne and Howell (2003) Gajewski and Ginglinger (2002) Karim, Rudledge, Gara and Ahmed (2001) Denis (1994) Guo and Mech (2000) Asquith and Mullins (1986) Mikkelson and Partch (1986) 54 Market Reaction -2.68% -2.25% -2.92% -2% to -3.3% -0.82% -1.75% -1.00% -1.57% Market USA USA USA USA USA USA France USA Period 1980-1997 1980-1996 1974-1983 1974-1990 1977-1988 1976-1993 1986-1996 1991-1994 Sample Size 5,776 424 223 1,881 60 1,861 237 283 -2.49% -2.79% -2.70% -3.56% USA USA USA USA 1977-1990 1980-1994 1963-1981 1972-1982 435 1,509 531 80 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 2. Frequency Distribution Frequency distribution of a sample of 82 firms from 15 Western European countries that announced multiple subsequent primary, secondary as well as both equity offerings within a share issue privatization process between 1979 and 2003. Sequence of issue Total (%) Primary shares issued Secondary shares issued Primary and secondary shares issued 1 79 58.96% 32 23.88% 15 11.19% 7 5.22% 1 16 69.57% 5 21.74% 2 8.70% 0 0.00% 0 55 60.44% 21 23.08% 9 9.89% 6 6.59% 0 3 50.00% 1 16.67% 2 33.33% 0 0.00% 0 0.75% 0.00% 0.00% 0.00% 134 23 91 6 2 3 4 5 Total Table 3. Annual Distribution of SIP Transactions Annual distribution of a sample of 82 firms from 15 Western European countries that announced multiple subsequent primary, secondary as well as both equity offerings within a share issue privatization process between 1979 and 2003. Year No. of SEOs 1979 1983 1985 1986 1987 1988 1989 1991 1992 1 2 3 1 2 3 2 1 5 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 6 9 7 18 13 15 11 9 5 10 2003 11 6.72% 5.22% 13.43% 9.70% 11.19% 8.21% 6.72% 3.73% 7.46% 8.21% Sum 134 100.00% Percent 0.75% 1.49% 2.24% 0.75% 1.49% 2.24% 1.49% 0.75% 3.73% 4.48% cum. Percent 0.75% 2.24% 4.48% 5.22% 6.72% 8.96% 10.45% 11.19% 14.93% 19.40% 26.12% 31.34% 44.78% 54.48% 65.67% 73.88% 80.60% 84.33% 91.79% Primary shares issued 1 Secondary shares issued 1 Primary and secondary shares issued n.a. 2 2 1 1 1 3 1 1 1 1 4 2 3 2 2 1 3 3 1 1 1 2 5 5 13 10 10 5 6 3 9 100.00% 1 1 2 1 1 10 23 91 1 1 3 1 2 1 1 1 6 14 55 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 4. CAARs of SIP announcements – all transactions Panel I: all transactions Event window Nobs. Median CAR CAAR t-Test t-value Boehmer Test Corrado Rank Test z-score z-score [-10;+10] [-10;+5] [-10;+1] [-10;0] [-5;+10] [-5;+5] [-5;+1] [-5;0] [-1;+10] [-1;+5] [-1;+1] [-1;0] 134 134 134 134 134 134 134 134 134 134 134 134 -1.166% -1.436% -1.560% -0.823% -1.704% -1.442% -1.417% -0.966% -0.148% -0.056% -0.666% -0.270% -1.766% -1.282% -1.442% -0.876% -1.517% -1.033% -1.193% -0.626% -1.015% -0.531% -0.691% -0.125% -2.021** -1.613 -2.268** -1.495 -2.120** -1.606 -2.427** -1.479 -1.655 -0.975 -1.913* -0.426 -1.165 -1.111 -1.907* -1.276 -1.253 -1.211 -2.201** -1.506 -0.812 -0.712 -1.900* -0.858 -5.504*** -5.110*** -6.886*** -4.635*** -5.263*** -4.853*** -6.668*** -4.361*** -2.744*** -2.265** -4.064*** -1.699* [0;0] 134 -0.397% -0.373% -1.547 -1.675* -2.775*** ***, **, and * indicate statistical significance at the 1%, 5%, and 10% levels, respectivel Table 5. CAARs of SIP announcements – offering of secondary shares only Panel II: secondary SIPs Event window Nobs. Median CAR CAAR t-Test Boehmer Test Corrado Rank Test t-value z-score z-score [-10;+10] [-10;+5] [-10;+1] [-10;0] [-5;+10] [-5;+5] [-5;+1] [-5;0] [-1;+10] [-1;+5] [-1;+1] [-1;0] 91 91 91 91 91 91 91 91 91 91 91 91 -1.803% -2.093% -0.943% -0.113% -2.404% -2.217% -1.917% -1.171% -1.568% -1.186% -0.905% -0.448% -2.825% -1.922% -1.560% -1.013% -2.657% -1.754% -1.392% -0.845% -2.154% -1.251% -0.889% -0.342% -2.538** -1.936* -1.773* -1.273 -2.682*** -2.068** -1.930* -1.363 -2.849*** -2.172** -1.818* -0.898 -1.911* -1.455 -1.295 -0.955 -2.151** -1.744* -1.646 -1.296 -2.045** -1.563 -1.381 -0.831 -8.510*** -6.155*** -4.753*** -3.723*** -8.820*** -6.416*** -4.986*** -3.931*** -6.805*** -4.307*** -2.807*** -1.720* [0;0] 91 -0.598% -0.459% -1.363 -1.461 -2.883*** ***, **, and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively. 56 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 6. Regression Results Abnormal returns are the dependent variable in all regressions and are calculated as the twelve and 16-day abnormal returns surrounding the SIP announcement date. The abnormal returns are based on a market model, which was estimated over the [t−220,t−20] time period. Financial Services and Utility are binary variables to capture a firms affiliation to the financial or utility industry. Market Value t0 is the market value of equity calculated at the the announcement day. Risk is a slope coefficient of the market model regression in order to control for a company‘s systematic risk. Absolute Value of Shares and Relative Value of Shares Issued are the absolute amount of equity issued as well as the proportion of shares issued to the total number of shares outstanding. SIP Frequency indicates whether a firm had prior subsequent SIPs (coded as zero) or not (coded as one). Relative Changes in Number of Employees One Year Prior to Announcement refers to the percentage change in staff one year before the subsequent announcement. Market-to-Book Value t0 is the ratio of the market value of equity and the book value of equity at the announcement date. Mean Return (Ri(t−220,−20)) is the mean stock during the [t−220,t−20] time period, whereas Standard Deviation of Benchmark Index captures the volatility of the respective benchmark index. We estimated two models for each event-window in order to avoid the problem of multicollinearity. All test statistics are computed using the heteroskedasticity-consistent covariance matrix from White (1980). CAR [-10;1] Model I Model II CAR [-5;10] Model III Model IV Constant Financial Services Utilities Market Value t0 Abs. Value of Shares Issued Relative Value of Shares Issued 0.040 -0.006 0.048** ---0.000** --- 0.0715** -0.008 0.0437** -0.000*** ---0.010*** 0.074*** -0.038 0.041*** ---0.000** --- 0.115*** -0.035 0.040** -0.000** ---0.009*** Proportion of Secondary Shares of all Shares Issued SEO Frequency -0.005 -0.014 -0.018 -0.018 -0.016 -0.022* -0.029* -0.027** rel. Changes in No. of Employees One Year Prior to Announcement Market to Book Value t0 Mean Return RI(200) Risk -0.062* 0.001 -9.878* --- -0.068* ---9.978** -0.019 Standard deviation of Benchmark Index -3.052** -2.553 -4.281*** -4.121*** Number of Observations adj. R2 103 12.78% 108 24.30% 103 16.65% 108 24.35% -0.020 0.001 -13.233** --- -0.027 ---12.884*** -0.028* ***, **, and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively. 57 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 CEO DUALITY AND FIRM PERFORMANCE—AN ENDOGENOUS ISSUE Chia-Wei Chen*, J. Barry Lin**, Bingsheng Yi*** Abstract Whether dual CEO leadership structure is better for corporations is one of the most hotly debated issues in corporate finance. This paper uses a recent data to re-examine the relationship between CEO duality and firm performance, controlling for other important variables such as firm characteristics, ownership structure, CEO compensation, and agency costs. We find a recent trend of increased number of firms converting from dual to non-dual CEO structure. However, our empirical results do not show a significant relationship between CEO duality and firm performance nor improvement in firm performance after change in leadership structure. We find evidence of endogeneity, and we attribute the insignificance of the relationship between CEO duality and firm performance to the possibility that CEO duality is endogenously and optimally determined given firm characteristic and ownership structure. Keywords: Corporate governance, CEO duality, Leadership structure, endogeneity *Tunghai Univeristy, Taichung, Taiwan Email: [email protected] **School of Management, Simmons College, 409 Commonwealth Avenue, Boston, MA 02215, Tel: 617-521-3845, Email: [email protected] *** corresponding author, College of Business and Public Policy, California State University-Dominguez Hills, 1000 E. Victoria ST, SBS C 327, Carson, CA 90747 Tel: (310) 243-2621, Fax: (310) 217-6964, Email: [email protected] 1. Introduction In the period from 1999 to 2003 hundreds of firms converted from dual CEO leadership structure to nondual structure, while a much smaller number of firms converted in the opposite direction. This recent trend is partly due to several high-profile cases where powerful dual CEOs were found to abuse their tremendous power at the expenses of the company and shareholders. However, empirical evidence is scant and inconclusive on whether non-dual, as versus dual, CEO leadership structure is associated with better firm performance. The objective of this paper is to re-examine this important issue in corporate finance by using a more recent data set as well as methodologies to control for potential selection bias and endogeneity, thus providing clear and timely evidence on this important issue. In addition to providing evidence on the relationship between CEO duality and firm performance, we attempt to answer the research question as to, given firm characteristics, whether leadership structure in term of CEO duality is in fact endogenously determined. Theoretical studies provide no consensus as to whether firms with split titles (CEO and chairman of the board) outperform firms with combined titles. Fama and Jensen (1983) and Jensen (1993) suggest that CEO duality may hinder board‘s ability to 58 monitor management and thereby increase the agency cost. As a result, splitting the titles of CEO and Chairman of the Board will improve firm performance. In contrast, Stoeberl and Sherony (1985) and Anderson and Anthony (1986) argue that CEO duality provides clear-cut leadership in strategy formulation and implementation and will therefore lead to better firm performance. Splitting titles may create information sharing costs, conflicts between CEO and non-CEO chairman and inefficiency: It will be costly to communicate firm-specific information to others in a timely manner; decision making process and execution may both be less efficient when there are two versus one key leader; it may be more difficult to assign blame for bad company performance. Whether combining or separating the leadership is beneficial to the firm is then an empirical question. However, the empirical evidence is mixed and inconclusive. Pi and Timme (1993) find that there is negative relationship between CEO duality and accounting performance measures in banking industry. Baliga, Moyer, and R. Rao (1996) found no evidence of performance changes surrounding changes in the duality status. Daily and Dalton (1997) find that there is no significant difference in performance between dual CEO and non-dual CEO firms. Dahya and Travlos (2000) document a positive association between CEO duality and firm Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 performance. Dahya (2005) show that splitting the titles of CEO and Chair of the Board among U.K companies is not associated with performance improvement. Faleye (2007) find that CEO duality is positively related to organizational complexity, CEO reputation and managerial ownership. His results suggest that firms do consider the costs and benefits of alternative leadership structure. As a result, the observed sample of firms that have chosen one type of leadership structure over the other are not random, consequently the OLS estimates are biased and inconsistent. Prior studies on leadership structure and performance fail to control for such potential selection bias. In this paper we use Heckman two-step procedure and control for the selection bias. We also use the fixed-effect model to control for unobservable factors, which may affect the relationship between CEO duality and firm performance. Furthermore, we examine the difference between sub-samples of firms announcing new dual CEOs versus non-dual CEOs without CEO replacements. By looking at only title change, without CEO replacements, we provide a clear view as to whether combined titles really affect firm performance. We then use multivariate analyses to examine CEO duality and firm performance controlling for potential endogeneity. We also examine changes in firm performance within the 3-year period surrounding leadership structure changes. We find consistent evidence that there is no significant relationship between CEO duality and firm performance. We find that firms may change their leadership structure (from duality to non-duality or vice versa) in response to deteriorating performance. However, after change in the leadership structure, there is no improvement in firm performance. Our results suggest that the leadership structure in firms is endogenously and optimally determined given firm characteristic and ownership structure. This paper proceeds as follows. Section 2 describes methods and data. Section 3 presents recent trend in firms‘ leadership structure. Section 4 reports our empirical tests, and section 5 concludes. 2. Methods and Data A firm‘s leadership structure should maximize its value. Each type of leadership structure has its own benefits and costs. A non-duality leadership structure provides better oversight on CEOs and thereby reduces managerial agency costs. But in the mean time, it may generate information sharing costs, create rivalry between CEO and non-CEO chairman, lead to inefficient strategy formulation and implementation. In cases when the costs of maintaining a non-duality leadership structure exceed its monitoring benefits, a duality leadership structure should be preferred. The leadership structure of a firm should be considered an endogenous outcome that maximizes firm valuation given firm‘s characteristics. Evaluating the impact of leadership structure should also account for the endogeniety of choice of leadership structure. Following Campa and Kedia (2002), we use an endogenous self-selection model and Heckman‘s (1979) two-step procedure to control for the selection bias. Dit* = αZit + μit (1) Where Dit* is an unobservable latent variable about the type of leadership structure, Zit is a set of firm characteristics that may affect leadership structure. Suppose a duality leadership structure is chosen if Dit* >0, and a non-duality leadership structure is chosen if Dit* 0. We can only observe whether a firm has a dual CEO or none-dual CEO. We model a firm‘s performance (measure by Tobin‘s Q, the ratio of market value to book value of assets. Market value of assets is computed as market value of equity plus book value of assets minus book value of equity.) as a function of leadership structure and a set of firm characteristics as Equation (2): Qit = β0 + β1 Dit + β2X it + vit (2) Where Dit is a CEO duality dummy variable, which equals one if CEO is also the chairman of the board, and is 0 otherwise. The OLS estimation on β1 will be biased if there is correlation between the error term in equation (1)—μit, and the error term in equation (2)—vit. We employ a treatment-effects model based on Heckman‘s (1979) two-step procedure that corrects for self-selection bias. The model accounts for the possibility that some firm specific characteristics that affect leadership structure may also affect firm performance. We first estimate equation (1) using a probit model to get consistent estimates of α, which are then used to get estimates of selectivity correction λit (lambda, or inverse of Mill‘s ratio). Then we model firm performance as a function of leadership structure, firm characteristics and selectivity correction as shown in equation (3): Qit = β0 + β1 Dit + β2X it + β3λit + vit (3) If β3, the coefficient of λit is significant, it indicates the existence of self-selection bias. We also use the fixed-effect model to control for unobservable firm characteristics that may affect firm performance. Besides comparing firm characteristics and performance among firms with different leadership structure, we specifically examine firms changing their leadership structure without replacing their CEOs, which hasn‘t been done in prior researches. Without controlling for whether CEOs are replaced or not when leadership structure changes, it will be difficult to decide whether the change in firm performance is due to change in CEO or the leadership structure or both, since the new CEOs might have different characteristics or skills, which may affect firm performance as well. Our method therefore provides a better test on the impact of leadership. We collect CEO duality, CEO career information, and compensation data from Standard and Poor‘s ExecuComp database from 1999 to 2003. ExecuComp includes executive compensation data for firms in the S&P 1500 index, which comprises the S&P 500, the S&P 400 mid cap, and the S&P 600 59 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 small cap indices.41 We obtain accounting data and stock return from COMPUSTAT and Center for Research in Security Prices (CRSP) respectively. Board structure and ownership data are obtained from Compact Disclosure database and proxy statements. To investigate the effect of CEO duality, we include variables related to corporate governance mechanisms, firm characteristics, agency costs, and compensation structure. For corporate governance mechanisms, we measure the CEO ownership, institutional ownership, board size, percentage of independent directors, financial leverage, G-index,42 CEO age, and chairman age. These variables reflect the degree of agency problems and internal or external monitoring mechanisms. Firm characteristics include firm size, firm age, number of business segments, R&D expenses scaled by annual sales, and sales growth in percentage. Firm size is the market value of each firm calculated by stock price at the end of the year times the common shares outstanding. Sales growth is the percentage of sales growth in the last 3 years. These variables provide measures to check if combined or split titles are related to certain type of firms. We follow Ang et al. (2000) in using operating expense ratio and asset utilization to capture agency costs. Operating expense ratio is operating expense scaled by annual sales. Asset utilization ratio is annual sales divided by total assets. Agency costs are inversely related to asset utilization ratio but positively related to expense ratio. Compensation structure measures how the CEO is compensated. Salary, bonus, value of restricted stock granted, and value of stock options granted are all measured in thousands of dollars. Value of stock options granted is calculated by S&P using the Black and Scholes methodology. Percentage of options granted is calculated by value of stock options granted divided by total compensation. Total compensation is the variable TDC1 extracted from ExecuComp database. It includes salary, bonus, other annual compensation, value of restricted stock granted, value of stock options granted, long-term incentive payouts, and all other total. These variables provide information on whether dual and non-dual CEOs are compensated differently in both dollar amount and in the structure of their compensation, which might result in different incentive for CEO to work hard. 3. Recent trend in CEO duality Most previous work related to CEO duality focuses on the period of 1980s and early 1990s and find U.S 41 ExecuComp also contains information on firms that are not currently in the S&P500, the S&P400, and the S&P600 indices, but were previously included in one the aforementioned indices. Thus, the number of observations in each year could be different. 42 G-index, or governance index as developed by Gompers, Ishii and Metrick (2003), is obtained from http://finance.wharton.upenn.edu/~metrick/governance.xls. 60 firms are more likely to have combined titles compared with European firms, the percentage of dual CEOs firms is around 80% and there is no evidence of a decline in the popularity of the duality leadership structure in the U.S. (Baliga, Moyer, and Rao, 1996; Brickley, Coles and Jarrel, 1997, among others). 43 Different from previous studies, we investigate CEO duality with a relatively large sample from recent years. Before directly testing the relation among CEO duality, firm characteristics, and firm performance, it is of interest to examine the recent trend in CEO duality. Despite the mixed evidence of superiority of non-duality over duality leadership structure in firm performance, corporations have been facing increasingly stronger pressure from regulators, exchanges, and or shareholders to separate CEO and chairman duties after corporate scandals since 2001. For example, in the U.S., the number of shareholders proposal calling for non-duality leadership structure increase from 3 in 2001 to 20 in 2003, and 32 in 2004 (Faleye, 2007). Table 1 shows a tendency that duality leadership structure is becoming less and less popular in the U.S. Part I of Table 1 shows that the proportion of firms with combined titles drop from about 65.5 percent in 1999 to just over 60 percent in 2003, compared the stable level of 80 percent in the 1980s and early 1990s. More and more firms switch their leadership structure from duality into non-duality as shown in Part II. Among firms that changed their leadership structure, the proportion of firms switching from duality to non-duality increased from 55 percent in 1999 to nearly 70 percent in 2003. 4. Empirical Results 4.1 CEO duality and firm characteristics Table 2 compares firm characteristics and performance measures for dual versus non-dual CEO firms. We find significant differences in most of the variables. For corporate governance mechanisms, dualCEO firms have higher G-index and larger board size, suggesting that dual CEO firms have poorer governance and more inefficient board. Interestingly, dual CEO firms also have higher CEO ownership, which might be required to more strongly align the interests of CEO and shareholders. Dual-CEO firms also have higher institutional ownership and financial leverage, indicating more external monitoring, which also might be required to reduce agency problem resulting from the increased power of dual-CEOs. Similarly, we found a relatively high percentage of independent directors in dual CEO firms. The results suggest that dual CEO firms might suffer poor corporate governance from the board, however, alternative mechanisms (CEO ownership, oversight from institutional investors, more independent board 43 Dahya, and Travlos (2000) provides clear summary of previous studies related to CEO duality. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 members, creditors, etc.) might come to play and reduce the agency costs for CEO duality. There is no significant difference in operating expense ratio between non-dual CEO and dual-CEO firms, while dual-CEO firms have significantly higher asset utilization ratio than non-dual CEO firms. The results indicate that the agency costs of dual-CEO firms are not higher than those of non-dual CEO firms. Table 1. Distribution of firms with different leadership structure from 1999 to 2003 Table 1 provides the number of Dual and Non-dual CEOs in each year from 1999 to 2003 on part I. Part II provides the distribution of firms that changed their leadership structure in each year. Year 1999 2000 2001 2002 2003 Average % I: Distribution of duality and non-duality firms Number of firms with dual CEOs 1186 1137 1031 1029 904 62.56 (65.49) (63.45) (61.74) (61.88) (60.23) Number of firms with non-dual CEOs 625 655 639 634 597 37.44 (34.51) (36.55) (38.26) (38.12) (39.77) II: Distribution of firms that changed their leadership structure Number of firms switching from non184 150 90 68 67 37.19 duality to duality (44.99) (41.90) (35.29) (33.17) (30.59) Number of firms switching from duality 225 208 165 137 152 62.81 to non-duality (55.01) (58.10) (64.71) (66.83) (69.41) Table 2. Comparisons of Dual and Non-dual CEO Firms Table 2 provides summary statistics for the whole sample firms and compares firm characteristics between duality and nonduality firms. CEO ownership, insider ownership, institutions ownership, blockholder ownership are the proportions of common stocks held by CEOs, corporate insiders, institutional investors and blockholders respectively. G-index is the governance index constructed by Gompers, Ishii and Metric (2003) to proxy for the level of shareholder rights. Board size is measured by the number of directors. Independent directors are directors whose only connection to the corporation is their directorship. The ratio of independent directors is the number of independent directors divided by the number of directors. Leverage is long-term debt divided by book value of total assets. Tobin‘s q is the ratio of market value to book value of assets. Market value of assets is computed as market value of equity plus book value of assets minus book value of equity. Return on asset is net income divided by book value of asset. Return on equity is net income divided by book value of common equity. Firm size is natural logarithm of the book value of total assets. Operating income before depreciation, R&D expenses, advertising expenses, capital expenditure, tangible assets are all scaled by book value of total assets. Operating expense scaled by annual sales and asset utilization ratio are measures of agency costs. Salary, bonus, and value of restricted stock granted, Black-Scholas value of options granted, and total compensations are in thousands of dollars. Levels of significance for the tand Wilcoxon tests are indicated by a, b, and c for 1%, 5%, and 10% respectively. The value in parenthesis is the number of observations. All sample firms Non-dual CEO Dual CEO firms Differences (5154) firms (3354) (1800) Mean Median Mean Median Mean Median t-test Wilcoxon Corporate governance mechanisms CEO ownership 0.026 0.003 0.020 0.002 0.029 0.004 -5.21a -8.44a a Insider ownership 0.068 0.018 0.077 0.025 0.063 0.014 3.80 9.87a Institutional ownership 0.651 0.687 0.642 0.671 0.655 0.695 -2.13b -2.67a Blockholder ownership 0.344 0.323 0.380 0.359 0.325 0.301 8.46a 8.81a Board size 9.270 9 8.905 9 9.467 9 -7.61a -13.7a Ratio of independent directors 0.650 0.667 0.607 0.625 0.673 0.7 -12.9a -13.3a a Leverage 0.200 0.194 0.188 0.169 0.206 0.205 -3.70 -5.35a CEO age 55.26 55 53.67 53 56.12 56 -10.4a -11.6a a G-index 9.319 9 8.754 9 9.613 10 -6.94 -7.05a (1968) (1968) (674) (674) (1294) (1294) Agency costs Operating expense scaled by annual 0.263 0.219 0.263 0.224 0.263 0.215 0.034 1.43 sales (4261) (4261) (1572) (1572) (2689) (2689) Asset utilization ratio 1.052 0.895 1.089 0.903 1.032 0.891 2.41a 1.39 61 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 2 continued Firm performance and characteristics Tobin‘s q Return on asset Return on equity Firm size Number of business segments Firm age R&D expenses Advertising expenses Operating income before depreciation Capital expenditure Sales growth Tangible assets Compensation structure Salary Bonus Value of restricted stock granted Value of stock options granted Total compensation 2.519 0.025 -0.065 (5153) 7.541 2.974 (4618) 20.55 0.030 1.937 0.042 0.109 (5153) 7.358 3 (4618) 17 0 2.638 0.018 2.049 0.043 2.455 0.028 1.866 0.042 2.83a -1.69c 6.01a -0.96 0.008 7.105 2.643 (1591) 18.13 0.036 0.098 6.961 2 (1591) 15 0 -0.105 7.776 3.148 (3027) 21.84 0.026 0.116 7.609 3 (3027) 20 0 0.475 -15.5a -8.93a -6.24a -14.4a -9.31a -10.4a 5.34a -9.13a 3.04a 0.011 0 0.010 0 0.012 0 -1.93c -1.98b 0.132 0.004 0.930 0.300 0.130 0.041 0.262 0.241 0.129 0.058 0.695 0.298 0.129 0.041 0.294 0.233 0.134 0.054 1.056 0.302 0.130 0.042 0.246 0.245 -1.69c 2.28b -1.10 -0.63 -1.47 0.723 1.218 -1.67c 666.7 753.1 618.7 383.1 552.3 509.0 500.6 257.0 728.2 884.2 696 488 -19.5a -9.59a -19.7a -11.2a 534.9 3439.4 (5135) 5828.1 (5135) 0 951.9 (5135) 2713.9 (5135) 385.7 3251.2 (1792) 4911.2 (1792) 0 716.8 (1792) 1964.9 (1792) 614.9 3540.0 (3343) 6319.5 (3343) 0 1084.6 (3343) 3123.8 (3343) -3.11a -0.63 -6.00a -6.72a -2.92a -12.9a For firm performance, non-dual CEO firms have mean (median) Tobin‘s Q of 2.64 (2.05), while dualCEO firms have mean (median) Tobin‘s Q of 2.46 (1.87), the differences in mean and median are both significant at the one percent level. Non-dual CEO firms have higher mean return on assets (ROA) than dual-CEO firms but there is no significant difference in median. In contrast, non-dual CEO firms have lower median return on equity (ROE) than dual-CEO firms but there is no significant difference in mean return on equity.44 In terms of firm characteristics, larger and older firms tend to give combined titles to their CEOs. Firms with combined titles have relatively more business segments. These firms tend to have less growth opportunity, spend less in R&D expenditure, and carry more tangible assets. For CEO compensation structure, dual CEOs have significantly higher total compensation, with higher salary, higher restricted stock, and higher bonuses, while there is no significant difference in stock option. In the univariate tests we find non-dual-CEO firms have significantly higher Tobin‘s Q than dualCEO firms. However, without controlling for other 44 Harris and Helfat (1998) located 13 studies providing statistical evidence regarding impact of CEO duality on firm performance. Only three of those studies find negative impact of CEO duality on firm performance. Pi and Timme (1993) examine the banking industry only. Berg and Smith (1978) find a negative impact of CEO duality on return on investment but not on return on equity. Rechner and Dalton (1991) find a negative effect of duality on return on investment and return on equity. We will focus on Tobin‘s Q, which is a widely used firm performance measure in finance literature. 62 factors that may impact firm performance, we cannot be confident whether leadership structure affects firm performance or not. Since a firm‘s leadership structure might be an endogenous outcome of its characteristics, we apply Heckman‘s two-step procedure to control for the endogeneity of leadership structure and examine its impact on firm performance 4.2 Determinants of CEO duality Table 3 reports a probit regression on the relation between CEO duality and firm characteristics. Model one includes Tobin‘s Q as a measure of performance. Faleye (2007) finds that organization complexity, CEO reputation, and managerial ownership increase the probability of CEO duality. We find firm size, CEO-age, and CEO-ownership to increase the probability of CEO duality. In addition we find that board independence and institutional ownership are positive determinants, while block ownership is a negative determinant on CEO duality. The performance variable Tobin‘s q is insignificant, although positive. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 3. Determinants of CEO duality This table reports probit regression results of firm performance and characteristics on CEO duality dummy. Firm performance is measured by Tobin‘s q, return on asset and return on equity. CEO duality dummy equals one if CEOs also act as chairs of the boards of directors and equals zero otherwise. Levels of significance are indicated by a, b, and c for 1%, 5%, and 10% respectively. Intercept -2.755a -2.755a Tobin‘s q 0.00007 Firm size 0.146a 0.146a Sales growth 0.008 0.008 Tangible asset -0.108 -0.108 CEO age 0.020a 0.020a CEO ownership 3.606a 3.606a Ratio of independent directors 1.336a 1.336a Insider ownership -0.323 -0.323 Insider ownership square 0.736 0.736 Institutional ownership 0.713a 0.713a Blockholder ownership -0.593a -0.593a Leverage 0.093 0.093 Yeas dummies Yes Yes Industry dummies Yes Yes No. of observations LR Chi2 Pseudo R² 5154 658.8 0.099 4.3 CEO duality and firm performance Table 4 reports the effect of CEO duality on firm performance based on OLS regression, a regression using Heckman self-selection model to control for selection bias, and a fixed effect model to control for impacts of non-observable firm characteristics. 5154 658.8 0.099 While many of the firm characteristics variables are statistically significant, our key variable, the dualCEO dummy variable, is insignificant for all three models. This is strong and robust evidence that, cross-sectionally, there is no evidence that CEOduality significantly affects firm performance. Table 4. CEO duality on firm performance This table reports results of CEO duality on firm performance based on OLS regression which does not control endogeniety of CEO duality, regression using Heckman self-selection model, and fixed effect model to control for the endogenity of CEO duality. Levels of significance are indicated by a, b, and c for 1%, 5%, and 10% respectively. OLS Self-selection Fixed effects Intercept 1.993a -1.603a 12.67a CEO duality dummy -0.044 0.014 0.095 Board size -0.069a -0.070a -0.064b c c Insider ownership 0.862 0.967 -2.728a c a Insider ownership square 1.362 3.833 6.823a Institutional ownership -0.113 0.719a -0.129 Blockholder ownership -0.249c -1.265a 0.177 Firm size 0.065a 0.207a -1.352a Leverage -2.099a -3.416a -1.436a R&D expenses 9.641a 9.611a -2.228 A&D expenses 2.385a 2.370a 3.698 Operating income before depreciation 7.030a 7.054a 7.121a Capital expenditure 0.094 0.028 0.286 Lambda 3.864a Yeas dummies Yes Yes No Industry dummies Yes Yes No No. of observations F-Statistic R² 4.4 CEO duality change and firm performance To further investigate the relationship between CEO duality and firm performance, we identify a sample of firms that changed their leadership structure (from dual to non-dual or vice versa). We focus only on firms with new announcement of dual or non-dual CEOs without changing the CEO to avoid the potential contaminating impact of CEO replacement 5154 78.57 0.277 5154 79.53 0.287 5154 44.75 0.054 on firm performance. Table 5 reports the effect of CEO duality on firm performance for firms changing their leadership structure without replacing CEOs. Here we use only two of the three earlier regression models, as the fixed effect model is not applicable due to insufficient number of observations. We again find the CEO duality dummy to be statistically insignificant, though positive, confirming earlier regression results. We note that the existence of endogeneity is indicated in both Table 4 and 5, 63 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 where the coefficients of lambda are both significant at one percent level. This suggests that firms endogenously choose their leadership structure as a part of the broader firm characteristics and ownership structure decision. To provide some evidence of the endogeneous relationship between firm performance and CEO duality, we investigate the time patterns of firm performance around a CEO-duality change. Table 5. Effects of CEO duality on firm performance for firms changing their leadership structure without replacing CEOs Fixed-effect model is not applicable due to insufficient number of observations. Intercept CEO duality dummy (1 = dual CEO) OLS 4.573 1.076 Board size Insider ownership Insider ownership square Institutional ownership Blockholder ownership Firm size Leverage R&D expenses A&D expenses Operating income before depreciation -0.365b -15.17b 35.65a -3.750b 0.976 0.134 -2.439 6.462a 38.59a 7.882a -0.354b -16.98a 34.31a -8.182a 1.966 0.035 -2.336 4.530 35.02b 8.729a Capital expenditure Lambda Yeas dummies Industry dummies No. of observations F-Statistic Adjusted R² -3.186 -1.108 -7.276a Yes Yes 254 4.95 0.362 Yes Yes 254 4.70 0.340 Self-selection 10.17a 0.505 Table 6. Tobin‘s Q surrounding change in leadership structure Table 6 reports measures of firm performance from three years before occurrence of change in leadership structure until three years after the change in leadership structure. Firms included are firms that changed their leadership structure without replacing their CEOs. Year 0 is the year in which firms changed their leadership structure. Year From dual to non-dual From non-dual to dual Mean Difference (# of observations) (# of observations) (t-test, H0: Diff = 0) -3 3.144 (54) 2.806 (307) 0.338 (0.862) -2 3.418 (55) 2.937 (324) 0.482 (0.817) -1 2.919 (54) 2.902 (323) 0.017 (0.040) Pre-change average 3.162(163) 2.883 (954) 0.279 (1.006) 0 2.423 (52) 2.768 (323) -0.345 (-0.927) 1 2.312 (50) 2.454 (319) -0.142 (-0.634) 2 2.041 (45) 2.394 (302) -0.353 (-1.758c) 3 Post-change average 2.422 (40) 2.242 (253) 2.254 (135) 0.908 (3.177a) 2.372 (874) 0.511 (3.919a) Difference (t-test) Table 6 shows Tobins‘ Q from three years before an announcement of change in leadership structure to three years after the change in leadership structure. As in Table 5, firms included are firms that changed their leadership structure without replacing their CEOs. Figure 1 plots the changes in Tobin‘s Q. We observe in Table 6 and Figure 1 that firms switching from duality to none duality or vice versa were experiencing deterioration in performance prior to leadership change announcements, and the deterioration in performance continues even after change in leadership structure. For example, for firms that switched from dual CEOs into non-dual CEOs, their three-year average pre-change Tobin‘s Q is 64 0.179 (0.524) -0.110 (-0.770) 3.162, exceeding the three-year average post-change Tobin‘s Q by 0.91. And the difference is significant at the one percent level. Similar results can be found among firms switching from non-dual to dual CEOs. The time pattern in Tobin‘s q illustrate clearly that CEO duality changes are motivated by firms in response to deteriorating performance, in support of the notion that firm leadership structure is endogenously determined. Our results therefore cast doubt on the arguments for the non-duality leadership structure, which has been more prevalent after recent corporate scandals. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Figure 1. Tobin's Q Surrouding Change in Leadership Structure 5. Conclusion Both theoretical and empirical studies are inconclusive as to which might be better: vesting both CEO and Chair of the Board positions into one person, or splitting the titles. However, in many countries including the U.S., regulators and investors have become more and more strongly recommending separation of CEO and chairman duties. In this paper, we utilize a more recent set of data and investigate the issue of CEO duality in relation to firm characteristics, ownership characteristics, agency costs, and firm performance. We apply methodology to control for endogeineity of leadership structure. Our empirical findings provide clear answers to the research question that we raise in the beginning of the paper. We find significant differences in firm characteristics between dual and non-dual CEO firms. However, our multivariate tests find no evidence that CEO duality has a significant effect on firm performance. It is important to note that we find the existence of endogeneity in CEO duality, indicating that the corporate leadership structure is endogenously and optimally determined, given firm characteristic and ownership structure. Our evidence casts doubt on the notion that firms changing from dual to non-dual leadership structure would improve performance. It seems that, given firm characteristics and ownership structure, firms endogenously and optimally determine their choice of dual or non-dual CEO structure. This paper contributes new evidence to this important issue in corporate finance. References 1. 2. 3. Anderson, C. A. & Anthony, R. N. (1986). The new corporate directors: Insights for board members and executives (New York: Whiley). Ang, J., R. Cole, and J. Lin, 2000, Agency costs and ownership structure, The Journal of Finance 55, 81106. Baliga, R., Moyer, C., and R. Rao, 1996, ―CEO duality and firm performance: What‘s the fuss?‖ Strategic Management Journal 17, 41-53. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. Berg, S. and S. K. Smith, 1978, ―CEO and board chairman: A quantitative study of dual vs. unitary board leadership‖, Directors & Boards 3, 34-39 Boyd, B., 1995, ―CEO duality and firm performance: A contingency model,‖ Strategic Management Journal 16, 301-312. Brickley, J.A., Coles, J.L., and G. Jarrell, 1997, ―Leadership structure: Separating the CEO and chairman of the board,‖ Journal of Corporate Finance 3, 189-220. Campa, J., Kedia, S., 2002. Explaining the diversification discount. Journal of Finance 57, 1731-1762. Dahya, J., A.A. Lonie, and D.M. Power, 1996, ―The case for separating the roles of chairman and CEO: An analysis of stock market and accounting data,‖ Corporate Governance-An International Review 4, 71-77. Dahya, J. and N.G. Travlos, 2000, ―Does the one man show pay? Theory and evidence on the dual CEO revisited,‖ European Financial Management 16. Dahya, Jay, "One Man Two Hats - What's All the Commotion!" (August 2005). Available at SSRN: http://ssrn.com/abstract=853006 Daily, C. and D. Dalton, 1997, ―Separate, but not independent: board leadership structure in large corporations,‖ International Corporate Governance – An International Review 5, 126-136. Faleye, O., 2007, ―Does one hat fit all? The case of corporate leadership structure,‖ Journal of Management and Governance, Vol 13. N.3, 239-259 Fama, E.F. and M. Jensen, 1983, ―Separation of ownership and control‖, Journal of Law and Economics 26, 301-325. Pi, L. and S.G. Timme, 1993, ―Corporate control and bank efficiency‖, Journal of Banking and Finance 17, 515-530. Harris, D., and C.E. Helfat, 1998. ―CEO Duality, Succession, Capabilities, and Agency Theory: Commentary and Research Agenda‖, Strategic Management Journal 19, 901-904 Rechner, P.L. and D. R. Dalton, 1989, ―The impact of CEO as board chairperson on corporate performance: Evidence vs. rhetoric‖, Academy of Management Executive 3, 141-143. Stoeberl, P. A. & Sherony, B. C. (1985). Board efficiency and effectiveness. (In E. Mattar & M. Balls (Eds.), Handbook for corporate directors (pp. 12.112.10). New York: McGraw-Hill). 65 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 VALUE BASED FINANCIAL PERFORMANCE MEASURES: AN EVALUATION OF RELATIVE AND INCREMENTAL INFORMATION CONTENT Pierre Erasmus* Abstract Value-based (VB) financial performance measures are often advanced as improvements over traditional measures. It is argued that the inclusion of a firm‟s cost of capital in the calculation of these measures facilitates the evaluation of value creation. Furthermore they attempt to remove some accounting distortions resulting from the limitations of conventional accounting information. This paper investigates the ability of four VB measures to explain market-adjusted share returns and compare it to that of some traditional measures. Empirical results indicate that the relative information contents of the VB measures are not greater than that of earnings. The incremental information content tests indicate that their components add significantly to the information content of earnings, but that the level of significance is relatively low. Keywords: financial performance, cost of capital, accounting information *Department of Business Management, University of Stellenbosch, Private Bag X1, Matieland, 7602, SOUTH AFRICA E-mail: [email protected], Tel : +27 21 8082215, Fax : +27 21 8082226 1. Introduction Firms focused on the maximisation of shareholder value need to ensure that all activities yield positive net present values. A number of value-based financial performance measures have been developed in an attempt to guide management actions towards achieving this objective. These value-based measures, such as Economic Value Added (EVA) and Cash Value Added (CVA), attempt to include a firm‘s cost of capital and to adjust financial statement information in order to remove some of the accounting distortions contained in traditional financial performance measures. Performance exceeding the cost of capital yields value, while the failure to achieve this results in the destruction of shareholder value. Value-based financial performance measures (VBM) are presented by their proponents as a major improvement over the traditional performance measures. Most importantly, by including a firm‘s cost of capital in their calculation they could be applied in order to evaluate the value creating potential of a firm (Young and O‘Byrne, 2001: 431; Lehn and Makhija, 1996: 35). If the returns generated on a firm‘s projects are in excess of the cost of capital, these projects would yield positive net present values and consequently shareholder value is increased (Grant, 2003: 81; Stewart, 1991: 174). These VBM also attempt to overcome some of the problems associated with the traditional measures by removing the accounting distortions contained in the 66 financial statements (Ehrbar, 1998: 80; Peterson and Peterson, 1996: 10; Stewart, 1991: 66). Perhaps one of the best known value-based performance measures is Economic Value Added (EVA). EVA is an estimate of the economic profit generated by a firm (Stewart, 1994: 73) and is calculated by comparing a firm‘s net operating profit after tax (NOPAT) to the total cost of all its forms of capital (debt, as well as equity) (Grant, 2003: 2). Maximising a firm‘s EVA should result in an increase in shareholder value created (Stewart, 1991: 174). Proponents of the measure report high levels of correlation with share returns (Worthington and West, 2004: 201; O‘Byrne, 1999: 95; Bacidore, Boquist, Milbourne and Thakor, 1997: 17; O‘Byrne, 1996: 117; Grant, 1996: 44; Lehn and Makhija, 1996: 36; Peterson and Peterson, 1996: 45; Stewart, 1994: 75, 136; Stewart, 1991: 66). The measure Cash Value Added (CVA) is considered as another form of residual income (Young and O‘Byrne, 2001: 428). This measure calculates the difference between a firm‘s operating cash flow and a capital charge based on the gross amount of invested capital (Young and O‘Byrne, 2001: 440). One of the major differences between CVA and EVA is that depreciation and accruals are added back to NOPAT when calculating the operating cash flow values included in CVA (Martin and Petty, 2000: 128). Furthermore, accumulated depreciation is included with the invested capital amount when the gross invested capital is determined (Martin and Petty, 2000: 141). According to Young and O‘Byrne (2001: 429), the calculation of CVA is less complex Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 than the calculation of EVA since no accounting adjustments are required. They also argue that since depreciation is added back during the calculation of CVA the measure is not influenced by a firm‘s depreciation policy (Young and O‘Byrne, 2001: 440). They perceive this characteristic of CVA as an advantage over EVA where different depreciation policies can result in large variations in the value of the measure. A number of limitations with regard to CVA, however, are also highlighted. According to Young and O‘Byrne (2001: 461), EVA is a better financial measure than CVA. They argue that the problem of different depreciation policies in the case of EVA can be solved by including an accounting adjustment. Furthermore, they indicate that by removing accruals and depreciation from the calculation of CVA the measure may loose important information required by the market when evaluating an enterprise. The process of removing the effects of accounting accruals in the calculation of CVA could also be relatively complex. They also warn that the incorporation of CVA values into valuation models should be considered carefully since CVA is based on historical accounting figures that do not represent the expected future cash flow generated by the enterprise (Young and O‘Byrne, 2001: 442). Another problem experienced with CVA occurs when uneven cash flow values are considered (Martin and Petty, 2000: 149). The resulting CVA values may provide conflicting signals with regard to the value creation of the projects under consideration. From the existing literature it is not clear whether CVA is able to outperform other financial performance measures. The measure Cash Flow Return on Investment (CFROI) has been presented as an improvement over some of the other traditional and value-based measures by its proponents (Dzamba, 2003: 10). It is calculated by considering the inflation-adjusted investment in assets, the inflation-adjusted cash flow generated by employing these assets in the firm, and determines the yield generated over the estimated lifetime of the assets. Madden (1999: 110) considers the calculation of CFROI to be based on basic DCF principles. The four inputs required to calculate the measure are as follows: o The average life of the depreciating assets. o The total amount of assets (includes both depreciating, as well as nondepreciating assets) adjusted for inflation. o The inflation-adjusted cash flows generated by the assets over their lifetime. o The final inflation-adjusted residual value of the non-depreciating assets at the end of the asset lifetime. The calculations of the CFROI inputs are discussed in greater detail in Reviewers‘ Appendix 1. These four inputs are represented in the cash flow diagram provided in Figure 1: Inflation-adjusted gross cash flows 1 2 3 4 5 Non-depreciating assets Estimated asset lifetime Non-depreciating assets Depreciating assets Figure 1. Cash flow diagram representing the four CFROI components 67 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Based on these inputs the firm‘s CFROI value is calculated as the discount rate that would ensure that the present value of all the future cash flows (the equal annual inflation-adjusted gross cash flows, as well as the terminal non-depreciating assets amount) is equal to the initial investment (total nondepreciating and depreciating assets). As such, the CFROI may be viewed as a return on investment (ROI). However, it is not calculated for individual projects, but rather for the firm as a whole. This CFROI figure is compared to the firm‘s inflation-adjusted (real) cost of capital. If a firm is able to generate CFROI values in excess of its inflation-adjusted cost of capital it should increase its shareholders‘ value while CFROI values below the real cost of capital will result in the destruction of shareholders‘ value. One of the characteristics of this measure is that is focuses on the return offered to all the capital providers of the firm and not only the shareholders (Madden, 1999: 101). Relatively little empirical research, however, have been conducted on the performance of CFROI relative to other financial performance measures. In this paper the ability of the value-based measures residual income (RI), EVA, CVA and CFROI to explain market-adjusted share returns is investigated for a sample of firms listed in the Industrial Sector of the Johannesburg Securities Exchange (JSE) and compared to that of the traditional financial performance measures earnings before extraordinary items (EBEI) and operating cash flow (CFO). In the first part of the study the relative information contents of the value-based measures relative to the traditional measures are evaluated. The second part of the study investigates the incremental information content of the components of the valuebased measures, and test whether the inclusion of these components contributes significantly to the information content of the other measures. The empirical results indicate that the relative information contents of the value-based measures are not greater than that of earnings. The incremental information content tests indicate that the components of some of the value-based measures do add significantly to the information content of earnings. The level of significance, however, is relatively low. The remainder of the paper consists of six sections. The first section focuses on the breakdown of the measures into their contributing components that is required for the information content tests. The second section describes the research method. The third section contains the descriptive statistics of the measures and components included in the relative and incremental information content tests. The fourth section provides the results from the relative information content tests, while the fifth section reports on the incremental information content tests. The final section contains the summary and the conclusions. 68 2 Components of the Value-Based Measures This paper investigates the relative and incremental information content of the measures cash flow return on investment (CFROI), nominal and inflationadjusted cash value added (CVAnom and CVAreal), nominal and inflation-adjusted economic value added (EVAnom and EVAreal), operating cash flow (CFO), earnings before extraordinary items (EBEI) and residual income (RI). To do so, these measures are partitioned into their contributing components using an approach applied by Biddle, Bowen and Wallace (1997: 305). The following section provides a break-down of the components included in the calculation of the nominal versions of the measures included in the study. Thereafter, the inflation adjustments proposed by International Accounting Standard 15 (IAS15) are highlighted. Finally, the components of the inflationadjusted measures EVAreal, CVAreal and CFROI are considered. 2.1 Nominal Measures To explore the relationships between the various measures, one should commence by defining EBEI, and then discuss all the additional components required to calculate the measures. According to Biddle et al. (1997: 305) a firm‘s EBEI could be defined as follows: EBEIt = CFOt + Accrualt, where: EBEIt = The earnings before extraordinary items and tax for period t. CFOt= The net cash from operating activities. Accrualt = The total operating accruals of the firm. The difference between EBEI and the net operating profit after tax (NOPAT) is that NOPAT does not take the after-tax interest expense into account, while EBEI does. Therefore: NOPATt - ATIntt = EBEIt where: ATIntt = Interest expense after provision for tax While EBEI makes provision for the cost of debt by subtracting the interest expense, RI is calculated by deducting the cost of the total (i.e. debt and equity) capital. RIt = NOPATt – (c* x ICt-1) where: c* = The firm‘s estimated weighted average cost of capital (WACC) after tax ICt-1= The amount of capital invested in the firm at the beginning of the period Firms that achieve positive RI values are able to generate profits in excess of their total cost of capital, and consequently shareholder value should be created. Negative RI values are an indication that insufficient profits are generated, and as a result, shareholder value could be destroyed. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 EVA is calculated in a similar way as RI. The major difference between the two measures relates to a number of adjustments to NOPAT and IC included in the calculation of EVA. These adjustments are included with a view to removing some of the accounting distortions identified by Stewart (1991: 28). EVAt=(NOPATt + AcctAdjop; t) – [c* x (ICt-1+ AcctAdjc;t)] where: AcctAdjop; t=Adjustments to remove the accounting distortions from operating profit AcctAdjc; t=Adjustments to remove the accounting distortions from invested capital Since EVA values are not published by Stern Stewart for South African firms, the EVA values are obtained from the McGregor BFA database (2005). Although these EVA values do not include all the adjustments recommended by Stern Stewart, the standardisation process applied to the financial statements contained in the database already makes provision for a number of the adjustments. A firm‘s CVA is calculated by considering the operating cash flow rather than operating profit (as was the case for EVA), and subtracting the gross capital charge. To convert NOPAT into the operating cash flow, depreciation and amortisation are added back (Martin & Petty, 2000: 128). Changes in other long-term liabilities, such as provisions and deferred taxes, are also added to NOPAT to convert it into a cash flow figure (Young & O‘Byrne, 2001: 441). The capital charge is based on the gross value of the invested capital and not on the net figure (Martin & Petty, 2000: 141). Accumulated depreciation is, therefore, added back to the invested capital. CVAt=Operating cash flow –gross capital charge =(NOPATt + CVAAdjop; t) – [c* x (ICt-1+ AccDeprt-1)] where: CVAAdjop; t=Depreciation, amortisation and changes in other long-term liabilities AccDeprt-1=Accumulated depreciation Based on these definitions CVA can be presented as follows: CVA=CFO + Accrual + ATInt – CapChg + AcctAdj + CVAAdj where: CapChg =c* x ICt-1 AcctAdj =AcctAdjop; t – (c* x AcctAdjc; t) CVAAdj=CVAAdjop; t – AcctAdjop; t + [c* x (AcctAdjc; t + AccDeprt-1)] 2.2 Inflation-Adjusted Measures In addition to the nominal measures, this study also investigates the information content of the inflationadjusted versions of EVA and CVA, as well as the measure CFROI. In order to calculate the inflationadjusted versions of these measures, inflation adjustments are calculated according to the guidelines contained in IAS15. These guidelines recommend adjustments to the cost of sales, the depreciation, the level of gearing, and the property, plant and equipment (PPE). The calculations of these adjustments are described in more detail in Reviewers‘ Appendix 2. After calculating the IAS15 inflation adjustments, the inflation-adjusted version of the measure EVA is calculated as follows: EVAreal;t =NOPATreal;t – (ICreal;t-1 x c*real; t ) = (NOPATnom;t - COSAdjt – DeprAdjt ± GearAdjt) – [(ICnom;t-1 + PPEAdjt) x c*real; t ] where: EVAreal;t =EVA in real terms, calculated after the inflation adjustments to NOPAT and IC, are included NOPATreal;t=NOPAT after including the cost of sales, depreciation and gearing adjustments c*real; t =the inflation-adjusted cost of capital ICreal;t-1 =the invested capital after including the PPE inflation adjustment The real CVA is then calculated as follows: CVAreal; t= (NOPATnom; t + CVAAdjop; t - COSAdjt – * DeprAdjt ± GearAdjt) – [ c real x (ICnom; t-1 + PPEAdjt + AccDeprt-1)] where: CVAreal; t = CVA in real terms, calculated after the inflation adjustments to NOPAT and capital, are included CVAAdjop; t = Depreciation, amortisation and changes in other long-term liabilities AccDeprt-1 = Accumulated depreciation The measure cash flow return on investment (CFROI) compares the inflation-adjusted cash flow generated by a firm with the inflation-adjusted cash investment required to achieve it (Young & O‘Byrne, 2001: 382). By including the estimated lifetime of the firm‘s depreciable assets and the expected residual value of its non-depreciable assets an internal rate of return is calculated. This CFROI figure is then compared to the firm‘s inflation-adjusted (real) cost of capital. In order to investigate the relative and incremental information content of the measure and to compare it with the other measures included in this study the CFROI margin is defined as the difference between a firm‘s CFROI and its real cost of capital: CFROIMargin =CFROI - c*real The CFROI margin can be presented as follows: CFROIMargin = CFO + Accrual + ATInt – CapChg + AcctAdj + InflAdj + CVAAdjreal + CFROIAdj where: Accrual = The total operating accruals of the firm ATInt = Interest expense after provision for tax CapChg = The capital charge based on the cost of capital and the invested capital at the beginning of the financial year AcctAdj = The accounting adjustments to NOPAT and ICt-1 to calculate EVAnom InflAdj = The IAS15 inflation adjustments included to calculate EVAreal 69 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 CVAAdjreal = The adjustments made to EVAreal to calculate CVAreal CFROIAdj = The difference between CVAreal and the firm‘s CFROIMargin The relationship between the CFROIMargin components is summarised in Figure 2 (Biddle et al., 1997: 307): CFROIMargin = CFO + Accrual + ATInt – CapChg + AcctAdj + InflAdj + CVAAdj real + CFROIAdj earnings (EBEI) operating profits (NOPAT) residual income (RI) economic value added (EVA) real economic value added (EVAreal) real cash value added (CVAreal) cash flow return on investment margin (CFROIMargin) Figure 2. Components of the cash flow return on investment margin (CFROIMargin) 3 Research Method 3.1 Hypotheses The information content of a financial measure refers to the additional information that the market deduces from its publication and incorporates into the expected future financial performance of the firm. In order to evaluate the relative and incremental information content of the traditional and the value based measures included in this study, an approach developed by Biddle et al. (1997: 307) is applied. According to this approach, relative information content comparisons should be used to compare different measures, or when a choice between the 70 measures is required. Incremental information content is used to determine whether one component of a measure provides additional information over and above that provided by another component. To investigate the relative information content of the measures, the following null hypothesis is formulated (Biddle et al., 1997: 308): HREL: The information content of measure X1 is equal to that of X2 where X1 and X2 are pairwise combinations of the measures under investigation. Rejection of the null hypothesis indicates a statistically significant difference in the information content of the two measures. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 In order to investigate the incremental information content of the components of measure Xi, it is necessary to decompose it into its contributing components: Xi = Y1 + Y2 + Y3 + … + Yn The following null hypothesis is then formulated (Biddle et al., 1997: 308): HINC: Component Y1 does not provide information content beyond that provided by the remaining components Y2-Yn where Y1-Yn are the various components of the measure Xi investigated. Pairwise comparisons of the components are conducted to evaluate the incremental information content. Rejection of the null hypothesis indicates that the inclusion of the component under investigation will contribute significant additional information content. 3.2 Statistical Techniques In order to evaluate the information content of the measures, the relationships between the measures and market adjusted share returns are investigated. For this purpose, regression analyses with the share return as dependent variable and the various measures as the independent variables are conducted. The statistical technique employed in this study focuses on the forecast errors of the various measures (calculated as the difference between the actual and expected values), which are standardised to size. When assessing the information content of a measure, the statistical significance of the slope coefficient b1 from the following ordinary-least squares regression is examined (Biddle et al., 1997: 308): Dt = b0 + b1 FEXt / MVEt-1 + et (1) where Dt (the dependent variable) is a measure of return for time period t; FEXt / MVEt-1 is the unexpected realisation (or forecast error) of the measure X (FEXt), divided by the market value of the firm‘s equity at the beginning of the financial year (MVEt-1); while et is a random disturbance term. The unexpected realisation of the measure X for time period t is defined as the difference between the observed value of the measure (Xt) and the market‘s expected value of the measure (E(Xt)): FEXt = Xt – E(Xt) (2) Assuming that the market‘s expected value is formed according to a discrete linear stochastic process in autoregressive form, E(Xt) may be defined as: E(Xt) = δ + 1Xt-1 + 2Xt-2 + 3Xt-3 + … (3) where δ is a constant and the ‘s are the autoregressive parameters. Substituting Equations (2) and (3) into Equation (1) yields: D = b0 + b1 [Xt – (δ + 1Xt-1 + 2Xt-2 + 3Xt-3 + …)] / MVEt-1 + et = b b X / MVE b X / MVE b X / MVE ' 0 ' 1 t t 1 ' 2 t 1 b4' X t 3 / MVEt 1 ... et t 1 ' 3 t 2 where E b0' b0 b1 δ , E b1' b1 , and E b bi i 1 for i > 1. Equation (4) provides ' i the relationship between abnormal returns (Dt), and the lagged measures of accounting performance (X) scaled by MVE. For the purpose of this study, Equation (5) is limited to one lag: Dt = b0' b1' X t / MVEt 1 b2' X t 1 / MVEt 1 et (5) 3.2.1 Tests for Relative Information Content The relative information contents of the measures are assessed by means of a statistical test developed by Biddle, Seow and Siegel (1995: 9). The independent variables are included in individual regressions against the dependent variable based on the following equation: Dt = b0' b1' X t / MVEt 1 b2' X t 1 / MVEt 1 et (6) where Dt is the market-adjusted return on a firm‘s shares for time period t, X is one of the measures investigated, and MVE is the market value of the firm‘s equity. According to the test, pairwise comparisons of the adjusted R2 values from the individual regressions are conducted. Statistically significant differences between two adjusted R2 values result in the rejection of the null hypothesis HREL. This indicates a statistically significant difference in the ability of the two measures under investigation to explain the variation in the dependent variable (Biddle et al., 1997: 310). 3.2.2 Tests for Incremental Information Content In order to evaluate the incremental information content of the components of the measures investigated in this study, the following regression is conducted (Biddle et al., 1997: 311): Dt = d0 + d1 Y1;t / MVEt-1 + d2 Y1;t-1 / MVEt-1 + d3 Y2;t / MVEt-1 + d4 Y2;t-1 / MVEt-1 + et (7) where Y1 and Y2 are two different components of the measure under investigation. The individual regression coefficients are assessed by means of ttests to investigate the contribution of the specific component. F-tests are used to assess the following joint null hypotheses: H 0Y1 : d1 = d2 = 0 H 0Y2 : d3 = d4 = 0 Rejection of the null hypotheses indicates that the inclusion of a component provides significant incremental information. 3.3 Measures 3.3.1 Dependent Variable t 1 (4) The relative and incremental information content tests applied in this study focus on the relationship between 71 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 the independent variables and the unexpected return generated on a firm‘s shares. In order to estimate the unexpected return, the market adjusted return is calculated (Biddle et al., 1997: 312). This value indicates whether a firm over- or under performed relative to the overall market. MktAdjRet The market adjusted return is calculated as the difference between the 12-month compounded return on a share and the 12-month compounded return on the ALSI index. These returns are calculated for a period ending three months after the end of a firm‘s financial year-end to ensure that the information contained in the financial statements is reflected in the share prices. The 12-month compounded share returns, as well as the return on the ALSI index, are obtained from the McGregor BFA database (2005). 3.3.2 Independent Variables The primary objective of this study is to investigate the relative and the incremental information content of a number of traditional and value based financial performance measures. The measures included in the relative information content test are CFO, EBEI, RI, EVA, and CVA, as well as the inflation-adjusted measures EVAreal, CVAreal and CFROI. The measures are calculated based on information obtained from the standardised financial statement data contained in the McGregor BFA database (2005). Stern Stewart does not publish EVA values for South African firms. The McGregor BFA database (2005), however, contains EVA values that are calculated based on the standardised financial statements included in the database. Through the standardisation process applied by the database the majority of the EVA accounting adjustments are addressed. The equity adjustments proposed by Stern Stewart, however, are not included in the EVA values reported in the database. In the case of firms listed at the end of the research period, values for EVA, cost of capital and invested capital are obtained from the McGregor BFA database (2005). Since these values are not available for those firms that delisted during the period under review, they are estimated using the same method as the one employed in the database. In order to evaluate the effect of inflation on the measures, the inflation adjustments proposed by IAS15 are quantified and included in the calculation of EVAreal and CVAreal. CFROI values are not available from the McGregor BFA database (2005). Consequently, these values are estimated by using the approach described by Madden (1999). In order to evaluate the incremental information content of the components of the measures EVA, EVAreal, CVA, CVAreal and CFROI, the components 72 indicated in Figure 2 are required. These components are quantified by information obtained from the McGregor BFA database (2005). To reduce heteroscedasticity in the data, all the independent variables are divided by the market value of equity as measured three months after the beginning of the firm‘s financial year (MVE t-1) (Biddle et al., 1997: 313). This period is chosen to correspond with the period over which the dependent variable is calculated. 3.4 Data The measures CFO, EBEI, RI, EVAnom, EVAreal, CVAreal and CFROI, as well as their contributing components, are calculated for all firms listed in the industrial sector of the JSE during the 15-year period from 1991 to 2005. Those firms listed at the end of this period are considered for the initial sample. Focusing only on these firms, however, would expose the study to a survivorship bias. Consequently, all delisted firms that were listed during the period under investigation are also included in the sample. A total of 198 listed firms and 188 delisted firms are identified. Following Biddle et al. (1997: 311), those observations in excess of eight standard deviations from the median are classified as extreme outliers, and consequently 41 observations were removed from the sample. The number of observations classified as extreme outliers relative to the overall sample is relatively small. A closer investigation of those firms classified as extreme outliers also reveals that the majority of these values are observed for firms at the end of their lifecycle, where financial performance is diminishing, and share prices have already collapsed. Other examples include the first financial year of firms that listed for the first time, or firms that underwent financial reorganisation. Both the dependent and independent variables are also winsorised to ± four standard deviations from the median. The final sample investigated in the information content tests consists of 316 firms with 2 837 complete observations. 4 Descriptive Statistics of the Measures and Components Included in the Information Content Tests 4.1 Measures Included in the Relative Information Content Tests The descriptive statistics of the winsorised values of MktAdjRet, EBEI, CFO, RI, EVAnom, EVAreal, CVAreal and CFROIMargin included in the relative information content tests pooled across time are provided in Table 1. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 1. Descriptive statistics on the dependent and independent variables in the relative information content tests of CFROIMargin Descriptive statistics Dependent Variable Independent Variables MktAdjRet EBEI CFO RI EVAnom EVAreal CVAreal CFROIMargin Mean 0.141 0.202 0.297 -0.089 -0.142 -0.135 -0.039 -0.007 Median 0.018 0.125 0.151 0.003 -0.019 -0.007 0.022 -0.002 Std. Dev. 0.761 0.508 0.647 0.495 0.532 0.687 0.698 0.155 CVAreal CFROIMargin Correlations Dependent Variable MktAdjRet Independent Variables EBEI CFO RI EVAnom EVAreal MktAdjRet 1.000 EBEI 0.297 1.000 CFO 0.165 0.491 1.000 RI 0.161 0.374 0.018 1.000 EVAnom 0.118 0.261 -0.037 0.909 1.000 EVAreal 0.095 0.229 -0.065 0.747 0.833 1.000 CVAreal 0.121 0.314 0.069 0.687 0.748 0.954 1.000 CFROIMargin 0.186 0.280 0.056 0.418 0.342 0.323 0.317 1.000 Notes: All the variables are winsorised at ± four standard deviations from the median values. All the independent variables are size-adjusted by divided them by the market value of the equity as measured three months after the beginning of the financial year. All correlations are significant at the 1% level, except between CFO, and RI and EVAnom. The measures EBEI and CFO exhibit the highest mean and median values, while the value based measures display small mean and median values, which are all close to zero. The lowest mean and median values are observed for the measure CFROIMargin. If the correlations are considered, all are found to be statistically significant at the 1% level, except the correlations between CFO, and RI and EVAnom. The highest correlation between the dependent variable and an independent variable is observed between MktAdjRet and EBEI. In the case of CFROIMargin, the highest correlation is between the measure and RI (correlation coefficient of 0.418). It is also interesting to note that the correlation between MktAdjRet and CFROIMargin is the highest for all the value based measures. 4.2 Components Included in the Incremental Information Content Tests The descriptive data of the winsorised CFROIMargin components included in the incremental information content tests pooled across time are provided in Table 2. The correlations between the majority of the CFROIMargin components are statistically significant at the 1% level. The correlation between AccAdj and InflAdj is significant at the 5% level, while the correlation between CapChg and Accruals is significant at the 10% level. Only the correlations between MktAdjRet and InflAdj, AccAdj and Accruals, and CFROIAdj and ATInt are not significant. 5 Relative Information Content Tests of CFROImargin The relative information content of the measures included in this chapter is evaluated by comparing the adjusted R2 values obtained from seven separate regressions based on the following equation: Dt = b0 + b1 Xt / MVEt-1 + b2 Xt-1 / MVEt-1 + et. (8) where: Dt = the market-adjusted return for period t. X = one of the seven measures CFO, EBEI, RI, EVAnom, EVAreal, CVAreal and CFROIMargin. 73 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 MVEt-1 = the market value of the equity three months after the beginning of the financial year. The results from the relative information content tests are provided in Table 3: Table 2. Descriptive statistics on the dependent and independent variables in the incremental information content tests of the CFROIMargin components Descriptive statistics Dependen t Variable Independent Variables MktAdjRe CVAAdjrea t CFO Accruals ATInt CapChg AccAdj InflAdj l CFROIAdj Mean 0.141 0.297 -0.069 0.086 0.378 -0.053 0.009 0.096 0.031 Median 0.018 0.151 -0.022 0.029 0.169 -0.017 0.008 0.038 -0.017 Std. Dev. 0.761 0.647 0.589 0.175 0.650 0.215 0.346 0.195 0.667 Correlations Dependen t Variable Independent Variables MktAdjRe t CVAAdjrea CFO Accruals MktAdjRet 1.000 CFO 0.165*** 1.000 Accruals 0.054*** -0.505*** *** ATInt 0.094 CapChg 0.139*** AccAdj InflAdj CVAAdjreal CFROIAdj -0.068 *** 0.004 0.112 *** -0.082 *** 0.224 *** 0.441*** -0.117 *** -0.078 *** 0.446 *** -0.058 *** ATInt CapChg AccAdj InflAdj l CFROIAdj 1.000 -0.088*** 1.000 -0.035* 0.622*** -0.008 0.052 -0.263 *** -0.089 *** -0.165 *** *** 0.208 *** 0.561 *** 0.012 1.000 -0.228*** 0.051 *** 0.518 *** 0.282 *** 1.000 0.040** 1.000 -0.181 *** 0.264*** 1.000 -0.337 *** -0.617*** -0.259*** 1.000 Notes: All the variables are winsorised at ± four standard deviations from the median values. All the independent variables are deflated by the market value of the equity as measured three months after the beginning of the financial year. *** Significant at the 1% level ** Significant at the 5% level * Significant at the 10% level Panel A of Table 3 contains the adjusted R2 values calculated for the seven separate regressions. The measures are arranged in decreasing order based on their adjusted R2 values. EBEI has a significantly higher adjusted R2 value (0.0773) than the other measures. The regression analysis based on the CFROIMargin values yields the second largest adjusted R2 value (0.0438). It is followed by RI (0.0375), CFO (0.0319), EVAnom (0.0305), EVAreal (0.0139) and CVAreal (0.0138) correspondingly. In terms of relative information content, EBEI appears to outperform the other measures. In terms of the value based financial measures, CFROIMargin yields the best results. According to Hayn (1995: 127), Burgstahler and Dichev (1997: 192) and Collins, Pincus and Xie 74 (1997) profitable firms exhibit larger earnings responses than loss-making firms. O‘Byrne (1997: 51) also recommends a distinction between positive and negative EVA values. The tests for relative information content are repeated after allowing different coefficients for the positive and negative values of the different measures. The results from these regressions are provided in Panel B of Table 3. All the measures exhibit higher adjusted R2 values. The measure RI experienced the largest increase in its adjusted R2 value (0.0375 to 0.1126), and it exhibits the highest adjusted R2 value overall when compared to the other measures. It is followed by EBEI (0.0886), EVAnom (0.0855), EVAreal (0.0635), CVAreal (0.0597) and CFO (0.0472) respectively. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 3. Tests of the relative information content of CFROIMargin, CVAreal, EVAreal, EVAnom, residual income, earnings and operating cash flow Relative information content Rank order of R 2 Observatio ns (1) (2) (3) (4) (5) (6) Panel A: Coefficient of the positive and negative values of each performance measure constrained to be equal (7) a CFROIMargi All firms 2450 Adj. R2 EBEI > 0.0773 n > 0.0430 RI > 0.0375 CFO > 0.0319 EVAnom > 0.0305 Panel B: Coefficient of positive and negative values of each performance measure allowed to differ EVAreal > 0.0139 0.0138 b EVAno All firms Adj. R2 2450 RI 0.1126 > EBEI 0.0886 > m 0.0855 CVAreal CFROIMargi > EVAreal 0.0635 > CVAreal 0.0597 > CFO 0.0472 > n 0.0429 Notes: a In Panel A, the regression based on Equation (8) is conducted, where: Dt = b0 + b1 Xt / MVEt-1 + b2 Xt-1 / MVEt-1 + et. Dt is the market-adjusted return for period t, X is one of the seven measures CFO, EBEI, RI, EVAnom, EVAreal, CVAreal and CFROIMargin, and MVE is the market value of the equity three months after the beginning of the financial year. b In Panel B, the regression used in Panel A is adjusted to allow different coefficients for positive and negative values of the independent variable: The regression based on the following equation is conducted, where: Dt = c0 + c1 Xt;pos / MVEt1 + c2 Xt;neg / MVEt-1 + c3 Xt-1;pos / MVEt-1 + c4 Xt-1;neg / MVEt-1 + et. Dt is the market-adjusted return for period t, X is one of the seven measures CFO, EBEI, RI, EVAnom, EVAreal, CVAreal and CFROIMargin, and MVE is the market value of the equity three months after the beginning of the financial year. In the case of CFROIMargin, however, the measure dropped from the second to the last position overall in terms of the ranking of the adjusted R2 values. It is also the only measure where the adjusted R2 value decreased when the distinction between positive and negative values is allowed. A possible reason for this decrease could be the variable nature of the CFROI values. The cash flows included in the calculation of a firm‘s CFROI values are estimated based on the firm‘s profit figures. Relatively small changes in the profit figures, however, could result in CFROI values switching from a positive to a negative value (and vice versa). These changes are not the result of a pronounced difference in the firm‘s financial performance, but rather the way in which CFROI values (and IRR measures in general) are calculated. Distinguishing between the positive and negative values of the measure therefore reduces the adjusted R2 value of the regression analysis. 6 Incremental Information Content Tests Of The CFROImargin Components In order to evaluate the incremental information contents of the CFROIMargin components, the following regression analysis is conducted: MktAdjRett = d0 + d1 CFOt / MVEt-1 + d2 CFOt-1 / MVEt-1 + d3 Accrualt / MVEt-1 + d4 Accrualt-1 / MVEt1 + d5 ATIntt / MVEt-1 + d6 ATIntt-1 / MVEt-1 + d7 CapChgt / MVEt-1 + d8 CapChgt-1 / MVEt-1 + d9 AcctAdjt / MVEt-1 + d10 AcctAdjt-1 / MVEt-1 + d11 InflAdjt / MVEt-1 + d12 InflAdjt-1 / MVEt-1 + d13 CVAAdjreal; t / MVEt-1 + d14 CVAAdjreal; t-1 / MVEt-1+ d15 CFROIAdjt / MVEt-1 + d16 CFROIAdjt-1 / MVEt-1 + (9) The results of the incremental information content tests of the CFROIMargin components are provided in Table 4. If the results from the incremental information content tests are considered, it is observed that the regression coefficients of all the current year‘s CFROI Margin components except InflAdj are highly significant. If the previous year‘s variables are considered, only the correlation coefficient of ATIntt-1 is significant. The Fstatistic for the component InflAdj is not statistically significant, indicating that it does not contribute significant information content. The other F-statistics, however, are all significant, indicating that the remaining CFROI components contain statistically significant incremental information content. The adjusted R2 value for the multiple regression analysis conducted to evaluate the incremental information content of the CFROIMargin components in this study, however, is much lower than the values obtained in previous studies investigating the measures EVAreal, CVAnom and CVAreal. An adjusted R2 value of 0.0628 is observed in the case of the CFROIMargin components, compared to values of 0.1861, 0.1880 and 0.1995 (respectively) when the components of the other measures are investigated (Erasmus, 2008). Although the incremental information content of the CFROIMargin 75 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 components are statistically significant, it explains less of the variation in the market adjusted share returns. Table 4. Tests of incremental information content of CFROI Margin components: CFO, operating accruals, after-tax interest, capital charge, accounting adjustments, inflation adjustments, real cash value added adjustments and CFROI adjustments All firms a 2450 0.060 0.218 -0.029 0.134 -0.048 -0.442 0.700 0.186 -0.101 -0.302 0.011 -0.154 0.030 -0.471 0.253 -0.208 0.042 t-stat F-stat p-value b Observations Constant 3.35*** CFOt 5.12*** 13.36 <0.0001 CFOt-1 -0.62 Accrualt 3.46*** 5.97 0.0026 Accrualt-1 -1.14 ATIntt -2.43** 7.26 0.0007 ATIntt-1 3.79*** *** CapChgt 2.68 3.63 0.0265 CapChgt-1 -1.49 AccAdjt -3.25*** 5.51 0.0041 AccAdjt-1 0.12 InflAdjt -1.94* 1.99 0.1364 InflAdjt-1 0.37 *** CVAAdjt -3.02 4.82 0.0082 CVAAdjt-1 1.55 CFROIAdjt -3.81*** 7.39 0.0006 CFROIAdjt-1 0.72 Notes: a The regression based on the following equation is conducted: MktAdjRett = d0 + d1 CFOt / MVEt-1 + d2 CFOt-1 / MVEt-1 + d3 Accrualt / MVEt-1 + d4 Accrualt-1 / MVEt-1 + d5 ATIntt / MVEt-1 + d6 ATIntt-1 / MVEt-1 + d7 CapChgt / MVEt-1 + d8 CapChgt-1 / MVEt-1 + d9 AcctAdjt / MVEt-1 + d10 AcctAdjt-1 / MVEt-1 + d11 InflAdjt / MVEt-1 + d12 InflAdjt-1 / MVEt-1 + d13 CVAAdjt / MVEt-1 + d14 CVAAdjt-1 / MVEt-1 + d15 CFROIAdjt / MVEt-1 + d16 CFROIAdjt-1 / MVEt-1 + et. Dt is the market-adjusted return for period t, while the independent variables are the CFROI Margin components (CFO, accruals, after-tax finance cost, capital charge, accounting adjustments, inflation adjustments and cash value added adjustments). MVE is the market value of equity three months after the start of the financial year. b p-values in parentheses represent non-directional F-test of the null hypothesis of no incremental information content (Hypothesis HINC) *** Significant at the 1% level ** Significant at the 5% level * Significant at the 10% level 7 Summary The value-based financial performance measures economic value added (EVA), cash value added (CVA) and cash flow return on investment (CFROI) are proposed by certain research studies as improvements over the traditional financial measures. The objective of this paper was to evaluate the relative and incremental information content of these value-based measures compared to that of the traditional measures earnings and cash from operations. When the relative information contents of the different value-based financial performance measures are investigated, the results indicate that they are not able to outperform earnings (EBEI) in explaining market adjusted share returns. The results from the incremental information content tests indicate that the adjustments required in order to calculate the various value-based measures do contribute statistically significant incremental information content. If the adjusted R2 values of the 76 multiple regression analyses conducted to evaluate the incremental information content of the value-based measures are compared to the adjusted R2 values obtained for the traditional measures, however, a much lower value is observed. The components of the value-based measures therefore explain significantly less of the variation in market adjusted share returns than the components of the other measures. Although the contributions of these components are statistically significant, they are not economically significant when combined into the various measures. Based on the results reported in this study it appears as if the value based measures are not able to outperform the relatively simple traditional financial performance measure earnings (EBEI) in explaining the variation in market adjusted share returns. The incremental information content tests conducted to evaluate the contribution of the components of the value-based measures also yield much lower results than for similar tests conducted for the traditional measures. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 References 1. Bacidore, J.M., Boquist, J.A., Milbourn, T.T., & Thakor, A.V. (1997). The search for the best performance measure. Financial Analysts Journal, 53(3), 11-20. 2. Biddle, G.C., Bowen, R.M., & Wallace, J.S. (1999). Evidence on EVA. Journal of Applied Corporate Finance, 12(2), 69-79. 3. Biddle, G.C., Seow, G.S., & Siegel, A.F. (1995). Relative versus incremental information content. Contemporary Accounting Research, 12(1), 1-23. 4. Burgstahler, D., & Dichev, I. (1997). Earnings, adaptation and equity value. The Accounting Review, 72(2), 187-215. 5. Collins, D., Pincus, M., & Xie, H. (1997). Equity valuation and negative earnings: The role of book value of equity. Unpublished paper, University of Iowa, Iowa City, IA. 6. Dzamba, A. (2003). Focus on CFROI analysis to boost your firm‘s growth in 2004. IOMA‟s Report On Financial Analysis, Planning & Reporting, 3(11), 1012. 7. Ehrbar, A. (1998). EVA: The real key to creating wealth. New York: John Wiley & Sons. 8. Erasmus, P.D. (2008). The relative and incremental information content of the value based financial performance measure cash value added (CVA). Management Dynamics, 17(2), (Forthcoming). 9. Fabozzi, F.J., & Grant, J.L. (ed.). (2000). Valuebased metrics: Foundations and practice. New Hope: Frank J. Fabozzi Associates. 10. Grant, J.L. (2003). Foundations of economic value added (2nd ed.). Hoboken, New Jersey: John Wiley and Sons. 11. Grant, J.L. (1996). Foundations of EVATM for investment managers. Journal of Portfolio Management, 23(1), 41-48. 12. Hayn, C. (1995). The information content of losses. Journal of Accounting and Economics, 20(2), 125153. 13. Lehn, K.L., & Makhija, A.K. (1996). EVA and MVA as performance measures and signals for strategic change. Strategy and Leadership, 24(3), 3440. 14. McGregor BFA (Pty.) Ltd. (2005). McGregor BFA Version 04.211. 15. Madden, B.J. (1998). The CFROI valuation model. Journal of Investing, 17(1), 31-43. 16. Madden, B.J. (1999). CFROI valuation: A total system approach to valuing the firm. Boston: Butterworth-Heinemann. 17. Martin, J.D., & Petty, J.W. (2000). Value based management: The corporate response to the shareholder revolution. Boston: Harvard Business School Press. 18. O‘Byrne, S.F. (1999). EVA and its critics. Journal of Applied Corporate Finance, 12(2), 92-96. 19. O‘Byrne, S.F. (1996). EVA® and market value. Journal of Applied Corporate Finance, 9(1), 116-125. 20. Peterson, P.P., & Peterson, D.R. (1996). Company performance and measures of value added. Charlottesville: The Research Foundation of The Institute of Chartered Financial Analysts. 21. Stewart, G.B. (1994). EVATM: Fact and fantasy. Journal of Applied Corporate Finance, 7(2), 71-84. 22. Stewart, G.B. (1991). The Quest for value: The EVATM management guide. New York: HarperBusiness. 23. Worthington, A.C., & West, T. (2004). Australian evidence considering the information content of economic value added. Australian Journal of Management, 29(2), 201-223. 24. Young, S.D., & O‘Byrne, S.F. (2001). EVA and value-based management: A practical guide to implementation. New York: McGraw Hill. 77 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 MIGRATION TO ―NOVO MERCADO‖: DOES IT REALLY MEAN IMPROVEMENT OF CORPORATE GOVERNANCE PRACTICES? Andre Carvalhal*, Guilherme Quental** Abstract One of the most significant changes regarding the adoption of better corporate governance was the creation of special trading segments, which impose tighter disclosure rules and listing requirements. Most literature on the special trading segments focused on the European markets. Not much is known, however, about the Brazilian “Novo Mercado” (NM). While most European new markets have failed to attract IPOs and investors, NM has grown fast and reached 35% of the total number of listed companies and 57% of the market capitalization of the Sao Paulo stock exchange. Despite its success, no research has examined whether firms that list on NM really improve their corporate governance practices. Further, there is no empirical evidence whether there is a reward for companies that list on NM without improving governance practices. This paper addresses this question by investigating the stock market reaction to the listing on NM without improving governance practices. We provide evidence that firms that list on NM and improve governance practices earn positive abnormal returns, have higher liquidity and lower volatility. On the other hand, firms that list on NM without improving governance practices do not earn positive returns, but are rewarded with higher liquidity and lower volatility. Keywords: Novo Mercado, corporate governance, valuation, liquidity, volatility, Brazil *Coppead Graduate School of Business, Federal University of Rio de Janeiro (UFRJ), Rua Pascoal Lemme, 355 - Ilha do Fundao, 21941-918 - Rio de Janeiro – RJ – Brazil, Tel.: (55-21) 2598-9878 Fax: (55-21) 2598-9872, E-mail: [email protected] **Coppead Graduate School of Business, Federal University of Rio de Janeiro (UFRJ), Rua Pascoal Lemme, 355 - Ilha do Fundao, 21941-918 - Rio de Janeiro – RJ - Brazil Tel.: (55-21) 2598-9878, Fax: (55-21) 2598-9872, E-mail: [email protected] 1. Introduction Corporate governance has attracted considerable attention following recent corporate scandals in developed and developing countries. For the most part, the literature compares corporate governance mechanisms and standards among countries. La Porta et al. (1997, 1998) examine the content and the development of legal institutions in different countries, and conclude that the common law systems offer greater protection against managerial abuse than do civil law systems. Although most research on corporate governance has been cross-country, more recent studies, such as Klapper and Love (2004) and Gompers et al. (2003), have shown that corporate governance choices can vary a lot across firms within a country. Further, recent research highlights the importance of corporate governance and suggests empirical relation between governance and corporate performance. Results indicate that better corporate governance is associated to better performance and higher corporate valuation. La Porta et al. (1998, 2000, 2002) provide evidence that better shareholder protection is associated with higher valuation of corporate assets and with more developed and valuable financial markets. When the shareholders´ rights are better protected by the law, 78 outside investors are willing to pay more for financial assets such as equity and debt. One of the most significant changes of 1990s regarding the adoption of better corporate governance was the creation of special trading segments, such as the ―Neuer Markt‖ (Germany), ―Nouveau Marché‖ (France), ―TechMark‖ (UK), ―Nuovo Mercato‖ (Italy), ―Novo Mercado‖ (Brazil), among others. An important characteristic of these segments is that they impose tighter disclosure rules and listing requirements. Most literature on the special trading segments focused on the European markets. Not much is known, however, about the Brazilian ―Novo Mercado‖ (NM). The difference between the NM and the European special segments is that the latter have been designed to attract companies from fast-growing markets and high tech areas, while the Brazilian NM places no restriction on the field of activity, nor is reserved for small companies. While most European new markets have failed to attract IPOs and investors, NM has grown fast and reached 35% of the total number of listed companies and 57% of the market capitalization of the Sao Paulo stock exchange. Despite its huge success, only a few articles have studied the Brazilian NM. Chavez and Silva (2006) analyze the market price reaction and liquidity impact Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 of the firm‘s listing on NM and find significant enhancement of stock return and liquidity. In a similar study, Carvalho and Pennacchi (2006) provide evidence that the listing on NM brings positive abnormal returns, and an increase in share trading volume. Despite the trend on the study of the NM, no research examines whether firms that list on NM really improve their corporate governance practices. Further, there is no empirical evidence whether there is a reward for companies that list on NM without improving governance practices. This paper addresses this question by investigating the stock market reaction to the listing on NM without improving governance practices. We provide evidence that firms that list on NM and improve governance practices earn positive abnormal returns, have higher liquidity and lower volatility. On the other hand, firms that list on NM without improving governance practices do not earn positive returns, but are rewarded with higher liquidity and lower volatility. This paper contributes to our understanding of corporate governance in the following ways. First, it adds to the scant literature on the Brazilian NM. Brazil offers a unique case study given the prevalence of a weak legal environment (La Porta et al. (1998)) and the presence of the NM, on which firms of different sectors voluntarily decide to offer high standards of transparency as well as better corporate governance practices. Second, this paper examines whether companies that do not improve governance practices benefit from the listing on NM. The paper is structured as follows. Section 2 shows the main studies on special listing segments with enhanced corporate governance practices. Section 3 provides the main characteristics of the Brazilian market and NM. Section 4 describes the data, methodology and contains the empirical results. Section 5 discusses our findings and concludes. 2. Corporate Governance and Special Listing Segments Recent studies suggest that the Berle and Means (1932) model of widely dispersed ownership is not common even in developed countries. In fact, La Porta et al. (1999) show that large shareholders control a significant number of firms in the wealthier countries as well. Moreover, the country legal institutions differ from one another with respect to the protections that they afford to shareholders. La Porta et al. (1997, 1998) provide evidence that shareholder protection is greater in common law systems when compared to civil law regimes. There have been efforts by countries with weak corporate governance toward higher transparency and better shareholder rights either by enacting legislation reform or by creating new listing segments. Shleifer and Wolfenzon (2002) argue that legal reform is generally slow, because it faces political opposition from controlling shareholders. Further, when the legislation change passes, it is mandatory for all public companies, so that the differentiation across firms is lower when compared to voluntary actions toward better corporate governance practices. The other significant approach is the creation of special trading segments with enhanced corporate governance standards. Chavez and Silva (2006) show that the differentiation signal is clear and more visible when compared to legislation reform, because the firm voluntarily chooses to list on the special segment. Most importantly, a voluntarily set of better corporate governance practices should induce a selfselection of valuable firms and overcome the asymmetric information problems between controlling and minority shareholders. Enhanced governance through voluntarily listing on special segments should be characterized by better performance, higher corporate valuation and lower risk. This is consistent with La Porta et al. (1998, 2000, 2002), who document that investors would be willing to pay more for financial assets when their rights are better protected and the risk of expropriation is lower. Further, Brockman and Chung (2003) argue that better corporate governance practices should enhance market liquidity. Most literature on the special trading segments focused on the European markets created in the 1990s to attract companies from fast-growing markets and high tech areas, such as the ―Neuer Markt‖ (Germany), ―Nouveau Marché‖ (France), ―TechMark‖ (UK), and ―Nuovo Mercato‖ (Italy). While most European new markets have failed1, the Brazilian ―Novo Mercado‖ (NM) has developed significantly. However, only a few studies have analyzed the Brazilian NM. Chavez and Silva (2006) and Carvalho and Pennacchi (2006) provide evidence that listing on NM enhances firm valuation and liquidity. Nevertheless, none of them examine whether firms improve their corporate governance practices when they migrate to NM. This paper fills this gap and investigates the stock market reaction to the listing on NM without improving governance practices. 3. The Brazilian Corporate Market and the ―Novo Mercado‖ As shown by La Porta et al. (1998), the Brazilian legal system follows the French code tradition and seems to offer less protection to investors, both with regard to the written laws and their enforcement. The main characteristics of the Brazilian market are stated by the Law 6404/76 (―Law of Corporations‖), which had important amendments in 1997 and in 2001. In Brazil, companies are allowed to issue nonvoting shares in an amount up to two-thirds of the total capital2, which means that the control of a company can be guaranteed with only one-sixth of its total capital. In fact, the control can be kept with much less than one-sixth of total capital through the use of pyramidal structures. 79 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Besides the voting rights, another difference between voting and non-voting shares is the mandatory bid rule for voting shares in the case of a control transfer. This rule implies that the acquirer of the control block is also obliged to offer minority shareholders the same (or partially the same) price for their shares. The Brazilian law establishes the mandatory bid rule only for voting shares for at least 80% of the control block price. The NM was created by the Sao Paulo stock exchange (Bovespa) in 2000 and consists of three listing segments: Level 1, Level 2 and Level 33. These segments are designed for companies that voluntarily decide to offer high standards of disclosure and transparency, as well as better corporate governance practices. The main objective of the NM levels is to provide investors with corporate governance rights beyond what is legally required. What distinguishes the three levels is the adherence to the practices and the degree of commitment assumed by the company. The Level 1 requires that the companies improve their methods of disclosure and increase the dispersion of their shares. The main practices required for the Level 1 are: maintenance of a free-float of at least 25% of the capital; public offerings with mechanisms to facilitate capital dispersion; disclosure of consolidated financial statements and special audit revision; monthly disclosure of trades of stocks by the controlling shareholders and management; and disclosure of an annual calendar of corporate events. To be classified on Level 2, the company must adopt all the obligations of Level 1 and a much broader range of corporate governance practices: a two-year unified mandate for the entire board of directors, which must have at least 5 members, 20% of whom must be independent; disclosure of annual balance sheet according to the US GAAP or IFRS; mandatory bid rule for voting shares at 100% of the control block price; mandatory bid rule for non-voting shares at 80% of the control block price; voting rights granted to non-voting shares in relevant decisions such as incorporation, spin-off, merger, and approval of contracts between related parties; and admission to the arbitration for resolution of corporate disputes. To be listed on Level 3, the company is required to adopt all the obligations of Level 1 and 2 and issue only voting shares. Therefore, what distinguishes Level 2 from Level 3 is the prohibition of non-voting shares in the company‘s capital structure. In July 2007, the NM reached 35% of the total number of listed companies and 57% of the market capitalization of the Bovespa. The performance of these companies can measured by the evolution of the IGC (Special Corporate Governance Stock Index), designed to measure the return of a portfolio composed of companies with good corporate governance practices4. From its creation in June 2001 to July 2007, the IGC had a total return of 537%, significantly higher than the Ibovespa5 return of 273%. 80 4. Empirical Analysis 4.1. Data Our sample includes all firms that have migrated to NM as of June 2006. We exclude companies with incomplete or unavailable information and firms that had no trade on the Sao Paulo stock exchange during the 12 months before the migration to NM. The final sample consists of 28 firms, distributed as follow: 20 on Level 1, 4 on Level 2, and 4 on Level 3. Most of the data come from the Economatica, a financial database that contains a wide coverage of Brazilian stock market data, and Datastream. The information on the corporate governance provisions comes from the Brazilian Securities and Exchange Commission (CVM), and the dates on which the firms listed on NM are gathered from the Bovespa and the provider of news Factiva. 4.2. Event Study for Abnormal Returns We perform an event study to determine the return reaction when the firm decides to migrate to NM. The event study methodology requires the precise identification of the event date. The problem in performing an event study in the case of migration to NM is that the event date does not necessarily coincide with the date on which the information about the migration become publicly available, because firms may discuss over time with their shareholders and market participants about the possibility of migrating to NM. Since the migration must be approved in a shareholders‘ meeting, we consider two event dates: the date on which the call for the shareholders‘ meeting becomes publicly available, and the date on which the shareholders approve the migration. To calculate the abnormal returns, we estimate the market model using the Sao Paulo stock exchange index and a 250-day estimation window from trading day –255 to –6 relative to the event date (t=0)6. We use an 11-day event window (t-5 to t+5) to allow for information about the migration to be leaked in advance or to have a slow effect on the stock prices. On a particular day t, the abnormal return ARt is defined as the stock return in excess of its expected return calculated from the market model. For a multiday announcement window [t1 to t2], a cumulative abnormal return CAR [t1 to t2] is defined as the sum of the time-series of ARt within the event window. Cumulative abnormal returns over days -1 to +1 (CAR [-1,+1]), -5 to +1 (CAR [-5,+1]), and -5 to +5 (CAR [-5,+5]) are calculated around the event date for each share. There are 8 (out of 28) overlapping and thus non-independent event dates, which cause the partial clustering of event windows. Since the cross-sectional dependence in the data may cause downward bias in the standard error (see Bernard (1987)), the results assuming cross-sectional independence should be Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 interpreted cautiously. Therefore, due to event clustering and possible event-induced volatility, we compute a bootstrap p-value (see Boehmer, Musumeci, and Poulsen (1991), and Aktas, DeBodt, and Roll (2004)). We re-sample from non-clustered abnormal returns in order to find the distribution of the t-statistic assuming independent observations. Then, we determine the p-value by the location of the observed average abnormal return within the bootstrapped distribution7. The results of the event study are shown in Table 1. There are significantly positive abnormal returns when the firms call the shareholders‘ meeting and when the migration is approved. Although the AR0 is not statistically significant, the cumulative abnormal returns (ranging from 1.95% to 4.62%) are significant in both statistical and economical terms. We can note that the market reacts to both the call for the shareholders‘ meeting and the shareholders‘ meeting itself. One possible explanation is that, although the call for a shareholder‘s meeting does not necessarily mean that the migration is going to be approved in the shareholders‘ meeting, it conveys information about the probability of the approval. It is important to note that, since the control is highly concentrated in most Brazilian companies, the controlling shareholder must agree to migrate to NM. Since the shareholders‘ meeting is called by the Board of Directors, which is generally composed of corporate insiders and controlling shareholders, the inclusion of the migration to NM in the agenda of a shareholders‘ meeting may imply that the probability of approval by the controlling shareholder is high. 4.3. Regression Analysis of Liquidity and Volatility We now run regressions to analyze the effect of the migration to NM on the share liquidity and volatility. In our models, the liquidity (volatility) of share i in day t depends on the liquidity (volatility) of share i in day t-1, and on the liquidity (volatility) of the market index in day t. The following regressions are specified: Voli,t = 0 + 1Voli,t-1 + 2Volm,t + 3NMi,t + 4NMi,t x Voli,t-1 + 5NMi,t x Volm,t + i,t Liqi,t = 0 + 1Liqi,t-1 + 2Liqm,t + 3NMi,t + 4NMi,t x Liqi,t-1 + 5NMi,t x Liqm,t + i,t where Voli,t is the volatility (annualized standard deviation of daily returns in the last 250 trading days) of share i in day t, Liqi,t is the liquidity (trading volume throughout the previous 250 trading days relative to the total market value of the firm) of share i in day t, Volm,t is the volatility of the market index in day t, Liqm,t is the liquidity of the market index in day t, and NMi,t is a dummy variable that takes the value 1 if the firm i migrates to NM in day t, and are error terms. The results of the analysis of the liquidity and volatility are shown in Table 2 and 3, respectively. Table 2 indicates that the current share liquidity depends strongly on the previous share liquidity. The liquidity of the market does not seem to affect the share liquidity. Most importantly, there is a strong increase in the liquidity when the firms announces and approves the migration to NM. Table 3 indicates that the current share volatility depends on the previous share volatility, and on the current volatility of the market. Further, there is a significant decrease in the volatility when the firms announces and approves the migration to NM. Overall, our results for the regression analysis provide evidence that the migration to NM is positively (negatively) related to the share liquidity (volatility). 4.4. Migration to NM and Improvement of Corporate Governance Practices In Brazil, although all companies are subject to the same legislation, their corporate governance practices can differ substantially since corporate charter provisions can establish additional rights for minority shareholders. In order to measure the quality of the firm‘s corporate governance practices before and after the migration to NM, we use the corporate governance index (CGI) developed by Leal and Carvalhal (2007), who use an approach that has recently become very popular in the literature (Black et al. (2006), Klapper and Love (2004), and Gompers et al. (2003)). The index is composed of 15 questions. If the answer is ―yes‖ to any given question they interpret it as a pro-shareholder provision or action and attribute it the value of 1. The negative answers get a null value. The index is the simple sum of the values assigned to each question. The questions are grouped in four dimensions: disclosure, board composition and functioning, ethics and conflicts of interest, and shareholder‘s rights. The detailed description of the CGI is presented in the appendix Firms are divided into two groups: firms that do and do not improve corporate governance practices after the migration to NM. Table 4 shows whether corporate governance practices are improved after the migration for companies in all three NM levels. Most companies (16 out of 20) that migrated to Level 1 have not changed their practices. Only two of them have improved 1 point in the CGI, while two firms have had a decrease of 1 point in the CGI. The average CGI was 7.20 before the migration and remained at 7.20 after the migration. On the other hand, the CGI has increased substantially for the companies that have migrated to Level 2 (from 6.25 to 10.00, an average increase of 3.75) and Level 3 (from 7.75 to 13.25, an average increase of 5.50). As expected, the CGI increases more for Levels 2 and 3, which require a much broader range of corporate governance practices. 81 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 5 shows the event study for abnormal returns classifying the firms according to the improvement (or not) of corporate governance practices. The results indicate that the cumulative abnormal returns (ranging from 3.00% to 7.04%) are significantly positive for firms that improve the governance practices (all the results are statistically significant at 1%). In contrast, there are no abnormal returns for firms that do not improve governance practices. This result is consistent with a positive relation between better corporate governance and higher performance (La Porta et al. (1998, 2000, 2002)). Although the firms migrate to NM, their governance practices do not improve, so there should be no reward in terms of positive abnormal returns. The results of the regression analysis for the share liquidity and volatility are shown in Table 6 and 7, respectively. The results indicate that the share liquidity (volatility) increases (decreases) for firms that do and do not improve corporate governance practices. These results are consistent with those of Tables 2 and 3. Contrary to the abnormal return analysis, there is an enhancement of liquidity and decrease of volatility even for firms that migrate to NM without improving governance practices. There are two possible explanations. Although the firms do not improve governance practices, they must provide higher liquidity for their shares in order to list on NM, which requires a free-float of at least 25% of the capital. Moreover, the migration to NM implies that the firm´s commitment to governance practices increases, because the stock exchange will act as a certifier agent. A migrating firm‘s commitment to improved information disclosure would tend to reduce information asymmetries between the firm (and its controlling shareholders) and minority investors. Thus, minority investors are less likely to be expropriated, thereby decreasing the volatility. Overall, our results show that there are positive abnormal returns for firms that migrate to NM and improve the governance practices. As expected, there is no reward for firms that do not improve governance practices. Further, we provide evidence that there is an enhancement of liquidity and decrease of volatility for firms that migrate to NM, even for those that do not improve governance practices. 5. Conclusion There have been efforts by countries with weak corporate governance regimes toward higher transparency and better shareholder rights by creating new listing segments with enhanced corporate governance standards. The voluntary migration to the special governance segments should be characterized by better performance, higher liquidity and lower risk, because investors would be willing to pay more for financial assets when their rights are more protected and the risk of expropriation is lower. 82 Most literature on the special trading segments focused on the European markets. Not much is known, however, about the Brazilian ―Novo Mercado‖ (NM), which, in contrast to most European new markets, is not designed to attract companies from fast-growing markets and high tech areas. Further, there is no empirical evidence whether there is a reward for companies that list on NM without improving governance practices. This paper addresses this question by investigating the stock market reaction to the listing on NM without improving governance practices. We provide evidence that firms that list on NM and improve governance practices earn positive abnormal returns, have higher liquidity and lower volatility. On the other hand, firms that list on NM without improving governance practices do not earn positive returns, but are rewarded with higher liquidity and lower volatility. References 1. Aktas, N., De Bodt, E, Roll, R. (2004) Market Response to European Regulation of Business Combinations, Journal of Financial and Quantitative Analysis, 39, 731-757. 2. Berle, A., Means, G. (1932) The Modern Corporation and Private Property, New York: MacMillan. 3. Bernard, V. (1987) Cross-Sectional Dependence and Problems in Inference in Market-Based Accounting Research, Journal of Accounting Research, 25, 1-48. 4. Boehmer, E., Musumeci, J., Poulsen, A. (1991) EventStudy Methodology Under Conditions of EventInduced Variance, Journal of Financial Economics, 30, 253-272. 5. Brockman, P., Chung, D. (2003) Investor Protection and Firm Liquidity, Journal of Finance, 58, 921-937. 6. Black, B., Jang, H., Kim, W. (2006) Does Corporate Governance Affect Firms' Market Values? Evidence from Korea, Journal of Law, Economics and Organization, 22, 366-413. 7. Campbell, J., Lo, A., Mackinlay, A. (1997) The Econometrics of Financial Markets, Princeton: Princeton University Press. 8. Chavez, G., Silva, A. (2006) Improved Corporate Governance: Market Reaction and Liquidity Implications, Instituto de Empresa Working Paper, 06-08. 9. Carvalho, A., Pennacchi, G. (2006) Can Voluntary Market Reforms Promote Efficient Corporate Governance? Evidence from Firms' Migration to Premium Markets in Brazil, in Proceeding of the VI Brazilian Finance Conference, Rio de Janeiro. 10. Goergen, M., Khurshed, A., McCahery, J., Renneboog, L. (2003) The Rise and Fall of the European New Markets: on the Short- and Long-Run Performance of High-Tech Initial Public Offerings, in McCahery, J., Renneboog, L. (eds), Venture Capital Contracting and the Valuation of High Technology Firms, Oxford University Press. 11. Gompers, P., Ishii, J., Metrick, A. (2003) Corporate Governance and Equity Prices, Quarterly Journal of Economics, 118, 107-155. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 12. Klapper, L., Love, I. (2004) Corporate Governance, Investor Protection, and Performance in Emerging Markets, Journal of Corporate Finance, 10, 703-728. 13. La Porta, R., Lopez-de-Silanes, F., Shleifer, A. (1999) Corporate Ownership Around the World, Journal of Finance, 54, 471-518. 14. La Porta, R., Lopez-de-Silanes, F., Shleifer, A., Vishny, R. (1997) Legal Determinants of External Finance, Journal of Finance, 52, 1131-1150. 15. ________ (1998) Law and Finance, Journal of Political Economy, 106, 1113-1155. 16. ________ (2000) Investor Protection and Corporate Governance, Journal of Financial Economics, 58, 328. 17. ________ (2002) Investor Protection and Corporate Valuation, Journal of Finance, 57, 1147-1170. 18. Leal, R., Carvalhal, A. (2007) Corporate Governance and Value in Brazil (and in Chile). In: Chong, A., Lopes-de-Silanes, F. (eds). Investor Protection and Corporate Governance: Firm-Level Evidence Across Latin America. Palo Alto: Stanford University Press. 19. Schipper, K., Thompson, R. (1983) The Impact of Merger-Related Regulations on the Shareholders of Acquiring Firms, Journal of Accounting Research, 21, 184-221. 20. Schipper, K., Thompson, R. (1985) The Impact of Merger-Related Regulations Using Exact Distributions of Test Statistics, Journal of Accounting Research, 23, 408-415. 21. Shleifer, A., Wolfenzon, D. (2002) Investor Protection and Equity Markets, Journal of Financial Economics, 66, 3-27. Endnotes 1 See Goergen et al. (2003) for a study about the rise and fall of the European new markets. It is interesting to note that the German ―Neuer Markt‖ gave way to the Prime Standard segment, which requires transparency standards higher than those regulated by law, but, similar to the Brazilian NM, is not restricted to small and medium size firms in high-growth industries. 2 In 2001, the law changed the maximum amount of nonvoting shares to 50% of total capital, but this rule is mandatory only to non-public firms that decide to go public after the law. 3 The Level 3 is called the ―Novo Mercado‖. In this paper, we consider that all three governance levels are part of the NM, so that we can analyze the market reaction to the listing on each NM level separately. 4 Such companies should be traded on Levels 1, 2 or 3. The shares are weighted according to their respective market values and by a governance factor, which is equal to 2 (Level 3), 1.5 (Level 2), and 1 (Level 1). 5 The Ibovespa is the main indicator of the Brazilian stock market performance. 6 We also use the constant-mean-return model (see Campbell, Lo, and MacKinlay (1997)) to analyze the potential biases of our results. The results (not reported, but available upon request) are essentially identical to those obtained using the market model. 7 Alternatively, we use the approach developed by Schipper and Thompson (1983, 1985) and analyze the abnormal returns using unaggregated security-by-security data. While not reported in this paper, the results, although weaker, yield similar conclusions. Appendices Table 1. Abnormal Returns and Migration to NM Abnormal returns of firms that migrate to NM. Two event dates are considered: the date on which the call for the shareholders‘ meeting becomes publicly available, and the date on which the shareholders approve the migration. The abnormal returns are estimated through the market model using a 250-day estimation window. Abnormal returns during the event date (AR0) and cumulative abnormal returns over days -1 to +1 (CAR [-1,+1]), -5 to +1 (CAR [-5,+1]), and -5 to +5 (CAR [-5,+5]) are calculated. Bootstrap p-values (in parentheses) account for event clustering and event-induced volatility. ***, **, * denote statistical significance at the 1%, 5% and 10%, respectively. Event Abnormal Returns AR0 CAR [-1,1] CAR [-3,3] CAR [-5,5] Call for the Shareholders‘ Meeting 0.18 (0.70) 1.95%** (0.02) 2.20%** (0.02) 4.62%*** (0.00) Shareholders‘ Meeting 0.37 (0.47) 2.19%** (0.02) 2.20** (0.03) 3.41%** (0.05) 83 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 2. Liquidity and Migration to NM The dependent variable in each regression is the liquidity (Liq), measured as the trading volume throughout the previous 250 trading days relative to the total market value of the firm. Liqm is the liquidity of the market index, and NM is a dummy variable that takes the value 1 after the firm migrates to NM. Two dates are considered: the date on which the call for the shareholders‘ meeting becomes publicly available, and the date on which the shareholders approve the migration. The pvalues are shown in parentheses. ***, **, * denote statistical significance at the 1%, 5% and 10%, respectively. Variables Liqt-1 Liqm,t NM NM x Liqt-1 NM x Liqm,t Adjusted R2 Call for the Shareholders‘ Meeting 0.54*** (0.00) 0.01* (0.10) -0.07 (0.75) 0.08*** (0.00) 0.00 (0.52) 0.33 Event Shareholders‘ Meeting 0.52*** (0.00) 0.00 (0.41) -0.02 (0.30) 0.10*** (0.00) 0.00 (0.69) 0.32 Table 3. Volatility and Migration to NM The dependent variable in each regression is the volatility (Vol), measured as the annualized standard deviation of daily returns in the last 250 trading days. Volm is the volatility of the market index, and NM is a dummy variable that takes the value 1 after the firm migrates to NM. Two dates are considered: the date on which the call for the shareholders‘ meeting becomes publicly available, and the date on which the shareholders approve the migration. The p-values are shown in parentheses. ***, **, * denote statistical significance at the 1%, 5% and 10%, respectively. Variables Volt-1 Volm,t NM NM x Volt-1 NM x Volm,t Adjusted R2 Call for the Shareholders‘ Meeting 0.19*** (0.00) 0.54*** (0.00) -0.01*** (0.01) 0.01 (0.57) 0.06 (0.16) 0.09 Event Shareholders‘ Meeting 0.19*** (0.00) 0.55*** (0.00) -0.01*** (0.01) 0.00 (0.94) 0.06 (0.20) 0.09 Table 4. Improvement of Corporate Governance Practices and Migration to NM List of firms that migrate to NM, and quality of corporate governance practices before and after the migration to NM, measured by the corporate governance index (CGI) developed by Leal and Carvalhal (2007). The index is composed of 15 questions, and is the simple sum of the values assigned to each question. Firm Alpargatas Aracruz Bradesco Bradespar Confab Duratex Fras-Le Gerdau Gerdau Met Globocabo 84 Migration Date NM Level 15/Jul/03 16/Apr/02 26/Jun/01 26/Jun/01 19/Dec/03 05/May/05 11/Nov/04 26/Jun/01 25/Jun/03 26/Jun/01 1 1 1 1 1 1 1 1 1 1 CGI Before Migration 6 7 9 8 7 9 4 6 8 6 CGI After Migration 7 6 8 8 7 9 4 6 8 6 CGI Change 1 -1 -1 0 0 0 0 0 0 0 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 4 continued Iochpe-Maxion Itaubanco Klabin Randon Part Sadia Tran Paulist Ultrapar Unibanco Unipar VCP Average Level 1 10/Nov/05 26/Jun/01 10/Dec/02 26/Jun/01 26/Jun/01 18/Sep/02 27/Oct/05 26/Jun/01 24/Nov/04 14/Nov/01 1 1 1 1 1 1 1 1 1 1 9 7 8 6 8 8 8 8 6 6 7.20 9 7 8 6 8 8 9 8 6 6 7.20 0 0 0 0 0 0 1 0 0 0 0 Celesc Eletropaulo Eternit Marcopolo Average Level 2 26/Jun/02 13/Dec/04 02/Mar/05 03/Sep/02 2 2 2 2 6 6 8 5 6.25 10 7 14 9 10.00 4 1 6 4 3.75 Perdigão Rossi Resid Sabesp Tractebel Average Level 3 12/Apr/06 27/Jan/06 24/Apr/02 16/Nov/05 3 3 3 3 9 6 10 6 7.75 14 14 14 11 13.25 5 8 4 5 5.50 Table 5. Abnormal Returns and Improvement of Governance After Migration to NM Abnormal returns of firms that migrate to NM, divided into two groups: firms that do and do not improve corporate governance, which is measured by the corporate governance index (CGI) developed by Leal and Carvalhal (2007). Two event dates are considered: the date on which the call for the shareholders‘ meeting becomes publicly available, and the date on which the shareholders approve the migration. The abnormal returns are estimated through the market model using a 250-day estimation window. Abnormal returns during the event date (AR0) and cumulative abnormal returns over days -1 to +1 (CAR [-1,+1]), -5 to +1 (CAR [-5,+1]), and -5 to +5 (CAR [-5,+5]) are calculated. Bootstrap p-values (in parentheses) account for event clustering and event-induced volatility. ***, **, * denote statistical significance at the 1%, 5% and 10%, respectively. Event Abnormal Returns AR0 CAR [-1,1] CAR [-3,3] CAR [-5,5] Call for the Shareholders‘ Meeting Do Improve Do Not Improve Governance Governance 0.85 0.13 (0.32) (0.82) 3.72%*** 1.14% (0.01) (0.24) 4.20%*** 1.25% (0.01) (0.24) 7.04%*** 3.52% (0.01) (0.11) Shareholders‘ Meeting Do Improve Do Not Improve Governance Governance 0.67 0.38 (0.25) (0.71) 3.03%*** 0.18% (0.00) (0.92) 3.00%*** 0.20% (0.01) (0.92) 4.51%*** 0.44% (0.01) (0.89) Table 6. Liquidity and Improvement of Governance After Migration to NM The dependent variable in each regression is the liquidity (Liq), measured as the trading volume throughout the previous 250 trading days relative to the total market value of the firm. Liqm is the liquidity of the market index, and NM is a dummy variable that takes the value 1 after the firm migrates to NM. Two dates are considered: the date on which the call for the shareholders‘ meeting becomes publicly available, and the date on which the shareholders approve the migration. The pvalues are shown in parentheses. ***, **, * denote statistical significance at the 1%, 5% and 10%, respectively. Event Call for the Shareholders‘ Variables Shareholders‘ Meeting Meeting Do Improve Do Not Improve Do Improve Do Not Improve Governance Governance Governance Governance Liqt-1 0.58*** 0.53*** 0.56*** 0.51*** (0.00) (0.00) (0.00) (0.00) Liqm,t 0.01*** 0.00 0.01*** 0.00 (0.00) (0.37) (0.00) (0.66) 85 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 6 continued NM NM x Liqt-1 NM x Liqm,t Adjusted R2 0.02 (0.39) 0.05*** (0.00) 0.00 (0.34) 0.42 -0.02 (0.70) 0.09*** (0.00) 0.00 (0.50) 0.32 0.00 (0.85) 0.03*** (0.00) 0.00 (0.52) 0.39 -0.02 (0.43) 0.10*** (0.00) 0.00 (0.78) 0.31 Table 7. Volatility and Improvement of Governance After Migration to NM The dependent variable in each regression is the volatility (Vol), measured as the annualized standard deviation of daily returns in the last 250 trading days. Volm is the volatility of the market index, and NM is a dummy variable that takes the value 1 after the firm migrates to NM. Two dates are considered: the date on which the call for the shareholders‘ meeting becomes publicly available, and the date on which the shareholders approve the migration. The p-values are shown in parentheses. ***, **, * denote statistical significance at the 1%, 5% and 10%, respectively. Event Variables Volt-1 Volm,t NM NM x Volt-1 NM x Volm,t Adjusted R2 Call for the Shareholders‘ Meeting Do Improve Do Not Improve Governance Governance 0.19*** 0.19*** (0.00) (0.00) 0.68*** 0.49*** (0.00) (0.00) -0.01* -0.01** (0.07) (0.02) -0.05 0.02 (0.15) (0.18) 0.02 0.08 (0.30) (0.18) 0.08 0.09 Shareholders‘ Meeting Do Improve Do Not Improve Governance Governance 0.17*** 0.19*** (0.00) (0.00) 0.60*** 0.54*** (0.00) (0.00) -0.01* -0.01* (0.07) (0.08) -0.06 0.00 (0.12) (0.47) 0.01 0.09 (0.33) (0.14) 0.07 0.09 Appendix. Description of the Corporate Governance Index (CGI) Corporate governance index developed by Leal and Carvalhal (2007). Each question corresponds to a ―yes‖ or ―no‖ answer. If the answer is ―yes‖, then the value of 1 is attributed to the question, otherwise the value is 0. The index is the sum of the points for each question. The maximum index value is 15. Index dimensions are simply for presentation purposes and there is no weighing among questions. All questions are answered from public information disclosed by listed companies and not by means of potentially subjective interviews. Disclosure 1. Does the company produce its financial reports by the required date? 2. Does the company use an international accounting standard (IASB/U.S. GAAP)? 3. Does the company use one of the leading global auditing firms? 4. Does the company disclose the compensation of the CEO and board members? Board Composition and Functioning 5. Are the Chairman of the Board and the CEO not the same person? 6. Is the board clearly not made up of corporate insiders and controlling shareholders? 7. Does the company have board monitoring committees (audit, compensation, etc.)? 8. Is there a permanent Fiscal Board? Conflicts of Interest 9. Is the controlling shareholder´s ratio of vote to cash-flow not higher than 1? 10. Is the company free of any inquiries or convictions by the Brazilian Securities and Exchange Comission (CVM) for governance malpractices? 11. Does the company charter establish arbitration to resolve corporate conflicts? Shareholder´s Rights 12. Does the company facilitate the voting process beyond what is legally required? 13. Does the company grant additional voting rights beyond what is legally required? 14. Does the company grant mandatory bid beyond what is legally required? 15. Does the shareholder agreements decrease the largest shareholder‘s control? 86 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 OWNERSHIP AND CONTROL OF ITALIAN BANKS: A SHORT INQUIRY INTO THE ROOTS OF THE CURRENT CONTEXT Leonardo Giani* Abstract This work does a short inquiry into the past experience of the Italian banking law and the ownership structure of the Italian credit industry. The inquiry is especially focused on the role played by culture and other historical events (e.g. political ones) in shaping the Italian economic framework. In other words, this paper wants to trace a short and descriptive outline of the evolution of the Italian banks‟ ownership structure in order to show how political and social factors counted in determining the present features of the system. Keywords: corporate governance, ownership and control, banking law, banks, evolution, Italy. *PhD Candidate in Law and Economics, University of Siena, Italy 1. The role of culture and history in the evolution of systems of capitalism and structures of ownership and control Culture and history constantly play an important role in the economy45. Even more, from the work for which Douglass North was awarded of the Nobel Prize can be learned that culture and history always matter46. For instance, it must be always kept in mind that economic incentives are not lonely suitable to drive the world towards efficiency. In other words, it‘s impossible to change the world just by legislative reforms aimed to provided such incentives, because they must be followed by a change in people‘s mind. Moreover, beside the general cultural determinants, also the dominant political attitudes deeply influence the economy47 (and not always politics coincides with culture). All these elements are part of the concept well known as «path dependence»48. For what especially concerns the matter under analysis, it can be noticed that each national ownership and control pattern is the result of the historical evolution of the national economy to which it pertains. However, it must be also said that corporate ownership and control structures never 45 «By culture we mean the transmission from one generation to the next, via teaching and imitation, of knowledge, values, and other factors that influence behaviours» [R. BOYD, P.J. RICHERSON, Culture and the Evolutionary Process, Chicago, The University of Chicago Press, (1985), p. 2]. 46 «In the modern Western world, we think of life and the economy being ordered by formal laws and property rights. Yet formal rules, even in the most developed economy, make up a small (although very important ) part of the sum of constraints that shape choices; a moment‘s reflection should suggest to us the pervasiveness of informal constraints. In our daily interactions with others, whether within the family, in external social relations, or in business activities, the governing structure is overwhelmingly defined by codes of conduct, norms of behaviour, and conventions. Underlying these informal constraints are formal rules, but these are seldom the obvious and immediate source of choice in daily interactions. That the informal constraints are important by themselves (and not simply as appendages to formal rules) can be observed from the evidence that the same formal rules and/or constitutions imposed on different societies produce different outcomes. (…) Where do informal constraints come from? They come from socially transmitted information and are part of the heritage that we call culture» [D.C. NORTH, Institutions, Institutional Change and Economic Performance, Cambridge, Cambridge University Press, (1990), p. 36-37]. 47 For a wise analysis focused on the American context see A Political Theory of American Corporate Finance, Colum. L. Rev., Vol. 91, (1991), p. 10; M.J. ROE, Strong Managers, Weak Owners: The Political Roots of American Corporate Finance, Princeton, Princeton University Press, (1994). 48 «Path dependence is a term that has come into common use in both economics and law. In all instances that path dependence is asserted, the assertion amounts to some version of ―history matters‖. Path dependence can mean just that: Where we are today is a result of what happened in the past. (…) In biology, the related idea is called contingency – the irreversible character of natural selection. (…) We must caution, however, that the analogies are incomplete. If turtles become extinct, they will not reappear suddenly when circumstances change to make it advantageous to have a shell. But if people stop using large gas-guzzling engines because gasoline has become expensive, or extent patent protection to the ―look and feel‖ of software, they can always revert to their old ways if they come to regret the switch» [S.E. MARGOLIS, S.J. LIEBOWITZ, Path Dependence, in P. NEWMAN, (Edited by), The New Palgrave Dictionary of Economics and the Law, Vol. 3, London, Macmillan Reference Limited, (1998), p. 17-18]. See also L. BEBCHUK, M.J. ROE, A Theory of Path Dependence in Corporate Ownership and Governance, Stan. L. Rev., Vol. 52, (1999), p. 127. M.J. ROE, 87 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 stand alone. On the contrary, every work dealing with corporate governance (included those about the specific topic of national patterns of corporate ownership and control) should start by looking at the matter from a more general perspective. Taking this perspective, let‘s start by quoting a prominent scholar. He begins one of his most significant works49 stating that the word «capitalism» is commonly used for the definition of a particular kind of economic organization traditionally pertaining to Western Europe, North America and Japan. More precisely, he states that this kind of economic organization is normally defined as a system in which the assets are owned by those people who invest their capitals for the production of goods or the providing of services. However, immediately after this first statement, the scholar himself specifies that, in practice, the ownership by investors is only a contingent feature of the free market economies, even if usually dominant. Indeed, in every free market economy (United States included) a number of different ownership structures coexist, involving various kind of owners and having different degrees of concentration. In few words, claiming that several «systems of capitalism» exist throughout the world only means that different economic organizations sharing the common trait of the ownership by investors as dominant (albeit contingent) feature are in place. Beyond the just mentioned common trait, all the other specific features of firms (even within the same system of capitalism) can vary a lot. In general, many historical factors, cultural elements and social relations are suitable to affect the way in which an economy is driven and organized. In this respect it must be remarked that, as already said, corporate ownership and control structures don‘t stand alone. However, the dominant way in which firms are owned and controlled within a certain country seems to be particularly important because it somehow reflects the influence of all the other forces. According to what explained above, it‘s possible to say that each single country has its own peculiar system of capitalism50 and, moreover, within the same 49 H. HANSMANN, The Ownership of Enterprise, Cambridge Mass., The Belknap Press of the Harvard University Press, (1996). 50 In some respects, it could be also said that different areas within the same country may have their own specific system of capitalism. Take for example the case of the north and the south of Italy: it‘s self evident that a region like Lombardy (one of the fastest growing and most economically developed in the whole Europe) has an economic organization completely different from Sicily (one of the slowest growing and less economically developed in the whole Europe). Moreover, take the example of different parts of the United States: California has an economic organization completely different from Montana. The practice to consider countries as uniform economic entities is correct and imposed for simplification, so this footnote is maybe an excess of precision, however 88 country firms may have different structures of ownership and control. Despite of this broad and persistent diversity, the various systems share some common elements that allow to group them under few categories. More precisely, the economic organizations of Western Europe, North America and Japan can be generally grouped under two categories: «market-centred systems» and «bank-centred systems»51. Italy is usually considered as a «bank-centred system». This categorization only catches one of the main distinctive features of the Italian capitalism, because it is characterized by many other very specific elements. However, the categorization stresses the important role that, also in Italy, credit institutions played and still play in the economy. As already said, corporate ownership and control structures can‘t be studied apart from the general economic context in which they have been developed, but they are very important anyhow. In particular, the ownership and control structures of the Italian banks have some specific characteristics that are very interesting to be analysed, in order to highlight how they reflect the impact of many different forces (cultural, historical and political ones) on this kind of institutions. 2. The primary roots of the current context: some notes about the initial development of a modern credit industry in Italy Around 1861, the year in which the country was politically unified, the Italian economy was stagnant and still resembling a medieval one from both a financial and an industrial perspective 52. From a financial perspective, a prominent scholar in banking observes four peculiar features of the post-unitary Italian economy: i) frequent financial crisis in pre-unitary States; ii) the scarcity of a monetary field in the Italian economy (90% of legal tender was hard money); iii) the absence of lending institutions both on long and short term; iv) strong elements of dualism and exposition to usury for a large layer of population53. In addiction, any stock exchange in a modern sense was in operation. From an industrial perspective, it can be noticed that in those years the Italian fabrics were still it‘s only to specify that there can be an enormous difference between economic borders and the geographical ones. 51 See, for instance, F. ALLEN, D. GALE, Comparing Financial Systems, Cambridge Mass., MIT Press, (2000); R. LA PORTA, F. LOPEZ-DE-SILANES, A. SHLEIFER, Corporate Ownership Around the World, J. Fin., Vol. 54, (1999), p. 508. 52 See for example G. FUA‘, (Edited by), Lo sviluppo economico in Italia, Milano, Franco Angeli, (1969). 53 M. ONADO, La lunga rincorsa: la costruzione del sistema finanziario, on P. CIOCCA, G. TONIOLO, (Edited by), Storia Economica d‟Italia, Bologna, Laterza, (2002), p. 384. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 handmade by artisans54, except for the silky production, which represented the «school for the Italian industrial take off»55. In addiction, Italy had no railroads at all (except for few hundreds of kilometres built more for the noblemen‘s pleasure than for economic purposes)56. However, even if during the 1860s and the 1870s Italy was still heavy economically injured because of recent wars, it experienced a fresh economic growth 57. This growth was especially boosted by a historical event. Indeed, the unification of the country produced expectations and enthusiasms that, for the first time in the Italian history, led to the built of modern factories and to the initial rise of an entrepreneurial class58. At the same time, the credit industry was still very segmented. Some different kind of banks coexisted in Italy during that period, sometimes as a heritage of the different pre-unitary systems. Firstly, monti di credito su pegno: different kind of banks dated back to the Middle Ages, variously called (e.g. monti di pietà, monti frumentari, monti pecuniari) and statutory aimed at lending small amounts of money on pledge59. Secondly, casse di risparmio: savings banks having various founders (governments, municipalities, associations of citizens or ecclesiastical authorities) and different organization (they could look like associations or foundations) but always aimed to safeguard deposits more than lend money60. Thirdly, banche popolari and casse rurali e artigiane: two different kinds of mutual banks chartered as cooperatives61. Finally, normal banks chartered as corporations. All of them were universal banks and all of them could be involved in activities that were regulated by special laws like agrarian lending or estate and construction lending62. Moreover, due to the pre-unitary division of the country in regional States, the credit industry dominantly had a local dimension63. Along with the regional dimension of banks, their ownership structures were local too. The literature seems to lack of precise and comprehensive data about the ownership structure of monti di credito su pegno and casse di risparmio in the nineteenth century. Indeed, they were very particular institutions in which different kind of players were variously involved. Only about few important monti di credito su pegno (e.g. Opere pie San Paolo di Torino, Monte dei Paschi di Siena, Banco di Santo Spirito) is known that at the end of the nineteenth century they were controlled by the State64. For what concern casse rurali e artigiane a similar lack of accurate data is observable, but the background on which such institutions were created undoubtedly allows to state that they were cooperatives with local range of activity and owners65. On the contrary, about banche popolari and normal banks chartered as corporations it‘s proven that, at the end of the 1870s, the shareholders of the former were about 70,000 and the shareholders of the latter were about 30,00066. 54 About Italy see F. BELLI, Legislazione bancaria italiana (1861 – 2003), Torino, Giappichelli, (2004), p. 50-51. 55 See L. CAFAGNA, Dualismo e sviluppo nella storia d‟Italia, Venezia, Marsilio, (1999). 56 According to a prominent Italian economist [G. TONIOLO, Storia economica dell‟Italia liberale 1850-1918, Bologna, Il Mulino, (1988), p.115], in 1860 Italy had just 2,000 km of railways, while the United Kingdom had 15,000 km, Germany 12,000 km and France 9,000 km. 57 For example, consider that in 1862 the Rattazzi‘s government undertook a rail policy for the south of the country, thanks to a network of Italian entrepreneurs and to the stream of French and English capitals. In 1864 the privatizations of the industrial government started: Italian government farmed out the mechanic plant of Pietrarsa (Naples) for the construction of railway assets. In the same years the shipyard of Leghorn and La Spezia became private. In 1865 a modern factory rose in Piombino (La Magona d‘Italia sprouted for the initiative of an English businessman Joseph Alfred Novello to exploit the mineral resource of the contiguous Elba island). 58 The unification of the country took in Italy a wave of commercial euphoria. A series of bank‘s initiatives bloomed and a run to the exploitation of mineral took place. Even if in 1864 many of the businessmen involved in this run saw the failure of their expectations. See G. LUZZATTO, L‟economia italiana dal 1861 al 1894, Torino, Einaudi, (1968). 59 See M. PIPITONE, Monti di credito su pegno, on Digesto delle Discipline Privatistiche – Sezione Commerciale, Torino, UTET, (1994), p. 74. 60 See L. PONTIROLI, Cassa di risparmio, on Digesto delle Discipline Privatistiche – Sezione Commerciale, Torino, UTET, (1987), p. 513. 61 The first Italian banca popolare was chartered in Lodi (Lombardy) in 1864 and 122 banche popolari existed in Italy in 1878 [see F. BELLI, A. BROZZETTI, Banche popolari, on Digesto delle Discipline Privatistiche – Sezione Commerciale, Torino, UTET, (1987), p. 166]. The first Italian cassa rurale and artigiana was chartered in a small town near Padova in 1883 by Leone Wollemborg, an economist who also became member of the Parliament and Ministry of Finance [see S. GATTI, Cassa rurale e artigiana, on Digesto delle Discipline Privatistiche – Sezione Commerciale, Torino, UTET, (1987), p. 541]. 62 It‘s important to notice the this market segmentation and growth of new species of banks is the same phenomenon experienced by the U.S. in that period. Also in Italy the main difference was about commercial banks and thrifts (e.g. casse rurali e artigiane and banche popolari). While the first were profit-making corporations owned by shareholders, the second originally were more charitableoriented institutions organized in a mutual form. 63 See, in general, G. CONTI, S. LA FRANCESCA, (Edited by), Banche e reti di banche nell‟Italia postunitaria – Volume II. Formazione e sviluppo di mercati locali del credito, Bologna, Il Mulino, (2000). 64 See, for example, G. CONTI, Processi di integrazione e reti locali: tipologie del credito e della finanza, on G. CONTI, S. LA FRANCESCA, (Edited by), Banche e reti di banche nell‟Italia postunitaria – Volume II. Formazione e sviluppo di mercati locali del credito, Bologna, Il Mulino, (2000). 65 See S. GATTI, Cassa rurale e artigiana, on Digesto delle Discipline Privatistiche – Sezione Commerciale, cit., p. 541 66 See A. POLSI, Alle origini del capitalismo italiano – Stato, banche e banchieri dopo l‟Unità, Torino, Einaudi, (1993). 89 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 For what especially concern banche popolari, being chartered as cooperatives, the number of shares owned by each single shareholder was limited, thus they can be described as a sort of public companies67. More precisely, according to a statistic dated back to that period, the shareholdings of banche popolari was composed for more than 65% by small landowners, farmers, artisans, shopkeepers and local notables or professionals68. For what concern banks chartered as corporations, on a total of 226, the 155 biggest ones globally counted 3711 shareholders and the largest part of them was Italian (3540 shareholders). Among them, the 50% were other banks (14.53%) or private bankers (35.47%), while the rest were merchants (9.77%), industrialists and artisans (7.77%), shipowners (6.41%), large landowners (4.81%), stockbrokers (4.22%), and lawyers (2.5%)69. The category of private bankers, being the largest one, need to be further explained. They were people whose principal occupation was not banking. In few words they were the evolution of the medieval bankersmerchants, who variously distributed their resources between different activities such as banking and trading70. Moreover, among private bankers, as well as among the other categories, many shareholders had more than one occupation, since they could also be noblemen or politicians71. Thus the shareholdings of Italian banks during the 1860s and 1870s was quite various and tangled in different activities. In those years, the role foreign investors was quite limited, since they represent just 231 underwritings (less than 5% of the total)72. However, foreign investors played an important role for the first Italian industrial and economic development, also affecting the ownership and control of Italian banks. In fact, in line with the unification of the country, one of the primary political objectives was to shift the Italian industry from a regional to a national dimension. In order to do so, a financially underdeveloped economy such as the Italian one needed banks large enough to drive the industrialization by collecting and lending money on a wide scale73. In this respect culture played an 67 See S. LA FRANCESCA, Storia del sistema bancario italiano, Bologna, Il Mulino, (2004), p. 70. 68 See A. POLSI, Alle origini del capitalismo italiano – Stato, banche e banchieri dopo l‟Unità, cit., p. 264. 69 See A. POLSI, Alle origini del capitalismo italiano – Stato, banche e banchieri dopo l‟Unità, cit., p. 266, 274 and 277. 70 A description of the Italian medieval companies as engaged in various kind of activities ranging from banking to commerce and industry is given by C.M. CIPOLLA, Storia economica dell‟Europa pre-industriale, Bologna, Il Mulino, (1997), p. 196. 71 See, in general, the fourth chapter of A. POLSI, Alle origini del capitalismo italiano – Stato, banche e banchieri dopo l‟Unità, cit., p. 263. 72 See again A. POLSI, Alle origini del capitalismo italiano – Stato, banche e banchieri dopo l‟Unità, cit., p. 267. 73 See S. LA FRANCESCA, Storia del sistema bancario italiano, cit., p. 17 and 43. 90 important role. Indeed, without having its own national model for such banks, the Italian ruling class looked at countries which were perceived to be more culturally similar. At the beginning, the country perceived to be most culturally similar was France and its model of banking was consequently adopted 74. In accordance with that model, Credito Mobiliare was chartered in 1863. It was a bank conceived following the example (and resembling also the name) of the French Crèdit Mobilier. Moreover, the shareholders were also French for a large part. The bank in fact was owned for a half by the previous shareholders of the Cassa Torinese del Commercio e dell‟Industria (an Italian bank merged into the Credito Mobiliare at the time of its creation) and for the other half by people linked with the French Crèdit Mobilier75. In addiction, few years later, in 1872, Banca Generale was chartered almost in the same manner. These two banks, along with others, are considered as main the drivers of the first Italian industrialization, as well as their activity is viewed as the earliest sign of a bank oriented system of capitalism76. At the beginning of the 1880s the Italian economy experienced an agricultural crisis 77, worsened by the commercial war against France (started when Italy became part of the anti-French military alliance set by Germany and Austria) but at the same time a construction fever took place in Italy. The Italian banks, harmed by the agricultural crisis, started to invest deeply in construction companies and to speculate in estate businesses78. All those speculations involved a large part of the Italian banks, generating a financial bubble that started to explode in 1886 and a crisis culminated in the period of two 74 The French model can be roughly described as based on the synergic interaction of three different kind of banks: the elitist private bank, the investment bank, the savings bank [see S. LA FRANCESCA, Storia del sistema bancario italiano, cit., p. 85]. 75 Among them can be listed also the Pereire brothers, two renowned French businessmen who played a very important role in the early Italian financial development [see S. LA FRANCESCA, Storia del sistema bancario italiano, cit., p. 45]. 76 See S. LA FRANCESCA, Storia del sistema bancario italiano, cit., p. 43. 77 Agricultural crisis started in Italy in 1876 for production stagnancy having reference to the contraction of cereals prices due to the American competition. This crisis was widely widespread in European countries and its effects endured in Italian economy until 1890. Italian GDP in 1876 is analogous to the 1887‘s one, thanks to the development of manufactured product‘s industries. See for example G. FEDERICO, Per una analisi dell‟agricoltura nello sviluppo economico italiano: note sull‟esportazione dei prodotti primari (1863-1913), on Storia e società, No. 5, (1979). 78 Those years are commonly viewed as the first step of the Italian industrialization: the economy grew at the approximate rate of 8% per year and the total capitalization of corporations increased as follows: 1,070 millions of lire in 1878; 1,342 millions in 1881; 1,685 millions in 1885; 1,746 millions in 1887 (see S. LA FRANCESCA, Storia del sistema bancario italiano, cit., p. 71). Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 years between 1893 and 189479. In those years, both the main drivers of the early Italian industrial development (Credito Mobiliare and Banca Generale) collapsed. Immediately after the collapse of Credito Mobiliare and Banca Generale, they were replaced by the creation of two other banks: Banca Commerciale Italiana in 1894 and Credito Italiano in 189580. These two banks replaced Credito Mobiliare and Banca Generale not only as the main players in the Italian credit industry, but also as drivers of the national economy. However, in these cases, the model of banking taken as example was not the French one, but the German one81. The commercial war against France (in consequence of the military alliance with Germany and Austria) can be tentatively regarded as a political determinant of this fact. Anyway, apart from the tentative location of a political determinant, is beyond doubt that the adoption of that model were also influenced by cultural affinities and implied a deep presence of German institutions in the ownership structure of both banks. Indeed, the initial capital of Banca Commerciale Italiana was underwritten by German banks (78%), Austrian banks (13%) and Swiss banks (9%), as well as the creation of Credito Italiano was in part financed by German investors82. The ownership of Banca Commerciale Italiana and Credito Italiano (which remained both in operation till few years ago) later gradually shifted in Italian hands. For instance, in 1907 a director of Banca Commerciale Italiana wrote to a German colleague that, on a total of 210,000 shares, about 190,000 are held by Italians, therefore implying that a process of «naturalization» was substantially completed83. Later, the same process was also completed for Credito Italiano (as well as for other important banks not mentioned in this work) by the wave of bids and takeovers which took place in the first decades of the twentieth century. 79 In these two years, the four most important Italian banks (Banca Generale, Credito Mobiliare, Banca Tiberina, Banca di Sconto e Sete) were helped by the Banca Nazionale del Regno d‟Italia, another important bank (Banca di Roma) was saved by the Vatican Treasury and, finally, the Banca Romana‘s financial scandal took place. The crisis culminated between 1893 and 1894 when, in few months, both Banca Generale and Credito Mobiliare collapsed (see F. BELLI, Lesiglazione bancaria italiana, cit., p. 89 and 90). 80 G. TONIOLO, Storia economica dell‟Italia liberale 18501918, cit., p. 180. 81 Their main investment activity can be roughly described as based on the acquisition of portfolios of shares held by other intermediaries in order to place them later on the stock market (see S. LA FRANCESCA, Storia del sistema bancario italiano, cit., p. 86). 82 See G. TONIOLO, Storia economica dell‟Italia liberale 1850-1918, cit., p.180. 83 See A. CONFALONIERI, Banche miste e grande industria in Italia – Volume I: L‟esperienza della Banca Commerciale e del Credito Italiano, Milano, Banca Commerciale Italiana, (1994), p. 47. Indeed, at that time the model was the universal bank and, most important, there was no separation of banking and industry. This fact allowed for a very active market for the corporate control and for wars of bids between banks and industrial companies84. Consequently, at the beginning of the 1920s banks and industrial companies were braided in a complex and unnatural way, constantly involved parallel takeovers by which everyone attempted to gain the control of the other85. 3. The shift from a private owned to a largely state owned credit industry The World War I had many important consequences. The War in fact deeply influenced also the economy, since the industry modified its production and made important efforts in order to comply with the demand of specific goods. In doing so, the industry enlarged its scale and sectors underdeveloped or inexistent until then finally became part of the economy. However, many problems also resulted from the War. Some areas of the country were almost completely destroyed or deeply injured. Moreover, the scale achieved by industries was no more supported by State‘s orders, since the national debt raised in the same years and the public finances were distressed. Consequently, the industry faced several difficulties, the attempts to reorganize the system implied a reduction of the achieved scale and a consequent growth of unemployment. At the same time, the rate of inflation grew and prices increased86. All these circumstances led to the emergence of a strong and spread discontent among the people. In particular, the traditional tools of the liberal economy seemed unable to solve those problems. Such an environment created the conditions for the birth of illiberal ideologies and political parties proposing authoritative solutions for the crisis. This is the summarized background in which the fascist party bore in 1919 and finally took the power in 1922 87. The fascist approach towards the economy was inspired by corporatism, protectionism and economic nationalism. One of the main theorists of the fascist 84 See again A. CONFALONIERI, Banche miste e grande industria in Italia – Volume I: L‟esperienza della Banca Commerciale e del Credito Italiano, cit., p. 47-72. 85 A prominent author refers that an important Italian banker of that period wisely called and regarded the weaving between banks and industrial companies as a «Siamese brotherhood» (see S. LA FRANCESCA, Storia del sistema bancario italiano, cit., p. 132). 86 A short but effective description of the economic consequences of the World War I in Europe and, more precisely, in Italy can be found in V. ZAMAGNI, Dalla rivoluzione industriale all‟integrazione europea, Bologna, Il Mulino, (1999), p. 133 and 154. 87 The relation between the economic consequences of the World War I and the rising of fascism can be found in V. ZAMAGNI, Dalla rivoluzione industriale all‟integrazione europea, cit., p. 154. 91 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 approach towards the economy was Alfredo Rocco, a renowned lawyer finally also became Ministry of Justice. In accordance with the fascist concept, the main aim of the Italian industry should be «the advantage of the Country» and «the supreme interest of the Nation»88. In line with this idea, the interest of «the Nation» was not the sum of the individual interests of those who live in the nation. In other words, for the fascist theorists the economy shouldn‘t be driven in the interest of individuals but in the interest of the community (i.e. «the Nation»). Coherently with this line of thought, other traits of the fascist government finally became autarchy, State intervention in the economy and industrial planning. The fascist attitudes towards the economy were also fuelled by the Great Depression started in the United States of America in October 1929. Indeed, the deep contraction of business encouraged the research of new economic models. Moreover, the liberalist methods and ideas lost credibility, being apparently unable to solve or even soften a crisis which was prolonging for years. In that context, the fascism was perceived able to offer a convincing and feasible alternative to the free market economy89. The first effect of the crisis of many banks during the Great Depression was to give to the fascist regime the opportunity to take some initiatives that finally led to a wide nationalisation of banks. This process started at the beginning of the 1930s with the creation of IMI and IRI90. In addiction, the centrepiece of the reforms addressed to deal with the problems emerged from the Great Depression was the Banking Law enacted in two steps between 1936 and 1938. The state managers on charge in IMI and IRI can be also considered the architects of the Banking Law of 1936-38 and in this circumstance is possible to find the reasons why this regulation kept its utility and effectiveness for over fifty years. Indeed, the state managers mentioned before (leaded by Alberto Beneduce91 and Donato Menichella92) didn‘t belong 88 See A. CARDINI, Cultura economica e governo dell‟economia nella dittatura fascista, on A. MAZZACANE, (Edited by), Diritto economia e istituzioni nell‟Italia fascista, Baden Baden, Nomos Verlagsgesellschaft, (2002). 89 See A. CARDINI, Cultura economica e governo dell‟economia nella dittatura fascista, cit., p. 61. 90 IRI (Institute for the industrial rebuilding - Istituto per la ricostruzione industriale) and IMI (Italian investment institute - Istituto mobiliare Italiano) were two holding companies totally owned by the State. IMI was created in 1931, in order to avoid the failure of the main important Italian banks, and IRI (1933) became the owner of large part of the Italian industrial system, originally owned jointly by the failed banks. In particular IRI since 1940 to 1990 was the main Italian industrial group. For a confirmation of the fact that the Great Depression gave to the fascism the opportunity to nationalise the Italian credit industry by creating IMI and IRI see V. ZAMAGNI, Dalla rivoluzione industriale all‟integrazione europea, cit., p. 177. 91 Alberto Beneduce was a well-known Italian scholar and politician in the early years of the last century. In particular 92 to the anti-capitalistic and anti-liberalist circles then ruling the fascist party. On the contrary, they were high level experts, educated and grew up in the liberalist atmosphere across the nineteenth and the twentieth centuries, that always had a lukewarm attitude towards the fascism93. The Italian Banking Law of 1936-38 brought some changes of historical importance in Italy and two, in particular, are usually regarded as the most revolutionary ones. The first one concerned the separation of commercial banking from investment banking94. The second one concerned the classification of banks in different categories with an element in common, that was the state ownership (Sections 25-27 of the Banking Law)95. It‘s important to stress other cultural determinants lying behind the Banking Law of 193638. On the one hand, Italy never had an entrepreneurial class disposed to tolerate risks tied with financial activities just to maximize its expected profits. Rather firms were really interested in acquiring the control of banking activities solely to obtain a chartered financial canal96. On the other hand, during the 1920s we observe a financial market ruled by speculation of a concentrated economic power. Under these circumstances, the state ownership could be a means to treat savings in the «right hands»97. However, it‘s also important to stress that the nationalization of banks was wide but not complete. Indeed, the abolition of private property was unconceivable for the fascism, being jointly with statism the main feature marking its approach as a in 1933 Beneduce has been the main promoter and organizer of IRI and its president until 1939. 92 Donato Menichella was an important name of the Italian economic and political scene of the first part of the last century. Previously, he was nominated governor of the Italian central bank in 1948, he was since 1934 the general director of IRI. 93 See F. BELLI, Legislazione bancaria italiana, cit., p. 149. 94 See F. BELLI, Legislazione bancaria italiana, cit., p. 183. 95 Other critical changes introduced by the Banking Law of 1936-38 concern the redefinition of the credit institutions‘ functions and the creation of the Ispettorato per la difesa del risparmio e l‟esercizio del credito (IDREC), a supervisory body chaired by the governor of the Banca d‟Italia (Sections 1-24 of the Banking Law). Moreover, the Banking Law regulated the process of chartering and branching of the banks (Sections 28-40 of the Banking Law). Finally, several provisions introduced controls and tools aimed to ser the prudential supervision and the regulatory supervision (Sections 31, 32, 33 and 35 of the Banking Law). 96 See M.ONADO, La lunga rincorsa: la costruzione del sistema finanziario, cit.. 97 In this respect, it has been evidenced that such a cultural attitude towards the economy can be even dated back to the beginning of the century. See F. BARCA, Compromesso senza riforme nel capitalismo italiano, on F. BARCA, (Edited by), Storia del capitalismo Italiano, Roma, Donzelli, (1997). Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 «third way»98 between and the equally rival liberalist and communist ideologies99. Thus, the State finally controlled the 80% of the credit industry100, but some private owned banks always remained in operation. On the other hand, as a consequence of the just described process, the Italian economy became largely controlled by the State. Indeed, as mentioned at the end of the previous paragraph, during the 1920s banks and industrial companies were deeply tangled in the control of each other. Thus, being banks the shareholders of industrial companies, the rescue of distressed banks achieved through their acquisition by IMI and IRI implied that the State also became a large shareholder of many industrial companies. More precisely, after this process, the State totally controlled the production of weapons; the 80-90% of shipyards, shipping-lines, airlines and telephone companies; the 40% of the iron and steel industry; the 30% of the electric industry; the 25% of the mechanical industry and the 15% of the chemical industry101. 4. The gradual retreat of the State from a direct involvement into the economy The World War II had a destructive impact on the economy. For what especially concern Italy, after 1943 the final and harshest phase of the conflict, being the south occupied by Anglo-American troops, was fought in the central and northern regions (i.e. the industrial heart of the country). During those years, battles and bombardments almost completely destroyed infrastructures, factories and cities. At the end of the World War II Italy was totally ruined from an economic perspective. However, at the same time the war allowed for a deep influence of the Anglo-American culture throughout the country and freed many positive energies. Moreover, in 1946 the result of a referendum repealed the monarchy and established the republic. This vote gave the chance to provide the people‘s refreshed spirit with a new institutional framework which dismantled many of the previous age-old structures and prerogatives. Moreover, the first initiatives aimed to set a cooperative framework between different European 98 See A. CARDINI, Cultura economica e governo dell‟economia nella dittatura fascista, cit., p. 61. 99 Moreover, a confirmation of what described above can be found in an important paper [F. AMATORI, F. BRIOSCHI, Le grandi imprese private: famiglie e coalizioni, on F. BARCA, (Edited by), Storia del capitalismo Italiano, Roma, Donzelli, (1997), p. 118] were is written that the direct involvement of the State in the economy was not aimed to suppress private groups or entrepreneurial initiatives, since it was also practically hindered by the State‘s limited resources and by the need to maintain some social and political equilibriums. 100 See V. ZAMAGNI, Dalla rivoluzione industriale all‟integrazione europea, cit., p. 189. 101 See V. ZAMAGNI, Dalla rivoluzione industriale all‟integrazione europea, cit., p. 189. countries promoted trust and encouraged expectations about the future. In this renewed context, thanks also to the financial aid granted by the United States of America102, Italy experienced an economic boom, becoming one the world‘s most industrialized countries. The Italian economic development during the 1950s and 1960s has been wisely described by a prominent author as «an extraordinary compromise»103. In fact, it was a development contemporarily marked by many uncontrolled private entrepreneurial initiatives as well as a permanent direct involvement of the State in the economy. In other words, it was an original compromise between hyper-liberalism and strong statism. Under this compromise, both private and state owned firms coexisted and succeeded in their respective businesses104. About the role of culture, it‘s just incidentally interesting to notice that the mentioned coexistence of private and state owned firms occurred also in France and Germany105, two European countries perceived as culturally similar to Italy since the nineteenth century. However, in Italy the situation was quite different for what respectively concern banks and industrial companies. Indeed, while many and large industrial companies remained state owned, the number and the size of private owned firms also significantly increased106. On the opposite, most of the Italian banks remained controlled by the State and any new private bank was virtually chartered107. The reasons lying behind the immobility of the credit industry in those years could be found in the specific features of the Italian industrial boom. In fact, beside public or private huge industrial groups, the economic development was mostly driven in Italy by very small firms. These small industrial companies simply were the modern evolution of workshops in which the traditional handicraft was substituted by mechanization108. Such a kind of small company was 102 See V. ZAMAGNI, Dalla rivoluzione industriale all‟integrazione europea, cit., p. 201. 103 See F. BARCA, Compromesso senza riforme nel capitalismo italiano, cit., p. 12. 104 See, in general, F. BARCA, (Edited by), Storia del capitalismo Italiano, Roma, Donzelli, (1997). 105 See G.M. GROS-PIETRO, E. REVIGLIO, A. TORRISI, Assetti proprietari e mercati finanziari europei, Bologna, Il Mulino, (2001), p. 153 and 293. 106 See, in general, F. BARCA, (Edited by), Storia del capitalismo Italiano, cit.. 107 This is definitely true at least for the major players within the Italian credit industry. See G. FERRI, S. TRENTO, La dirigenza delle grandi banche e delle grandi imprese: ricambio e legami, on F. BARCA, (Edited by), Storia del capitalismo Italiano, Roma, Donzelli, (1997), p. 421-423. 108 The main advantages of such an atomistic system were to be highly dynamic and flexible. Moreover, these small industrial companies, being the modern evolution of traditional workshops, usually produced the typical good of the area in which they were established. Therefore, small companies producing a specific good were concentrated in different areas of the country historically and traditionally renowned for the production of that specific good (e.g. 93 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 (but in many cases it still is today) owned by members of a single family who financed it with their personal savings and with profits they reinvested in the business. Being «auto-financed», small companies didn‘t need any external financial assistance and therefore banks were merely used by families as custodians of savings. Moreover, the galloping economy of 1950s and 1960s also allowed the large industrial groups to be financed only by reinvested profits109. In fact, even if the largest industrial companies and banks always remained linked by interlocking directorates110, the whole entrepreneurial class of that time was basically autonomous in driving business111. Things started to change in the 1970s. Indeed, during the 1960s many opportunities to reform the system were gone lost112 and, at the beginning of the following decade, the galloping years of the economic boom were definitely ended. In those years, wages were growing and the rate of inflation was increasing in a context of international monetary turmoil and energetic crisis113. Under these circumstances, firms (especially the largest ones) could no more rely only on expected profits and their own finances. However, the biggest banks were mainly conceived as commercial banks, thus subjected to rigid controls set by the Banking Law of 1936-38 and unable to help the system. Then, Mediobanca, a semi-private bank chartered at the end of the World War II, gained a prominent role acting as merchant bank114. Mediobanca was one of the very few private owned banks at that time but, as already said, it was in fact only semi-private owned. Indeed, it was founded in 1946 by three of the biggest Italian banks which respectively divided among themselves its ownership: Banca Commerciale Italiana 35%, Credito Italiano textiles in Biella and Prato, furniture in Monza). These areas are still called «distretti industriali» (i.e. industrial districts) and played a very important role in the industrialization of Italy. Indeed, the organization in districts accounting several small firms with the same kind of business allowed to develop synergies among them which are able to supply to the lack of economies of scale. See S. BRUSCO, S. PABA, Per una storia dei distretti industriali dal secondo dopoguerra agli anni novanta, on F. BARCA, (Edited by), Storia del capitalismo Italiano, Roma, Donzelli, (1997), p. 265. 109 See F. AMATORI, F. BRIOSCHI, Le grandi imprese private, cit., p. 131. 110 See G. FERRI, S. TRENTO, La dirigenza delle grandi banche e delle grandi imprese: ricambio e legami, cit., p. 405. 111 See F. AMATORI, F. BRIOSCHI, Le grandi imprese private, cit., p. 131. 112 See M. D‘ANTONIO, La politica economica degli anni Sessanta ovvero le occasioni perdute, on M. ARCELLI, (Edited by), Storia, economia e società in Italia 1947-1997, Roma-Bari, Laterza, (1997), p. 185. 113 See F. AMATORI, F. BRIOSCHI, Le grandi imprese private, cit., p. 131. 114 For a detailed description of the role played by Mediobanca in those years see F. AMATORI, F. BRIOSCHI, Le grandi imprese private, cit., p. 131. 94 35%, and Banca di Roma 30%. However, these three banks were owned by IRI, thus controlled by the State. Therefore, at the beginning Mediobanca was also owned and controlled (albeit indirectly) by the State. In 1956 Mediobanca was listed on the stock exchange and the three founding banks decreased the amount of shares they held: Banca Commerciale Italiana to 24%, Credito Italiano to 24%, and Banca di Roma to 20%. Consequently, during the 1970s Mediobanca was owned for 32% by private institutions or individuals, but it was still indirectly controlled by the State through the three founding banks mentioned above (collectively holding the 68% of the bank‘s capital)115. Apart from Mediobanca and few other banks, the Italian credit industry was still widely controlled by the State. At the beginning of the 1980s Italy started to emerge from the recession and during that decade the economy grew up again 116. Notwithstanding the experienced crisis, then Italy was no more a country at the eve of industrialization as it was across the nineteenth and the twentieth century, nor a young and fast-growing economy as it was during the 1950s and 1960s. On the opposite, then Italy was one of the most industrialized countries of the world, a founder and main member of the European Economic Community and an internationally important commercial partner. Moreover, Italy joined the European Monetary System in 1979117. In the context shortly described above, the model of banking set during the 1930s entered in crisis. Since the creation of IMI and IRI and the Banking Law of 1936-38, almost any initiative or legislation of great consequence was taken or enacted in Italy concerning the credit industry118. At the beginning of the 1980s, the processes of liberalization undertaken by the EEC, as well as Italian market‘s internal factors, called for the privatization of the credit industry and the development of a more competitive system119. The dismantlement of the system settled by the creation of IMI and IRI and the Banking Law of 1936-38 was realised in three steps. Firstly, pressures to comply with the European Directives forced some initial regulatory changes. Secondly, the state ownership of banks was slowly repealed through a process of privatization started with the so called 115 For more information see www.mediobanca.it. For a detailed statistical research concerning the evolution of the Italian economy see M. DI PALMA, M. CARLUCCI, L‟evoluzione dei principali aggregati economici nell‟ultimo cinquantennio, on M. ARCELLI, (Edited by), Storia, economia e società in Italia 1947-1997, Roma-Bari, Laterza, (1997). 117 See M. ARCELLI, S. MICOSSI, Politica economica negli anni Ottanta (e nei primi anni Novanta), on M. ARCELLI, (Edited by), Storia, economia e società in Italia 1947-1997, Roma-Bari, Laterza, (1997), p. 263. 118 See F. BELLI, Legislazione bancaria italiana, cit., p. 204. 119 See M. CLARICH, A. PISANESCHI, Le fondazioni bancarie – Dalla holding creditizia all‟ente non-profit, Bologna, Il Mulino, (2001), p. 34. 116 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 «Legge Amato» of 1990 and followed by the Legislative Decree no. 153/1999120. Thirdly, the system was completely and deeply reformed by the approval of the Legislative Decree no. 385/1993 (Testo Unico delle leggi in materia bancaria e creditizia - TUB)121. For what concern the first step, the process of privatization occurred in Italy during the 1990s was preceded by a process of regulatory liberalization aimed to cut down entry barriers having legal origin and started to comply with the European Directives enacted in the banking field. The just mentioned elimination of entry barriers was needed because, under the system designed by the Banking Law of 1936-38, new branches could be opened only after a specific authorization granted by the Banca d‟Italia. This system prevented from any form of competition, being the authorization granted only in the respect of a planned territorial distribution of branches,. The mentioned elimination of entry barriers was pursued by the Banca d‟Italia‘s «piano sportelli» of 1982 and by the legislative accomplishment of the first EEC Banking Directive of 1985122. For what concern the second step, the «Legge Amato» started the privatization in 1990 by authorizing the state owned banks to chart private corporations (called «società conferitarie») to which they should transfer their banking activities. At the same time, the state owned banks should chart a fondazione bancaria (also called «ente conferente»). The fondazione bancaria is a particular type of foundation afterwards regulated by the Legislative Decree no. 153/1999 to promote the process of privatization. The aim of these institutions was to own all the shares of società conferitarie, in order to gradually sell them. To pursue at this aim, Section 25 of the Legislative Decree no. 153/1999 stated that every fondazione bancaria should sell all its shares by 31 December 2005 (or at least decrease its participation under a control level). An administrative committee would be settled to dispossess fondazioni bancarie still not complying with this provision at the mentioned deadline. Another intent of the Legislative Decree no. 153/1999 was that, after the shares‘ dismissal, fondazioni bancarie would continue to exist as mere non profit organizations. For what concern the third step, the biggest innovation brought by the TUB was the reintroduction of the universal bank (Section 10) and the consequent repeal of the separation between commercial and investment banking. It also set specific provisions about bank‘s ownership in order to pose limits to the shares of banks that could be owned by industrial companies, without completely prohibiting these participations (Sections 19-24). More generally, the mentioned law rearranged the system allowing for the existence of only three different kind of banks (Sections 19-37): ordinary banks chartered as corporations and two different kind of banks chartered as cooperatives (banche popolari and banche di credito cooperativo). These provisions formally privatized the system by ordering banks to assume the legal form of private corporations or cooperatives (but they practically remained out of the market as the following paragraph will explain). In addition, the TUB also designed the supervisory system for the banking sector and charged the Banca d‟Italia with its fulfilment. Indeed, the Banca d‟Italia is still charged of the following tasks: supervision of the financial and organizational situations of banks and banking groups; prudential control and validation of internal models for the risk measurement; safeguard of intermediaries‘ sound and prudent management (Sections 51-69). Moreover, the TUB provided a specific and detailed discipline of the banking groups (Sections 60-64). Finally, in 1996 the Legislative Decree no. 659/1996123 introduced in the TUB a new part (Sections 96-96 quater) providing for a system of deposits‘ insurance. 5. The final achievement of a (quasi) free market oriented credit industry At the mid of the 1990s the combined action of «Legge Amato» and TUB formally privatized the Italian credit industry. Banks were formally chartered as private corporations and controlled by private institutions (i.e. fondazioni bancarie). However, despite this formal change, banks were still out of the market. In fact, according to Section 4 of the Legislative Decree no. 153/1999, the majority of each fondazione bancaria‘s directors should be nominated by local institutions listed by Section 114 of the Constitution (i.e. municipalities, metropolises, provinces, regions). In other words, this provision implied a mere shift in the control of Italian banks from a central level (i.e. the State) to a peripheral level (i.e. local institutions). Under such circumstances, local institutions had incentives to maintain the control over banks through fondazioni bancarie in order to preserve their headquarters within the borders of the local community. Thus, there was the possibility that local institutions would compel fondazioni bancarie to avoid (or at least to delay) the accomplishment with Section 25 of the Legislative Decree no. 153/1999 (which imposed the gradual sell of shares they held). On the contrary, the majority of fondazioni bancarie gradually complied with above mentioned Section, while a few of them continued to control their società conferitarie. In fact, since the mid of the 1990s until now, the market for the control of banks 120 D.lgs. 17 maggio 1999, no. 153. D.lgs. 1° settembre 1993, no. 385. 122 See M. CLARICH, A. PISANESCHI, Le fondazioni bancarie – Dalla holding creditizia all‟ente non-profit, cit., p. 36. 121 123 D.lgs. 4 dicembre 1996, no. 659. 95 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 has been very active in Italy124. There have been several initial public offerings of banks and many mergers which progressively diluted the initial percentage of shares held by fondazioni bancarie. The main poles of aggregation during this wave of mergers have been the oldest, most famous and already mentioned Italian banks125. Firstly, around the old Credito Italiano (which was privatized in 1993 without following the scheme provided by «Legge Amato») Unicredito Italiano was formed. More precisely, by the merger of Cassamarca e Cassa di Risparmio di Verona, Unicredito was initially created in 1995. Later, Unicredito Italiano was created in 1998 by the merger of Cassa di Risparmio di Torino, Credito Italiano, Rolo Banca 1473 and Unicredito. Secondly, around the old Banca Commerciale Italiana (which was also privatized in 1994 without following the scheme provided by «Legge Amato») Banca Intesa was formed. More precisely, Banca Intesa was initially created in 1997 by the merger of Cassa di Risparmio delle Province Lombarde and Banco Ambrosiano Veneto. Later, in 1999, Banca Commerciale Italiana also merged in Banca Intesa. Thirdly, Sanpaolo IMI was created at the end of 1998 by the merger of Istituto San Paolo di Torino and IMI. Later, Sanpaolo IMI also acquired Banco di Napoli and Banca Cardine (which was created in 2000 by the merger of several casse di risparmio). Fourthly, Banco di Roma acquired some important banks such as Banco di Sicilia and Banca Nazionale dell‟Agricoltura. Later, Capitalia was created in 2002 by the merger between Banca di Roma and Bipop Carire. Finally, Banca Monte dei Paschi di Siena acquired some important banks such as Banca Toscana, Banca Agricola Mantovana and Banca del Salento. In sum, at the mid of 2000s, five banks can be regarded as the major players in the Italian credit industry: Unicredito Italiano, Banca Intesa, Sanpaolo IMI, Capitalia and Banca Monte dei Paschi di Siena126. Beside them, Mediobanca still was considered as the most renowned merchant bank of the country127. The rest of the credit industry accounted other banks chartered as corporations and banche popolari (which could both range from very 124 See F. PANETTA, La trasformazione del sistema bancario e i suoi effetti sull‟economia italiana, on F. PANETTA, (Edited by), Il sistema bancario italiano negli anni Novanta – Gli effetti di una trasformazione, Bologna, Il Mulino, (2004). 125 See, also for data and information provided below, F. TRIVIERI, Proprietà e controllo delle banche italiane, Catanzaro, Rubettino, (2005). 126 Except for Banca Monte dei Paschi di Siena, which is not included, see S. LA FRANCESCA, Storia del sistema bancario italiano, cit., p. 270. 127 See G.M. GROS-PIETRO, E. REVIGLIO, A. TORRISI, Assetti proprietari e mercati finanziari europei, cit., p. 260. 96 small to quite large dimensions) 128, along with tiny local banche di credito cooperativo. Given this context, it‘s possible to say that the ownership and control structure of the Italian banks in the first part of the current decade varied a lot. Mediobanca was the first to change its ownership and control structure in 1988. Then, the three founding banks decreased the amount of shares they held from about 57% to 25%. Part of the sold shares was acquired by a group of private investors which jointly held the same percentage of shares owned by the founding banks. These two groups (i.e. founding banks and private investors) formed a controlling syndicate which has been renewed some times (according to variations within the pool of shareholders) but still now controlling the bank 129. Among the other five most important Italian banks, fondazioni bancarie progressively decreased their shareholdings under a control level in four of them (Unicredito Italiano, Banca Intesa, San paolo IMI and Capitalia), whereas a fondazione bancaria maintained more than 50% of Banca Monte dei Paschi di Siena130. Beside banche popolari and banche di credito cooperativo (which, being chartered as cooperatives, necessarily had atomistic shareholdings), the rest of the credit industry was very variously owned and controlled131. However, in a wise book published in 2005, some prominent scholars claimed that the Italian banks could be mostly regarded as «quasi public companies» at that time132. Indeed, fondazioni bancarie had the control of the biggest part of the Italian credit industry since their institution, but in 2006 foreign banks surpassed fondazioni bancarie for the amount shares owned in the Italian banks133. However, in 2005 and 2006, financial scandals coupled with the distress of some banks and political oppositions to the acquisition of two Italian banks by foreign institutions shaped the image of Italy as a country that will never definitely overcome its lacks 128 See E. BONACCORSI DI PATTI, G. GOBBI, Piccole imprese e cambiamenti strutturali nei mercati locali del credito, on F. PANETTA, (Edited by), Il sistema bancario italiano negli anni Novanta – Gli effetti di una trasformazione, Bologna, Il Mulino, (2004), p. 205-207. 129 For more information see www.mediobanca.it. 130 Until 1999 see F. TRIVIERI, Proprietà e controllo delle banche italiane, cit., p. 152, 155 and 158. Later see L. GIANI, Profili di efficienza nel completamento della privatizzazione del sistema bancario italiano: il caso delle fondazioni bancarie, forthcoming on Studi e Note di Economia, (2009). 131 For what concern banks chartered as corporations and banks initially chartered as banche popolari (which later changed their form from cooperatives to corporations) see F. TRIVIERI, Proprietà e controllo delle banche italiane, cit., p. 82, 92 and 100. 132 See M. BIANCHI, M. BIANCO, S. GIACOMELLI, A.M. PACCES, S. TRENTO, Proprietà e controllo delle imprese in Italia, Bologna, Il Mulino, (2005), p. 151. 133 See the article appeared on «La Repubblica – Affari e Finanza» on 13 February 2006. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 of economic liberalism134. In other words, corporatism seemed still pervading the Italian system and jeopardising the final and real achievement of a private owned and free market oriented credit industry. Indeed, in this context the Law no. 262/2005135 (approved on 28 December 2005) changed the Section 25 of the Legislative Decree no. 153/1999 by stating that fondazioni bancarie were no more compelled to sell their shares, but they couldn‘t vote for more than 30% of shares owned in their società conferitarie. This in practice would have allowed the fondazioni bancarie not complying with Section 25 of the Legislative Decree no. 153/1999 to keep their banks definitely out of the market 136. Fortunately that was not the case. Maybe due to the fact that a free market oriented culture was more established than believed, another Law approved on the 1° December 2006137 repealed the Law no. 262/2005. In addiction, two foreign banks finally managed to acquire their Italian targets. At the same time, maybe in response to the couple of acquisitions mentioned above, the credit industry continued its process of concentration. In 2006 Intesa Sanpaolo resulted from the merger of Sanpaolo IMI and Banca Intesa and, the year later, Unicredit Group resulted from the merger of Unicredito Italiano and Capitalia. In this context, Banca Monte dei Paschi di Siena was forced to increase its size or to become unable to compete, consequently compelling the controlling fondazione bancaria to sell its shares. Thus, in 2007 Banca Monte dei Paschi di Siena finally mobilized its resources and took the control of Banca Antonveneta (one of the two banks acquired by foreign institutions few months before). Currently, Intesa Sanpaolo and Unicredit Group are two of the largest banks of Europe and they can be both (the second one in particular) substantially considered public companies for what concern their ownership structure. The third largest bank of Italy (Banca Monte dei Paschi di Siena) has reached a competitive size at a continental or even global level. Nowadays very few fondazioni bancarie (included that one which controls Banca Monte dei Paschi di Siena) continue to keep the control of some banks. However, at this time fondazioni bancarie are part of a system that seems to be effectively competitive, so that they are no more privileged institutions, but normal players forced to drive their businesses as any other one. In sum, apart from some persisting lacks, the Italian banking system seems to have finally took the shape of a free market oriented one and the credit industry can now be considered totally privatized. This is not to say that the Italian model of credit industry can be judged equal, for instance, to the American one or viewed as completely free from political and social influences. Italy, as every country in the world, has its own and persisting peculiarities. Notwithstanding this, it can be definitely said that, if the U.S. credit industry represents the model of a free market oriented system, a large part of the Italian banks is crossing the Atlantic. 6. Conclusions Culture and history always matter and, along with path dependencies, they often represent the main obstacles in changing a system of capitalism. As this work tried to explain, culture and history have deeply influenced the way in which the Italian economy has been organized and, more specifically, the ownership and control of the Italian banks. Since the unification of the country in 1861 and the end of the World War I cultural attitudes towards the economy were deeply marked by liberalism. Moreover, cultural affinities along with political strategies played an important role in shaping the Italian institutional framework in resemblance of the French or the German one. In this period, the Italian credit industry was widely private owned. Later, the social instances which fuelled the rise of fascism pressed for a strong intervention of the State into the economy and the credit industry became almost totally state owned. After the World War II and the fall of fascism, strong liberalistic attitudes towards the economy rose again. Notwithstanding this, the institutional framework settled during twenty years of fascist rule was difficult to dismantle. In addiction, also some of the most culturally similar countries had in that period friendly attitudes towards a certain degree of public intervention into the economy. Thus the Italian economy evolved in the second half of the previous century as a system in which both private and state owned firms coexisted. In this period, the credit industry was still largely state owned. Only few years ago, at the mid of the 1980s, political pressures (i.e. from the EEC), as well as social and economic instances, called for the retreat of the State from the economy. 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FUA‘ G., (Edited by), Lo sviluppo economico in Italia, Milano, Franco Angeli, (1969) GATTI S., Cassa rurale e artigiana, on Digesto delle Discipline Privatistiche – Sezione Commerciale, Torino, UTET, (1987), p. 541. GIANI L., Profili di efficienza nel completamento della privatizzazione del sistema bancario italiano: il caso delle fondazioni bancarie, forthcoming on Studi e Note di Economia, (2009). GROS-PIETRO G.M., REVIGLIO E., TORRISI A., Assetti proprietari e mercati finanziari europei, Bologna, Il Mulino, (2001). HANSMANN H., The Ownership of Enterprise, Cambridge Mass., The Belknap Press of the Harvard University Press, (1996). LA FRANCESCA S., Storia del sistema bancario italiano, Bologna, Il Mulino, (2004). LA PORTA R., LOPEZ-DE-SILANES F., SHLEIFER A., Corporate Ownership Around the World, J. Fin., Vol. 54, (1999), p. 508. LUZZATTO G., L‟economia italiana dal 1861 al 1894, Torino, Einaudi, (1968). MARGOLIS S.E., LIEBOWITZ S.J., Path Dependence, in NEWMAN P., (Edited by), The New Palgrave Dictionary of Economics and the Law, Vol. 3, London, Macmillan Reference Limited, (1998). NORTH D.C., Institutions, Institutional Change and Economic Performance, Cambridge, Cambridge University Press, (1990). ONADO M., La lunga rincorsa: la costruzione del sistema finanziario, on CIOCCA P., TONIOLO G., (Edited by), Storia Economica d‟Italia, Bologna, Laterza, (2002), p. 384. PANETTA F., La trasformazione del sistema bancario e i suoi effetti sull‟economia italiana, on PANETTA F., (Edited by), Il sistema bancario italiano negli anni Novanta – Gli effetti di una trasformazione, Bologna, Il Mulino, (2004), p. 13. PIPITONE M., Monti di credito su pegno, on Digesto delle Discipline Privatistiche – Sezione Commerciale, Torino, UTET, (1994), p. 74. POLSI A., Alle origini del capitalismo italiano – Stato, banche e banchieri dopo l‟Unità, Torino, Einaudi, (1993). PONTIROLI L., Cassa di risparmio, on Digesto delle Discipline Privatistiche – Sezione Commerciale, Torino, UTET, (1987), p. 513. ROE M.J., A Political Theory of American Corporate Finance, Colum. L. Rev., Vol. 91, (1991), p. 10. ROE M.J., Strong Managers, Weak Owners: The Political Roots of American Corporate Finance, Princeton, Princeton University Press, (1994). TONIOLO G., Storia economica dell‟Italia liberale 1850-1918, Bologna, Il Mulino, (1988). TRIVIERI F., Proprietà e controllo delle banche italiane, Catanzaro, Rubettino, (2005). ZAMAGNI V., Dalla rivoluzione industriale all‟integrazione europea, Bologna, Il Mulino, (1999). Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 THE EFFECT OF THE SOUTH AFRICAN MARKET CONCENTRATION ON PORTFOLIO PERFORMANCE Jakobus Daniël (JD) van Heerden*, Sonja Saunderson** Abstract Portfolio risk is mainly a function of portfolio concentration and covariance between the assets in a portfolio. This study shows that South Africa experiences a high level of market concentration and that assets with large weights in the FTSE/JSE All Share Index (ALSI) have large covariances with each other. Together these two phenomena suggest that a high level of portfolio risk can be expected. Active portfolio managers in South African generally attempt to decrease portfolio concentration by deviating from the benchmark‟s weighting structure in order to decrease their portfolio risk. The effect of such a portfolio construction process on the measurement of relative performance, where the ALSI is used as the benchmark, was investigated by means of a simulation process. The results indicated that during times when those shares with larger weights in the index perform well, the probability of outperforming the ALSI is very small, while the probability of outperforming the ALSI during times when those same shares perform poorly is very high. These findings suggest that investors need to be educated about the bias regarding relative performance measurement using broad market indices, while alternative or additional methods of performance measurement need to be investigated to minimise this bias. Keywords: stock market, South Africa, performance measures *Senior Lecturer, Department of Business Management, University of Stellenbosch, Private Bag X1, Matieland, 7602 South Africa [email protected] **Deputy Chief Investment Officer, Advantage Asset Managers, PO Box 330, Gallo Manor, 2052, South Africa [email protected] Introduction In general, "market concentration" is defined as the tendency of a market to be dominated by a few big companies. The literature suggests that emerging countries show much higher levels of market concentration than do developed countries (Du Plessis, 1979, Roll, 1992, Bekaert et al., 1995, Aggarwal et al., 1999, Bradfield et al., 2004). A study done by Roll (1992), for instance, showed that South Africa had the third highest level of market concentration in the world as measured by the Herfindahl-Hirschmann Index, following Mexico and New Zealand. Together with this high level of concentration, South Africa showed the highest level of equity index variance as measured by the standard deviation. In the literature it is suggested that a positive relationship exists between the level of market concentration and portfolio risk. Bradfield et al. (2004) argue that owing to this relationship between market concentration and portfolio risk, portfolio managers are inclined to deviate from the market‘s weighting structure in order to decrease portfolio risk, where the market is defined as the FTSE/JSE All Share Index (ALSI). During the time period from 2002 until 2007 most of the South African General Equity Unit Trust portfolio managers outperformed the ALSI during the bear phase (a time period during which security prices fall significantly) while underperforming the ALSI during the bull phase (a time period during which security prices rise significantly). The objective of this study was to investigate the possibility of a relationship between the tendencies of portfolio managers to hold less concentrated portfolios in order to decrease portfolio risk, and their performances during different market phases. This paper is organised as follows: First an overview of the literature on the relationship between market concentration, covariance and portfolio risk is provided. The approach followed in executing the study is discussed in the research methodology section, followed by the results of the empirical study. From these results emanate recommendations regarding the use of a broad market index such as the ALSI as a relative performance measurement technique, which is discussed in the conclusions section. Literature overview According to Clarke (1985), market concentration refers to the degree to which production for or in a particular market or industry is concentrated in the 99 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 hands of a few large firms. Various measures of market concentration are described by Clarke (1985) of which the best-known and most widely used measure in the literature is the Herfindahl-Hirschman Index (HHI). The HHI index was the result of two independent studies by Albert O Hirschman (1945) and Orris C Herfindahl (1950), in which each of them used their own version of what is now known as the HHI index. Since the establishment of the HHI index, some prominent economists have touted the HHI as superior to other concentration measures (Laine, 1995). In 1982 the HHI was adopted by the United States Department of Justice for measuring market concentration in governmental merger analysis. In his study on benchmark concentration regarding the FTSE 100 Index, Tabner (2007) found that a range of other measures discussed by Clarke (1985) showed time series paths that were very similar to those of the HHI index. For these reasons, it seems that the HHI index is the most appropriate concentration metric to be used in measuring market concentration, and was therefore utilised in this study. The HHI is calculated by summing the squares of the market shares of all the participants in a given market. In mathematical terms, the HHI index can be formulated as follows: N HHI Wi 2 (1) i 1 where Wi is the market share (or investment weight) in the ith counter (or company listed on the index in this case) and N is the number of securities in the index. Thus, the higher the HHI, the more concentrated the market is. In his Nobel-prize-winning article, Markowitz (1952) has described how to combine assets into efficiently diversified portfolios. This approach assumes that variance can be used to quantify the risk of a portfolio. Against this background the terms "portfolio variance" and "portfolio risk" will be used interchangeably in this paper. Elton et al. (2003) argue that the total risk of a portfolio, using variance as the measurement, can be calculated using the following formula: N N i 1 i 1 j 1, j i p2 wi2 i2 where portfolio, N w w i j (2) ij wi is the weight of the ith security in the i is the variance of security i, ij is the covariance between securities i and j and N is the number of securities in the portfolio. Covariance is a measure of the degree to which two variables move together (DeFusco et al., 2004). Using formulas (1) and (2), assuming that the securities are uncorrelated and have the same variance, and applying algebra, Bradfield et al. (2004)1 derived the following formula: p2 p2 HHI 100 (3) where p2 is the average security variance. Formula (3) indicates that, under these assumptions, the degree of concentration as measured by the HHI index has a direct impact on the portfolio variance and therefore portfolio risk. When these assumptions are relaxed, Elton et al. (2003) point out that portfolio variance can be expressed as follows: p2 1 2 N 1 i ij N N (4) The above formula only holds, however, if the securities in the portfolio are weighted equally, i.e. when portfolio concentration is zero. The first term of formula (4) indicates that as the number of securities increase, the portfolio variance decreases, and for large N values the contribution of individual security variance to portfolio variance is insignificant. The second term indicates that for large N values the portfolio risk converges to the average covariance across the securities. Although some (rather unrealistic) assumptions have been made by Bradfield et al. (2004) and Elton et al. (2003) in deriving equations (3) and (4), these equations show that portfolio risk is mainly a function of concentration (weighting structure) and covariance respectively (Bradfield et al., 2004). Understanding the contribution of these two components to portfolio risk and reverting back to the first term of equation (2), it can be stated that if securities with larger weights also have higher variances, portfolio risk will increase. The second term of equation (2) suggests that if securities with larger weights also have larger covariances with each other, portfolio risk will increase (Bradfield et al., 2004). In other words, if a high level of concentration is combined with high levels of variance and covariance associated with those securities contributing the most to the high level of concentration, portfolio risk will be higher. This relationship was also examined and confirmed by Bekaert et al. (1995). Throughout the literature it seems that emerging markets, like South Africa, experience a higher degree of market concentration and therefore a higher level of market volatility compared to developed markets (Du Plessis, 1979, Roll, 1992, Bekaert et al., 1995, Aggarwal et al., 1999, Bradfield et al., 2004). One of the first studies done on the level of concentration in South Africa was that by Du Plessis (1978) who showed that economic power in South African manufacturing was highly concentrated. Roll (1992) showed that South Africa had the highest level of volatility and the third-highest degree of concentration in its national stock market out of 24 countries analysed (including both developed and emerging markets). Looking back to equation (2), these studies imply that one would expect South Africa to show a higher-than-average level of portfolio risk. Markowitz (1952) tested the rule that the investor does (or should) consider expected return a Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 desirable thing, and variance of return an undesirable thing. He found that this rule is sound both as a maxim for, and hypothesis about, investment behaviour. Therefore it can be argued that a higher degree of concentration, combined with higher individual security volatility and covariances, leads to investors (and portfolio managers) making an effort to move away from these securities when constructing portfolios, in an attempt to decrease portfolio risk. As part of their research, Bradfield et al. (2004) explore this proposition by comparing the concentration level of the ALSI, which is defined as the South African ―market‖ for the purposes of this study, to the average concentration level of the equity component of South African General Equity Unit Trusts. They have found that the ALSI has a concentration level (as measured by the HHI) of nearly 1.5 times higher than the average concentration of the unit trusts, which highlights the aversion South African managers have to the high level of concentration in the South African market, supporting Markowitz‘s (1952) findings. Since active managers are paid for both return enhancement as well as risk management (or enhanced return adjusted risk outcomes), the average South African General Equity Unit Trust manager tries to move away from the highly concentrated index by either excluding some of the larger securities (measured on a market capitalisation basis) or else underweights those securities relative to the ALSI. The question is, however, if portfolio managers deliberately move away from the ALSI‘s weighting structure to construct less concentrated (and therefore less risky) portfolios, how will this decision affect relative performance when maintaining the ALSI as the benchmark to which portfolio results are compared? Methodology The research done by Du Plessis (1979), Roll (1992) and Bradfield et al. (2004) has shown that South Africa has a very high level of market concentration. Following Bradfield‘s approach and extending the period under review (a historical period of 3 years was used by Bradfield et al.), the level of market concentration in South Africa was measured by applying the HHI method on the ALSI. The main variable needed to calculate the HHI is the market capitalisation for each company listed on the ALSI. The data was sourced from I-NET Bridge and the FTSE-JSE directly. The annual HHI was calculated over a period of 6 years (2002 until 2007). Next, a correlation matrix was produced over the same period to provide an indication of the level of covariance between those securities carrying the largest weights in the index. Keeping in mind that portfolio risk is a function of concentration and covariance, the results of the first two steps can be used to determine the expected level (expressed as high or low) of portfolio risk for the ALSI. Finally the impact of the portfolio construction process, which is a function of the expected level of portfolio risk (Bradfield et al., 2004) on portfolio performance results relative to the benchmark (ALSI), was measured by means of a simulation process. Random portfolios were generated by assigning random weights to the ALSI constituents, assuming a specific tracking error (the allowed level of deviation from the ALSI). This process was repeated a thousand times each for different levels of assumed tracking error during a bear market as well as during a bull market, resulting in a thousand portfolios for each of the assumed tracking errors within the specific market phase. A distribution of the returns of these random portfolios was generated for both the bull and bear markets. The simulated portfolio returns were compared to the ALSI return, making it possible to determine whether the portfolio construction process affects the range of possible returns relative to the ALSI. For the simulation process, ALSI constituent return figures were used as the main variable, and were sourced from I-Net Bridge as well as the FTSE/JSE. Results The HHI was calculated for the ALSI on a monthly basis over the period 2002 until 2007. The HHI ranged between 4% and 7.3%, with an average of 5.2% over the 6-year period. This result is very much in line with the 5.3% HHI calculated by Bradfield et al. (2004) over a 3-year period. Different interpretations of the value of the HHI were found in the literature (see for example Roll, 1992 and Laine, 1995). The basic ―rule‖ is that the higher the HHI, the more concentrated the market is. The question is whether 5.2% is high or not? Some interpretations found in the literature might suggest that this is not a meaningful number, but the following analysis of the HHI which was done for the ALSI specifically, will help to put this number into perspective. Figure 1 shows the level of concentration as measured by the HHI for the ALSI when omitting a number of the top shares (where "top shares" are defined by market capitalisation). 101 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Figure 1 0.06 0.05 0.04 HHI 0.03 0.02 0.01 0 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 Number of top companies omitted Figure 1 shows that when all the shares in the ALSI are included (this is on average 160 shares), the HHI is 5.2%. When only the top 2 shares are omitted, a steep drop in the HHI to a level of 3.2% is experienced, indicating that the top 2 shares alone contribute almost 40% to the total level of concentration. Omitting the top 5 shares results in an HHI of 2.7%, almost half of the HHI value when all the shares are included, meaning that the top 5 companies contribute almost 50% to the level of concentration found in the index. As the number of shares that are omitted increase, the HHI decreases, but at a slower rate, until it stabilises at around 30 shares. This means that the ALSI is dominated by only a few shares, as indicated by the substantial decrease in the level of concentration when the top few shares are omitted. Table 1 was generated to further assist in the interpretation of the calculated HHI: Table 1 Percentage of index weight Number of shares 1 2 3 4 5 10 15 20 30 40 50 100 100% 1 0.5 0.333 0.25 0.2 0.1 0.067 0.05 0.033 0.025 0.02 0.01 90% 0.81 0.405 0.27 0.203 0.162 0.081 0.054 0.041 0.027 0.02033 0.016 0.008 The values in Table 1 represent the HHI value for a hypothetical index of 160 shares (similar to the ALSI), assuming that a specific number of shares (first column) represent a specific weight (first row) in the index, while the remainder of the 160 shares are equally weighted. For example, if it is assumed that only one share out of a total of 160 shares carries 100% of the index weight (which is the extreme case), the HHI will be 1 (or 100%). If the top 2 shares each carry a weight of 50% of the index, the HHI will be 0.5 or 50%, and so on. The highlighted HHI is the 102 80% 0.64 0.32 0.214 0.16 0.128 0.064 0.043 0.032 0.022 0.0163 0.013 0.007 70% 0.49 0.246 0.164 0.123 0.098 0.05 0.033 0.025 0.017 0.013 0.011 0.006 60% 0.36 0.18 0.12 0.09 0.073 0.037 0.025 0.019 0.013 0.01 0.009 0.006 50% 0.252 0.127 0.085 0.064 0.052 0.027 0.018 0.014 0.01 0.008 0.007 0.0067 value closest to the actual HHI value calculated for the ALSI (5.2%). The purpose of this table and the highlighted values is to compare a concentration level of 5.2% for the ALSI to different scenarios of a similar index (consisting of 160 shares) where a different number of shares contribute a specific accumulated weight in the index. In other words, the 5.2% HHI found for the ALSI is comparable to a similar index of which 20 shares (weighted equally) contribute 100% of the index weight, or put differently, the ALSI has a similar concentration level Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 of an equally weighted index consisting of only 20 shares. The last row shows the HHI level for an index of which the top 5 shares (weighted equally) represent 50% of the index, while the remaining 155 shares (also equally weighted) represent the other 50%. This is the closest to the actual case for the ALSI, as the top 5 shares of the ALSI (which is of course not equally weighted) represent approximately 40% to 50% (depending on the time of measurement) of the index, showing the same HHI value of 5.2% as the hypothetical index. The number of shares in the index also has an impact on the level of the HHI. Table 2 below represents the HHI for a different number of shares in a hypothetical index which is comparable to the ALSI, and the assumption is made that the top 5 shares represent 50% of the total index (which is approximately the average aggregated weight of the top 5 shares taken over the 6-year period under review). Put differently, each row in Table 2 represents a hypothetical index, 50% of which is represented by the top 3.125% shares. The 3.125% is calculated under the assumption that the top 5 shares represent 50% of the total index weight, i.e. dividing 5 by 160. Table 2 Number of shares in index 10 20 30 40 50 100 160 HHI 0.8258 0.413 0.275 0.206 0.165 0.083 0.052 The first row in Table 2 shows that if an index of 10 shares were assumed of which the top 3.125% of shares represented 50% of the index, the HHI would have been 0.8258. According to some of the interpretations in the literature, this would be regarded as an extremely high level of concentration. If, for example, an index consisted of 40 shares, and the top 3.125% of shares (or 1.25 shares) represented 50% of the index, the HHI would have been 0.206, and would still be regarded as very high. Keeping the percentage of top shares representing 50% of the index constant (on 3.125%), and increasing the number of shares in the index, clearly shows (Table 2) that the HHI level decreases and is therefore a function of the number of shares in the index. Taking the above analysis of the HHI into account and keeping in mind that the HHI is a function of a number of factors (for example the number of shares), it would seem that an HHI level of around 5.2% for the ALSI can be regarded as high, implying that the level of concentration in the ALSI is high. This means that the first component of portfolio risk, namely concentration (refer to the earlier literature overview), is expected to increase the expected level of risk. In order to investigate the second component of portfolio risk, covariance, 6 shares that were continuously in the top 10 shares (based again on market capitalisation) over the 6-year period, were identified. At the end of August 2007, these shares represented approximately 41% of the ALSI. The actual value of the covariance is not very meaningful owing to its level of sensitivity to the scale of the variables as well as its wide range of possible values. It is therefore more useful to calculate the correlation coefficient, which measures the strength of the linear relationship between two variables (DeFusco et al., 2004). The correlation coefficient ranges from -1 to +1, where -1 indicates a perfect negative correlation, 0 indicate no linear relationship and +1 a perfect positive correlation. Table 3 represents the correlation matrix for the 6 variables identified, using monthly returns over the 6-year period. Table 3 AGL AGL BIL SOL RCH SAB OML BIL SOL RCH SAB 1 0.714985 1 0.542061 0.629087 1 0.560687 0.413939 0.472906 1 0.429364 0.30148 0.360472 0.436797 1 0.251487 0.340407 0.343229 0.598157 0.291276 Table 3 shows that most of the 6 shares identified tend to move closely together, indicated by the high correlation coefficients. Because of the high correlation coefficients, it can be said that the second component, namely covariance between the large capitalisation shares, can also be expected to increase the level of portfolio risk. Furthermore, these shares also have high volatility, as measured by the standard deviation, which ranges between 5.3% and 8.1%, OML 1 contributing even more to a higher expected risk level. Of the two components of portfolio risk, concentration and covariance, portfolio managers can only control the concentration component by deviating from the ALSI weighting structure when constructing their portfolios (Bradfield et al., 2004). The level of deviation from the ALSI weighting structure is reflected in the tracking error. A higher 103 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 tracking error is an indication of the level and number of ―bets‖ a manager takes by over- or underweighting the shares in his or her portfolio relative to the ALSI (in the extreme case, shares might be underweighted by 100%, meaning that the share is not included in the portfolio at all). Managers take these bets to generate alpha, i.e. a return greater than that obtained by the benchmark (or ALSI in this case). But managers also deviate from the ALSI weighting structure to decrease their portfolio risk. One way of achieving a lower level of portfolio risk is by underweighting the large capitalisation shares, and overweighting the smaller capitalisation shares. Evidently from the analysis on the two components contributing to the level of portfolio risk, by underweighting the large shares, the level of concentration will decrease, resulting in a lower level of portfolio risk. Bradfield et al. (2004) have shown that the ALSI has an HHI of nearly 1.5 times higher than the average General Equity Unit Trust fund, which emphasises the tendency of South African portfolio managers to deviate from the ALSI weighting structure, specifically underweighting the large shares, in order to obtain lower levels of concentration and therefore lower levels of risk in their portfolios. However, most of these portfolio Figure 2 managers still use the ALSI as their benchmark against which their portfolio performance is measured. Using the ALSI as the benchmark creates a concern, as it seems logical to expect that if the top shares (in terms of market capitalisation) are underweighted, the portfolio will underperform the ALSI in periods during which those shares perform well, while the opposite might be true during times when those shares perform poorly. To determine whether the deviation from the market-weighting structure does indeed result in portfolio under-performance during times when the top shares perform well, and portfolio outperformance when the top shares perform poorly, a simulation process was performed2. Random portfolios were generated, and sorted into risk profiles according to tracking error bands. One thousand random portfolios were constructed to derive the manager‘s opportunity set (i.e. the range of possible returns for the manager, given the level of tracking error) around the ALSI for 2005. This period can be considered a bull phase, as the ALSI returned approximately 47% for the year. The results are presented in the boxplot in Figure 2. Simulated Tracking Error Outcomes for Alsi 2005 0.7 Return Outcome 0.6 0.5 0.4 0.3 0.2 0.1 1 2 3 4 Tracking Error In Figure 2 horizontal lines are drawn at the median (the lines within each ―box‖) and at the upper and lower quartiles (the top and bottom lines of each ―box‖). The vertical line is drawn up from the upper quartile, and down from the lower quartile, to the most extreme data point that is within a distance of 1.5 times the interquartile range (IQR). The horizontal dotted line represents the ALSI return for 2005. When a tracking error of one is assumed, the boxplot shows that the ALSI return lies within the upper end of the upper quartile of the range of possible returns, indicating that there was a small chance (less than 25%) for a manager to outperform the ALSI, given that he or she does not deviate too much (i.e. assuming a low tracking error) from the ALSI weighting structure. The higher the assumed 104 tracking error, the smaller is the chance of outperforming the ALSI. For a tracking error of 4, for example, it is almost impossible to outperform the ALSI during this period, shown by the ALSI return lying at a distance of approximately 1.5 times the IQR from the upper quartile. These simulation results suggest that the more a fund manager is deviating from the highly concentrated top performing shares in the ALSI, the more likely it is that he would have underperformed the ALSI. The same simulation process was performed during a bear phase. The ALSI showed a return of approximately -8% during 2002, which is the period chosen to represent the bear phase for the simulation process. The results of this analysis are provided in the boxplot in figure 3. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Figure 3 Simulated Tracking Error Outcomes for Alsi 2002 Return Outcome 0.05 0 -0.05 -0.1 -0.15 -0.2 -0.25 1 2 3 4 Tracking Error Figure 3 shows that during a bear phase, the opposite results from those obtained during the bull phase analysis can be expected with regard to manager performance. For an assumed tracking error of one, the chance of outperforming the ALSI is more or less the same as during a bull phase (refer Figure 2). However, even the median random portfolio outperforms the ALSI when the tracking error is assumed to be 2, while the number of random portfolios outperforming the ALSI when the tracking error is assumed to be 3, moves towards the 75% mark. Figure 3 indicates that continuing to increase the assumed tracking error results in an increasing probability of outperforming the ALSI. Thus the more the manager deviates from the large capitalisation shares that are performing poorly (and therefore are driving the bear phase), the higher the chance of outperformance. Conclusion Following the approach by Bradfield et al. (2004), this study shows that portfolio risk is mainly a function of portfolio concentration and covariance between the assets in the portfolio. Using the Herfindahl-Hirschman Index as a measure of concentration and the All Share Index as the market, the first component, concentration, was investigated and it was found that South Africa experiences a high level of market concentration. The second component, covariance, was investigated by means of a correlation matrix, showing the correlation coefficients of the top 6 shares (according to market capitalisation) of the ALSI over a period of 6 years. These coefficients were generally high, which means that those shares with large weights in the index also tend to move closely together. Combined, these two components suggest that a high level of portfolio risk (assuming the ALSI as the market portfolio) can be expected. As was argued by Bradfield et al. (2004), most South African portfolio managers underweight the large capitalisation shares of the ALSI to decrease their portfolio risk by holding a less concentrated portfolio. The effect of such a portfolio construction process on the measurement of relative performance, where the ALSI is used as the benchmark, was investigated by means of a simulation process. Random portfolios were generated and sorted into risk profiles according to tracking error bands. The simulation process showed that managers find it very difficult to outperform the ALSI during bull phases, while almost any manager (even investors who are not professional portfolio managers as suggested by the random portfolios created) can outperform the ALSI during a bear phase. These results imply that using the ALSI as the one-and-only yardstick to measure the performance of General Equity Unit Trust portfolio managers is biased. Unfortunately this is the most commonly used method for determining manager performance and skill, as it is easy to understand and very simple to interpret. If the manager underperforms the ALSI, it is a reflection of poor skill; if he outperforms, he gets praised for his above-average ability to pick the right shares. However, the simulation process illustrates that outor underperformance of the ALSI during a specific phase doesn‘t have a lot to do with skill, but can rather be ascribed to the manager‘s attempt to move away from portfolio risk by holding less concentrated portfolios. Therefore using an index such as the ALSI as a measurement of performance, a manager can be regarded as very skilful one year, but incompetent the very next year. The question therefore is whether using the ALSI as the main approach to measure manager performance is fair, as it seems that portfolio performance is dominated more by the effect of market concentration than manager skill. To address this bias, it seems necessary to educate investors about this phenomenon and to investigate or create alternative or at least additional methods that can be used to measure manager performance. It also highlights the inherent dangers in constructing active mandates based on pre-specified tracking errors, since these often force fund managers to take unintended bets, resulting in unintended performance biases. 105 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Footnotes 1 Permission was obtained from Professor David Bradfield to quote their article ―Concentration – Should we be mindful of it?‖ The article is unpublished and intended for clients of Cadiz Financial Strategists only. Professor Bradfield is the Team Leader of the Quantitative Research team at Cadiz Financial Strategists. 2 The simulation process was performed by means of a simulation model developed and used by Advantage Asset Managers. 7. 8. 9. References 1. 2. 3. 4. 5. 6. 106 Aggarwal, R., Inclan, C. & Leal, R. 1999. Volatility in Emerging Stock Markets. The Journal of Financial and Quantitative Analysis, 34(1): 33 – 55, March. Bekaert, G. & Harvey, C.R. 1995. Emerging Equity Market Volatility. National Bureau of Economic Research. Cambridge. Bradfield, D. & Kgomari, W. 2004. Concentration – should we be mindful of it? Cadiz Financial Strategists. Unpublished. Clarke, R. 1985. Industrial Economics. Cambridge. De Fusco, R.A., McLeavey, D.W., Pinto, J.E.,& Runkle, D.E. 2004. Correlation and Regression. In Quantitative Investment Analysis, second edition. New Jersey, Hoboken. p.281 – 324. Du Plessis, P.G. 1978. Concentration of Economic Power in the South African Manufacturing Industry. 10. 11. 12. 13. 14. The South African Journal of Economics, 46(3): 172182, September. Du Plessis, P.G. 1979. An International Comparison of Economic Concentration: A Note. The South African Journal of Economics, 47(3): 204-211, September. Elton, E.J., Gruber, J.G., Brown, S.J., & Goetzmann, W.N. 2003. The Characteristics of the Opportunity Set Under Risk. In Kraham, L. & Rhoads, C. (eds.), Modern Portfolio Theory and Investment Analysis. New York: John Wiley & Sons. p. 44 – 67. Herfindahl, Orris C. 1950. Concentration in the Steel Industry. Columbia: Columbia University. [PhD dissertation] Hirschman, Albert O. 1945. National Power and the Structure of Foreign Trade. Berkely and Los Angeles: University of California Press. Laine, Charles R. 1995. The Herfindahl-Hirschman Index: A concentration measure taking the consumer‘s point of view. The Antitrust Bulletin, 423 – 432, Summer. Markowitz, H. 1952. Portfolio Selection. The Journal of Finance, 7(1): 77 – 91, March. Roll, R. 1992. Industrial Structure and the Comparative Behavior of International Stock Market Indices. The Journal of Finance. 47(1): 3 - 41, March. Tabner, Isaac T. 2007. Benchmark Concentration: Capitalisation weights versus equal weights in the FTSE 100 Index. [Online]. Available: http://ssrn.com/abstract=741144 [12 December 2007] Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 РАЗДЕЛ 2 ОПЦИОНЫ НА АКЦИИ SECTION 2 STOCK OPTIONS THE IMPACT OF EXPENSING STOCK OPTIONS IN BLOCKHOLDERDOMINATED FIRMS. EVIDENCE FROM ITALY Andrea Melis*, Silvia Carta** Abstract Accounting for stock options and executive remuneration have been one of the most debated and controversial issues in accounting regulation and corporate governance. The purpose of this study was to explore the impact of the mandatory adoption of IFRS 2 for accounting of stock options in Italian non financial listed companies. This paper has investigated the economic consequences of recording the cost of stock options at its fair value, in terms of its impact on the companies‟ reported earnings, and other key financial performance indicators, such as diluted earnings per share (EPS) and return on assets. The impact of the mandatory recording of the cost of stock options measured at its fair value has generally reduced the reported earnings and other key performance measures moderately. Despite some evidence of creative accounting which was found concerning the elusion of the substance over form principle for the accounting of stock options plans set up before 7 th November 2002, accounting regulation has increased the level of disclosure by making companies report the “true” cost of stock options in their Profit or Loss. Based on 2004 stock-based remuneration disclosures of the value of options given to directors and employees, the expensing of options have a material negative impact on nearly 30 per cent of the sample firms‟ reported income and diluted EPS. The mandatory adoption of IFRS 2 seems to have relevant implications for corporate governance as it has reduced the information asymmetry between corporate insiders and outsiders on the “true” cost of stock-based remuneration. Keywords: stock options, blockholders, Italy *Department of Ricerche aziendali, University of Cagliari, Viale S. Ignazio 17, 09126 Cagliari – Italy [email protected], **Department of Ricerche aziendali, University of Cagliari, Viale S. Ignazio 17, 09126 Cagliari – Italy [email protected] Introduction The use of stock options as remuneration device and its accounting method has represented one of the most debated and controversial issues during the last decades, both in the accounting and in the corporate governance literatures. Financial reporting and corporate governance are highly interrelated systems (e.g. Whittington, 1993; Bushman, Smith, 2001; Melis, 2004). In particular, financial reporting constitutes an important element of the corporate governance system, as it may potentially reduce the information asymmetry between corporate insiders and outsiders. The recognition of stock option plans (and equity-settled share-based payments, in general) as a cost in Profit or Loss is a recent outcome of a long debate between standard-setter bodies and industrial associations (Guay et al., 2003). In the US the final result was the issue of a revised version of SFAS 123R (2004); in Europe, the outcome was the mandatory adoption of IFRS 2 (2004) imposed by the European Commission to the listed companies of its Member States. Both the two standards have required the mandatory recognition of a cost for stock options, 107 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 measured at the fair value of the equity instruments at the grant date. Accounting is concerned with how economic actors process information and make decisions. It cannot be considered simply a neutral technique for economic decision-making as it is able to sanction the distribution of wealth among corporate stakeholders, including shareholders (e.g. Horngren, 1973; Rappaport, 1977). Both the issue of the SFAS 123R in the US and of the IFRS 2 by the IASB has been the outcome of a significant lobbying activity by constituents (e.g. Shelton, Stevens, 2002; Zeff, 2002; Giner, Arce, 2007). This was due to the relevant economic consequences that the accounting regulation of stock options could have had on the wealth of corporate stakeholders, and on corporate governance in general. In particular, the concerns about executive remuneration represent a major aspect of the rationale for enhanced corporate governance (e.g. Core et al., 2003; Jensen et al., 2004). The main purpose of this study is to measure the impact of the mandatory adoption of IFRS 2 for accounting of stock options in Italian non financial listed companies. This paper will investigate the economic consequences of recording the cost of stock options at its fair value, in terms of its impact on the companies‘ reported earnings as well as on other key financial performance indicators, such as diluted earnings per share (EPS) and return on assets (ROA). The empirical results will be analysed taking into account the corporate governance implications that stock options‘ expensing might have, in terms of reducing information asymmetry between corporate insiders and outsiders on such a key issue as the cost of stock option-based remuneration. As noted by Chalmers and Godfrey (2005), any concern about the economic impact of expensing stock options is settled if the change does not significantly affect reported accounting measures used by investors to assess companies‘ performance. Using stock options disclosures, previous studies have provided evidence that if stock option-based remuneration was to be expensed, it would significantly affect key financial performance indicators of high-growth US companies (Botosan, Plumlee, 2001), and of large non-US companies listed on the NYSE and/or NASDAQ (Street, Cereola, 2004). However, Street and Cereola (2004) found that the materiality of the effect varied significantly by country. Chalmers and Godfrey (2005) found that the concerns about stock option expensing was not material for most of Australian listed firms. This paper extends previous literature by analysing Italian non financial listed companies, on which there is a scant empirical evidence. As Italy is one of the first countries, internationally, to adopt fully IFRSs, Italian listed companies provide an interesting sample and an early opportunity to examine the impact of the mandatory IFRS 2 108 adoption. The choice of a non-Anglo-Saxon country for a single country case study seems useful to extend previous literature findings which mainly focused on Anglo-Saxon companies (Botosan, Plumlee, 2001; Chalmers, Godfrey, 2005), or on non-AngloAmerican companies listed in Anglo-Saxon stock exchanges (Street, Cereola, 2004). The remainder of the paper is organised as follows. Section 2 summarises the Italian financial reporting regulation on stock options before and after the IFRS adoption in 2005. The research design and methodology is discussed in Section 3. In Section 4 results are presented and analysed. Section 5 concludes. The Italian regulation on stock options: a synopsis The adoption of IFRS 2 has completely changed the accounting for stock options in Italy. Italian accounting standards (CNDC-CNR, 2001, OIC, 2007) have never issued any standard on share-based payments, nor do they deal specifically with it yet. The accepted practice was driven by a 1998 CONSOB138 recommendation, which required Italian listed companies to disclose the details of the stock options given to directors and senior managers in the notes of the accounts as well as to credit equity when the options were exercised by the holders. Before 1998, information regarding stock options was not publicly available. As a matter of fact, the diffusion of stock options in Italy is relatively recent. Fixed wages have been the main ingredient of executive remuneration and, in general, equity-based schemes were rarely adopted by Italian non financial listed companies in the 1990s (Melis, 1999). Stock options plans started to be more widely adopted since 19981999 (Bertoni, 2002; Zattoni, 2003). The event that fostered the adoption of these plans by Italian companies was the 1998 Tax Reform which provided strong fiscal incentives for beneficiaries (Zattoni, 2007). The diffusion of stock option plans seems dependent on ‗external‘ factors, such as a favourable fiscal treatment in comparison to cash and other inkind remuneration (Di Pietra, Riccaboni, 2001; Quagli et al., 2006; Zattoni, 2007), and the accounting treatment of this transaction (Quagli, 2006). Until 2005 the recording of the cost of stock options was voluntary even for listed companies. Stock-options were basically an off-balance sheet operation, as almost none of the companies that gave stock-options to its directors, senior management (or other employees) as part of its compensation recognised such cost in their Profit or Loss. This creative accounting practice led to a reduction of the costs reported in the Profit or Loss, and could have 138 CONSOB is the Italian public authority responsible for regulating and controlling the Italian securities markets. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 had economic consequences in the cases in which the unrecognised cost was material. In 2005 the mandatory adoption of IFRSs has obligated Italian non financial listed companies to recognise the fair value of stock options as an expense in their Profit or Loss (IFRS 2, 2004). The cost of stock option plans is to be measured at the fair value of the equity instrument granted multiplied by the number of instruments the company estimates that will be exercised. non-adoption of IFRS 2 for specific stock option plans. Hence, 45 companies comprise the final sample (a list is reported in the Appendix). Among them, three companies had chosen to record the fair value of the stock options‘ cost in Profit or Loss before the mandatory adoption of IFRS 2 required them to do so (see ESOP 2004-No impact in table 1). Research design and methodology Data collection For each company, data have been gathered from consolidated financial statements referring to the years 2004 and 2005. The period considered was selected to allow to conduct a natural experiment to measure the impact of the accounting regulation on stock options‘ expensing. The same financial reality referring to 2004 results has been measured twice by each company: all the companies chosen for the investigation have been required to prepare and present their own 2005 consolidated financial statements according to IFRSs, presenting, at the same time, the 2004 data (which had been prepared according to Italian GAAPs) according to IFRSs. We investigated the impact of the mandatory adoption of IFRS 2 on firms‘ key performance indicators by comparing performance ratios calculated using actual 2004 reported financial figures with pro-forma ratios calculated using the 2004 reported numbers adjusted as if the stock options were expensed over the period. Specifically, we measured the impact of the unrecognised cost on the reported income (unrecognised cost of stock option / reported income) and we constructed the pro-forma key financial performance measures (ROA, and diluted EPS), based on the 2004 Italian GAAP data, as follows: Our study extends previous literature by examining the impact of stock options‘ expense recognition for non financial listed companies based in a non-AngloSaxon country. Specifically, the key research question that this paper seeks to answer is: is the impact of expensing stock option material in Italian non financial listed companies? The investigation has been conducted in terms of the ability of IFRS 2 to improve the perception of the cost of stock options to financial statements‘ users. This ability was explored in terms of impact of the cost of stock option on the companies‘ reported earnings and other key financial performance ratios, such as diluted EPS and ROA. Sample selection This study focused on Italian non financial listed companies (including real estate companies) which has been required to adopt IFRSs since 2005. Banks and insurance companies and other financial institutions have been eliminated in view of the peculiarities of the financial industry and its specific regulation. Non domestic companies listed in the MTA International segment139 have been discarded as they were not required to prepare and present their financial statements according to Italian GAAP. The complete directory of Italian non financial companies listed both in 2004 and 2005 that was required to adopt IFRSs140 was analysed. Among them, 61 companies which adopt stock option plans in 2004 have been identified and analysed. The great majority of the companies in the sample that recorded the cost of stock options in their Profit or Loss since 2005 used to treat stock option as an off-balance sheet operation beforehand. Based on an in-depth analysis of their consolidated financial statements, sixteen companies were eliminated from the sample as they recorded no cost as they choose to use one of the transitional provisions (IFRS 1, 2004, para 25b-c; IFRS 2, 2004, para 53-58) that allow the INSERT TABLE 1 ABOUT HERE 139 MTA International is the segment within Borsa Italiana‘s MTA regulated equity market dedicated to the trading of shares of non Italian issuers already listed in other EU regulated markets. 140 We excluded listed companies that were not required to adopt IFRSs in 2005, in accordance to CONSOB regulation. See CONSOB (2005, para 81bis, 82bis). 109 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 - impact on pro-forma diluted EPS ITA GAAP = (Diluted EPS PRO FORMA – Diluted EPS ITA GAAP ) | Diluted EPS ITA GAAP| where diluted EPS PRO-FORMA is equal to: Unrecogniz ed cost of stock option Diluted EPS ITA GAAP - Weighted number of shares - impact on ROA ITA GAAP = (ROA PRO-FORMA- ROA ITA GAAP ) where ROA PRO-FORMA is equal to Reported income - Unrecogn ised cost of stock option Total Assets ITA GAAP ITA GAAP Impacts on IFRS-based figures has been measured accordingly, by taking into account that diluted EPS PRO-FORMA is equal to: Cost of stock option Diluted EPS IFRS Weighted number of shares and ROA PRO-FORMA is equal to Reported income IFRS Cost of stock option Total Assets IFRS Data for the unrecognised cost of stock options, reported income, and pro-forma diluted EPS and ROA (i.e. the difference between 2004 Italian GAAP figures and the IFRS-converted figures) were handcollected from the consolidated financial statements. Results Sample demographics Table 2 provides a brief overview of the sample, in terms of size (total revenues and assets), and profitability. INSERT TABLE 2 ABOUT HERE The sample includes firms which are all controlled by a block-holder, i.e. a (group of) shareholder(s) that owns at least 10 per cent of voting rights, but have diverse financial characteristics: some are (highly) profitable, some others are loss making. Firms analysed are at various growth phases. The characteristics of the sample allow to extend the findings of previous literature which mainly focused on high-growth US companies (Botosan, Plumlee, 2001), large non-Anglo-American companies listed in the US (Street, Cereola, 2004), or Anglo-Saxon companies (Chalmers, Godfrey, 2005). Impact of expense recognition The mandatory adoption of IFRS 2 has increased the perceived cost of stock options at the eyes of the 110 financial statements‘ users. The overall impact of the cost of stock options on reported financial performance is moderate, although sometimes material. The impact on Italian GAAP income (proforma diluted EPS) is 8 % (14,13 %141) on average. This result is influenced by few values that deviate significantly from the mean. In fact, the median impact is 2.34 % on Italian GAAP income (2.68 % on diluted EPS142). Similar results have been obtained on IFRS-based 2004 data (see table 3). INSERT TABLE 3 ABOUT HERE The framework of the IASB (1989, para 30) considers that information is deemed to be material if its omission, misstatement or non-disclosure has the potential to adversely affect the decisions of financial statements‘ users and/or management‘s discharge of accountability. The materiality of an item in the statement of performance may be judged by comparing the item to the operating profit for the current reporting period. Along with previous literature on the subject (see Botosan, Plumlee, 2001; Street, Cereola, 2004; Chalmers, Godfrey, 2005), we adopted as a non-binding quantitative threshold (more than or equal to 5 %) to assess materiality. 141 This value does not include the companies that already recorded the fair value of the stock options‘ cost before the mandatory adoption of IFRS 2. 142 See note 4. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Our findings suggest that the fair value of stock options on the pro-forma Italian GAAP reported income (pro-forma Italian GAAP diluted EPS) is material for 31 % (29 %) of the Italian non financial listed companies with stock option plans. The impact on ROA is never material. Similar results are obtained on IFRS-based data. These results underestimate the materiality of the impact, as our estimate is based on the costs that have actually been disclosed in the consolidated financial statements. In fact, nearly 50 % of the companies whose reported impact is not deemed as material (i.e. < 5 %) has underestimated the ―true‖ cost of stock options by adopting one of the transitional provisions (IFRS 1, 2004, para 25b-c; IFRS 2, 2004, para 53-58) that allows the nonadoption of IFRS 2 for specific stock option plans. This choice may be considered creative in the sense that it was in accord to what allowed by accounting regulation, but elusive of the substance over form principle. Future application of IFRS 2 will have to be applied to all stock-based compensation, thus the materiality of the cost might increase. Impact of stock options’ expense recognition and firms’ characteristics We specifically investigate whether the impact of expensing stock options on reported income and key financial indicators is associated with companies‘ growth phases (Botosan, Plumlee, 2001), size (Zattoni, 2003), or industry (Apostolou, Crumbley, 2005). We tested three main hypothesis through the coefficient of Bravais-Pearson to measure the correlation between cost of stock options and its impact on ITA GAAP and IFRS reported income 143, and a χ2 test with regards to industry. Growth Botosan and Plumlee (2001) argued that high-growth firms tend to use stock option plans more extensively than ―mature‖ firms. Thus, we expected that: Hypothesis 1: The impact of stock option expensing is positive related to firm‟s growth. Growth was measured as the percentage variation of the firms‘ total assets in 2002, 2003 and 2004. Table 4 shows that a relationship between the variables does not exist (see table 4). The hypothesis may be rejected. In Italy there seems to be no significant difference between high- and non-high growth firms concerning the impact of stock option expensing. Size On a sample of Italian (financial and non financial) listed companies, Zattoni (2003) found that larger firms tend to use stock option more extensively than other firms. So we expected that: Hypothesis 2: The impact of stock option expensing is positive related to company size. We choose total assets in 2004 as a proxy for company size144. We found a weak positive relation between size and the magnitude of the cost of stock options (ρ–value = 0.2333), while there is a weak but negative relation between size and the impact of the cost on reported income (ρ–value = -0.1409) (see table 4). This evidence may be explained by considering that while it seems logical that larger firms give greater stock-based remuneration packages (as overall remuneration is usually linked with company size, see e.g. Jensen et al., 2004), the significance of the impact is deflated by the larger amount of assets (revenues) that characterises large firms. INSERT TABLE 4 Industry Firms in new-economy sectors are often considered to make a significant use of stock options plans (see, inter alia, Zeff, 2002; Apostolou, Crumbley, 2005; Avallone, Ramassa, 2006). So we expected that: Hypothesis 3: The impact of stock option expensing is material in firms which operate in new-economy sectors. Firms have been grouped into three types of industries (manufacturing, regulated market and neweconomy) because of the small number of firms in several single industries. Manufacturing companies are defined as companies that make tangible goods. New-economy industry includes high-tech, services and design industries, i.e. industries in which intangibles play a major role in production. Regulated industry includes companies where the production of goods or services is supervised by the State authorities to safeguard the public interest (telecommunications, energy, and public utilities). To examine the relation between industry and impact of cost on reported income we used a χ2 test. Evidence is mixed. We found that the materiality of the impact of stock options on IFRS-based reported income is significantly related to the sector in which the firms belong to (χ2 = 5,8098, significant at 10%), while its relation on ITA GAAP reported income is not significant (χ2 = 4,4487) 145. Concluding remarks and implications for corporate governance The economic consequences associated with the mandatory expense of stock option in non-Anglo144 143 We also run the same tests using the impact on diluted EPS as dependent variable, but we found no significant difference. Given the very low impact on ROA in all cases, we did not expect to find any relation with firm‘s characteristics. We also tried total revenues of the companies in 2004 as a proxy for size, and the relation is even lower (ρ– value = 0.1586). 145 Same results were obtained on pro-forma diluted EPS. 111 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Saxon listed companies are largely unknown. This paper has conducted an exploratory study on the economic consequences of the mandatory adoption of IFRS 2 among Italian non financial listed companies, in terms of its impact on the companies‘ key financial performance measures. Empirical evidence on Italian non financial listed companies has shown that the impact of expensing the cost of stock options measured at its fair value was moderate on average, but sometimes material. The findings indicate that absent requirements that stock compensation expense be recognized, a material upward bias was reflected in performance indicators (reported income and diluted EPS) of nearly 30 % of the Italian non financial listed companies that had stock options plans in 2004. The impact on ROA was never material The mandatory adoption of IFRS 2 seems to have relevant implications for corporate governance. According to the so-called perceived-cost view (see Murphy, 2002), the use of option-based remuneration has arisen thanks to the favourable accounting treatment, which has made the perceived cost of a stock option much lower than its economic cost (Hall, Murphy, 2003). Companies had strong incentives to give stock options to their directors instead of cash, because stock option did not negatively affect their Profit or Loss. The mandatory adoption of IFRS 2 has improved the disclosure on the cost of stock options. By reducing the information asymmetry between corporate insiders (i.e. executive directors and controlling shareholders) and outsiders, it allows minority shareholders and other stakeholders to improve their perception about the ―true‖ cost of stock options plans. Although, some evidence of creative accounting was found concerning the elusion of the substance over form principle for the accounting of stock options plans set up before 7th November 2002, the ―perceived‖ cost of stock options should be now more clear. The reduction of the information asymmetry has implications for corporate governance as corporate outsiders may better safeguard their interests (Mallin, 2002). We found no significant relation between the magnitude of the impact of the cost of stock options and firms‘ characteristics such as growth phases and company size. This might be due to the fact blockholder-dominated companies might adopt stock options plans for reasons that are different from Anglo-Saxon public companies (Alvarez-Perez, Neira-Fontela, 2005; Zattoni, 2007). Further investigation on this issue seems needed. As the great majority of the listed companies around the world is characterised by a concentrated ownership and control structure (see La Porta et al., 1999; Barca, Becht, 2001). The study‘s limitations are acknowledged. This paper focused on a single country analysis. This choice fostered internal validity, however the extent to which the results of this study may be applied to 112 other countries is limited. Future research could investigate the impact of the mandatory adoption of IFRS 2 across a wide range of countries. Acknowledgements The authors would like to express their gratitude to Silvia Gaia for her research assistance. We also thank all the participants at the 2007 EIASM in Siena, and local seminars held at University of Cagliari and University of Padua. The normal caveats on the author‘s responsibility apply. This paper is the result of a joint effort of the two authors. In particular, Andrea Melis wrote the introduction and sections ―The Italian regulation on stock options: a synopsis‖ and ―Concluding remarks and implications for corporate governance‖, while Silvia Carta wrote sections ―Research design and methodology‖ and ―Results‖. References 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. Alvarez-Perez M., Neira-Fontela E., (2005), Stock option plans for CEO compensation, in Corporate Ownership and Control, Vol. 3, N. 1, pp. 88-100. Apostolou N., Crumbley D. (2005), Accounting for Stock Options, in The CPA Journal, Vol. 75, August, pp. 30-33. Avallone F., Ramassa, P. (2006), L‟applicazione dell‟IFRS 2 nei bilanci 2005, in A. 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Core, J., Guay W., Larcker D. (2003), Executive Equity Compensation and Incentives: A Survey, in Economic Policy Review, Vol. 9, N. 1, pp. 27-50. Di Pietra, R., Riccaboni, A. (2001) Reporting of stock options: creative compliance in a regulated environment, Università di Siena, Quaderni senesi di Economia aziendale e di ragioneria, Serie interventi, N. 72. Financial Accounting Standards Board (2004), Statement of Financial Accounting Standards No. 123 - Share-based payments, Norwalk, CT: FASB. Giner B., Arce M. (2007), Lobbying on accounting standards: an analysis of the due process of IFRS 2 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. on share-based payments, University of Valencia working paper. Guay, W., Kothari, S.P., Sloan R. (2003), Accounting for Employee Stock Options, in American Economic Review, Vol. 93, pp. 405-409. Hall, B., Murphy, K. (2003), The Trouble with Stock Options, in Journal of Economics Perspectives, Vol. 3, pp. 49-70. Horngren C. (1973), The Marketing of Accounting Standards, in The Journal of Accountancy, Vol. 136, October, pp. 61-66. International Accounting Standards Board (1989). Framework for the Preparation and Presentation of Financial Statements , London: IASCF. International Accounting Standards Board (2004). IFRS 1- First-time Adoption of International Financial Reporting Standards, London: IASCF. International Accounting Standards Board (2004). IFRS 2 – Share-based Payments, London: IASCF. Jensen M., Murphy K., Wruck E. (2004), Remuneration: Where we‟ve been, how we got to here, what are the problems, and how to fix them, ECGI Finance Working Paper N. 44. La Porta R., Lopez-De-Silanes F., Shleifer A. (1999), Corporate Ownership Around the World, in The Journal of Finance, Vol. 54, N. 2, pp. 471–517. Mallin, C (2002)., The Relationship Between Corporate Governance, Transparency and Financial Disclosure, in Corporate Governance: An International Review, Vol. 10, N. 4, pp. 253-255. Melis, A. (1999), Corporate governance. Un‟analisi empirica della realtà italiana in un‟ottica europea, Giappichelli: Turin. Melis, A. (2004), Financial reporting, corporate communication and governance, in Corporate Ownership and Control, Vol. 1, N. 2, pp. 31-37. Murphy, K. (2002), Explaining executive compensation: Managerial power vs. the perceived 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. cost of stock options, in University of Chicago Law Review, Vol. 69: 847-869. Organismo Italiano Contabilità (OIC) (2007), Principi contabili, Milan: Giuffré. Quagli, A. (2006), I piani di remunerazione a base azionaria, in P. Andrei (edited by) L‟adozione degli IAS/IFRS in Italia: impatti contabili e riflessi gestionali, Turin: Giappichelli, pp. 229-286. Quagli A., Avallone F., Ramaglia P. (2006), Stock options plans in Italy: does earnings management matter?, working paper. Rappaport A. (1977), Economic Impact of Accounting Standards – implications for the FASB, in The Journal of Accountancy, Vol. 143, May, pp. 8995. Shelton S., Stevens K. (2002), Corporate Lobbying Behaviour on Accounting for Stock-based Compensation: Venue and Format Choice, in Abacus, Vol. 38, N. 1, pp. 78-90. Street D., Cereola S. (2004), Stock option compensation: impact of expense recognition on performance indicators of non-domestic companies listed in USA, Journal of in International Accounting, Auditing & Taxation, Vol. 13, N. 1, pp. 21-37. Whittington G. (1993), Corporate Governance and the Regulation of Financial Reporting, in Accounting and Business Research, Vol. 23, N. 91A, pp. 311319. Zattoni A. (2003), I piani di stock option in Italia: diffusione e caratteristiche, in Economia e Management, Vol. 9, N. 6, pp. 71-90. Zattoni A. (2007), Stock Incentive Plans in Europe: Empirical Evidence And Design Implications, in Corporate Ownership and Control, Vol. 4, N. 4, pp. 54-62. Zeff, S. (2002). Political lobbying on proposed standards: A challenge to the IASB. In Accounting Horizons, Vol. 16, N. 1, pp. 43–54. Appendices Table 1. Recording the cost of stock options plans N. 3 13 3 42 61 ESOP (IFRS 1, para 25b-c) ESOP (IFRS 2, para 53-58) ESOP 2004 – No impact ESOP 2004 Total % 4.92 21.31 4.92 68.85 100.00 Table 2. Sample firms characteristics Amounts are presented in thousands of euros. Total asset (2004) Total revenue (2004) Reported income (2004) Cost of stock option Mean 7,084,289 4,885,148 293,620 2,542 Median 1,216,050 876,389 28,114 658 SD 16,894,653 13,644,506 1,263,186.57 5,597.69 113 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 3. The impact of the (unrecognised) cost of stock option on key performance indicators Key performance indicators Mean Median SD Max Min ITA GAAP Reported income -7.99% -2.34% 0.19676 -123.74% -0.05% IFRS Reported income -13.71% -1.76% 0.59158 -398.32% -0.04% ITA GAAP diluted EPS (1) -14.13% -2.68% 0.41975 -256.72% -0.04% IFRS diluted EPS 6.28% 1.75% 0.10552 51.32% 0.04% ITA GAAP ROA (1) -0.19% -0.09% 0.00263 -1.22% -0.0012% IFRS ROA 0.17% 0.08% 0.00227 0.86% 0.0011% Linear regression Size (assets - 2004) Size (revenues - 2004) Reported income ITA GAAP - 0.1409 - 0.1261 Reported income IFRS - 0.0903 - 0.0782 Cost of stock option 0.2333 0.1586 -0.2720 -0.0715 -0.1062 Growth (1) This value does not include the companies that already recorded the fair value of the stock options‘ cost before the mandatory adoption of IFRS 2. Table 4. ρ Bravais-Pearson 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 114 ASTALDI AEDES BENETTON BULGARI BUONGIORNO CAMPARI CDC CLASS EDITORI CREMONINI DMT DUCATI EDISON EL.EN ENEL ENI 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 ESPRINET EUPHON FIAT FINMECCANICA FULLSIX GEOX GRUPPO ESPRESSO INDESIT INTERPUMP GROUP IRIDE ITALCEMENTI LOTTOMATICA LUXOTTICA MARR MEDIASET 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 MONDADORI PININFARINA PIRELLI PIRELLI RE RCS MEDIAGROUP RECORDATI REPLY SABAF SAFILO SAIPEM SEAT PAGINE GIALLE SNAM SORIN TARGETTI SANKEY TXT Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 IS THERE A FIRM-SIZE EFFECT IN CEO STOCK OPTION GRANTS? Bruce Rosser*, Jean Canil** Abstract Schaefer (1998) and Baker and Hall (2004) posit a firm size effect for regular executive compensation but not specifically for executive stock option grants. They propose an inverse relation between payperformance sensitivity and firm size along with a positive relation between the marginal productivity of executive effort and firm size. The product of pay-performance sensitivity and executive productivity is „incentive strength‟. They find a weakly positive association between incentive strength and firm size. We substitute Hall and Murphy‟s (2002) pay-performance sensitivity metric to detect a firm size effect in CEO stock option grants. After adjusting for small-firm risk aversion and private diversification „clienteles‟, we document evidence of a residual small-firm effect impacting on incentive strength principally through grant size. Given lower small-firm deltas, grant size appears to have been increased by compensation committees to ensure small-firm CEOs are not under-compensated relative to their large-firm counterparts. We also find that firm complexity influences pay-performance sensitivity as well, but not labor productivity (proxying for CEO productivity). No evidence is found that firm smallness and complexity impact on labor productivity. However, we empirically confirm a negative relation between pay-performance sensitivity and firm smallness and, by implication, firm complexity. Keywords: stock options. CEO, firm size *University of Adelaide, Business School, Australia **corresponding author. email: [email protected], telephone: 61 8 8303 4510, fax: 61 8 8303 4368 This paper is derived from an earlier version presented at the Annual Meeting of the Southern Finance Association, Charleston, November 2007. 1. Introduction Schaefer (1998) and Baker and Hall (2004) modify the standard pay-performance sensitivity argument for the marginal productivity of CEO effort (or pay-toeffort). They identify a trade-off between CEO productivity and firm risk given that pay-performance sensitivity (as measured) is inversely-related to CEO risk aversion. Schaefer reports an inverse relation between pay-performance sensitivity on salary and bonus and the square-root of firm size, lending empirical support to the positive relation suggested by Jensen and Murphy (1990) when applying their dollar definition of pay-performance sensitivity to firm performance. Baker and Hall replicate the Schaefer result on stock and option compensation combined (linearly) but after modifying the sensitivity definition for interaction between pay-performance sensitivity and marginal productivity of effort (incentive strength) and find that incentive strength is approximately constant, or rises slightly, as firm size increases depending on the assumption made concerning CEO private wealth. The implication is that the marginal productivity of CEO effort increases with firm size at about the same rate as the level of firm risk faced by CEOs. Since neither of these studies explicitly considers CEO stock option grants, there is a gap in our knowledge concerning a firm size effect with respect to the incentive strength of option grants. As Baker and Hall (2004) admit146, option grants (along with restricted stock grants) remain a key instrument for reducing the agency cost of equity. To the extent CEOs of small firms are closer to owner-managers and because small-firm CEOs have lower risk aversion than large-firm CEOs, option grants in small firms are expected to have lower pay-performance sensitivities than in large firms. Hall and Murphy (2000, 2002) posit but do not test a relation between CEO risk aversion, private diversification and payperformance sensitivity for stock option grants, but omit to specify a firm-size effect. Hence, there is an absence of direct evidence on the issue whether small firms should tailor their stock option grants differently from large firms. Further, neither the Schaefer (1998) nor the Baker and Hall models accommodate the private diversification of CEOs. Baker and Hall also suggest that attributes of firm size may impinge on optimal incentive contracting, such as the degree of capital intensity, corporate diversification and differences in organizational structure. We therefore extend our analysis to embrace attributes that are characteristic of small firms in the event that firm smallness is proxying for at least one of these 146 Fn. 2, p.769. 115 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 attributes. The present paper seeks to establish empirically whether (i) a firm-size effect applies to CEO stock option grants, and (ii) whether any such size effect represents underlining attributes of firm size. To do this, we employ the option-specific measure of pay-performance sensitivity of Hall and Murphy (2000, 2002) in tandem with labor productivity (proxying for executive productivity) to yield an incentive strength metric. Pay-performance sensitivity is the product of the option delta and absolute grant size. Since delta and stock volatility are positively related, the expectation is that large U.S. firms (which typically are more risky than small U.S. firms) will have higher deltas and hence payperformance sensitivity for a given grant size. Contrary to the U.S., Australian small firms exhibit higher stock volatility than large firms which is attributable to the higher proportion of resource- and tech-based stocks among small firms. Thus, a largefirm effect attributable to higher stock volatility in the U.S. becomes a small-firm effect in Australia147. Specifically, we would then expect the inverse relation between pay-performance sensitivity (as measured) and firm size to reverse for Australia, effectively providing a robustness test of the Schaefer (1998) and Baker and Hall (2004) firm size propositions using a new dataset. Likewise, the positive relationship between firm size and executive productivity posited by these U.S. studies is also expected to reverse for Australian firms. Adherence to the Hall and Murphy (2002) payperformance sensitivity metric requires recognition of CEO risk-aversion and private diversification. Their model argues a positive relationship between payperformance sensitivity and an inverse relation with private diversification. The intuition is that a less (more) risk-averse CEO requires lower (higher) incentive, while a less (more) diversified CEO requires more (less) incentive. Small-firm CEOs are arguably less-diversified and less risk-averse than large-firm CEOs. The lower risk aversion of small firm CEOs is therefore expected to drive a lower payperformance sensitivity relative to large firms, while lower private diversification of small firm CEOs is expected to drive a higher pay-performance sensitivity. We document a small-firm effect in incentive strength via the pay-performance sensitivity component but not labor productivity (proxying for CEO productivity). We therefore provide empirical support for Baker and Hall (2004) but only with respect to pay-performance sensitivity. Notwithstanding their higher stock volatility, Australian small firms exhibit lower deltas and larger grants implying that grant size is used at least to offset the delta effect. One attribute of firm smallness, firm complexity, is found to have a similar explanatory power to that of firm size. 147 Hereafter, expectations concerning a large firm-size effect are stylized in terms of small-firm effect. 116 The paper is organized as follows. The following section provides a summary of the relevant literature that examines firm size and executive incentive. Sample selection procedures, measurement of key variables along with descriptive statistics are discussed in Section 3. Key relationships are analyzed and the results reported in Section 4, with the summary and conclusions following in Section 5. 2. Literature review Rosen (1992) and Holmstrom (1992) both challenge the implicit assumption of Jensen and Murphy (1990) that pay-performance sensitivity is independent of firm size: Rosen, along with Murphy (1985) specify a positive relation while Holmstrom proposes an inverse relation. Along with pay-performance sensitivity, Schaefer (1998) and Baker and Hall (2004) both recognize CEO marginal productivity for effort in their optimal incentive arguments. The optimal pay-performance slope (or sensitivity) is given by the general form bi* 1 , where k is a 1 k i i2 constant, i is absolute CEO risk aversion in ith firm, i2 is the variance of the ith firm‘s stock return. Baker and Hall define bi as the percentage of CEO stock ownership following Jensen and Murphy while Schaefer defines bi on salary and bonus. Baker and Hall replace both unities with marginal productivity 2b* 2 of CEO effort ( i2 i i * i ), while Schaefer 1bi 2 weights i i2 by a cost parameter (c) and St 1 , where St 1 is beginning firm value, is the marginal rate of change in firm risk and is the marginal return to effort: CEOs trade off for . Schaefer hypothesizes and finds that pay-performance sensitivity is higher for smaller firms, implying that the marginal productivity of CEO effort increases with firm size more slowly than the amount of risk faced by the CEO (i.e., ). In other words, for a given stock volatility, Schaefer attributes the lower pay-performance sensitivities of large-firm CEO salary and bonus to higher tenure risk that offsets the CEO‘s increased productivity (being the product of workload and ability), and also to conjectured higher stock volatility of large firms. Although CEO marginal productivity is likely higher in large firms than small firms, a talented executive in a small firm runs the risk of failing in a large firm owing to more complex organizational and political structures. Hence, larger firms are expected to have smaller payperformance sensitivities (as defined). On the other hand, Baker and Hall find pay-for-effort ln( i ) is positively associated with firm size as measured by ln(market value) across three assumptions concerning Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 CEO wealth148. An underlying inverse relation between pay-performance sensitivity (as defined by bi and consistent with Jensen and Murphy, 1990) and firm size is also noted. To summarize, Schaefer (1998) proposes and finds that larger firms have smaller pay-performance sensitivities on salary and bonus because the marginal productivity of CEO effort increases more slowly than the level of risk faced by the CEO. Modifying the measure of the pay-performance sensitivity metric to include the marginal product of CEO effort, Baker and Hall (2004) also propose and find that larger firms have smaller pay-performance sensitivities on total CEO compensation. Baker and Hall note that although CEOs of large firms typically own trivial fractions of the firm‘s stock, in absolute terms their shareholdings are larger than those of small firmCEOs, so higher small-firm pay-performance sensitivity is economically less significant than the leverage of large stock ownership in large firms. They assume the marginal productivity of CEO effort increases proportionately with firm size, such that incentive strength can be measured by the CEO‘s stock ownership in the firm. They define compensation as salary plus the change in CEO wealth resulting from changes in the value of stock and option holdings. They find that CEO incentive falls slightly as firms become larger. A stronger fall does not occur because the incentive-decreasing decline in percentage equity ownership is offset by the increase in marginal productivity. The implication is that lower pay-performance sensitivity of large firms is almost neutralized by CEOs increased productivity in large firms. Baker and Hall further posit a positive relation between executive incentive and firm size in more capital-intensive industries and a negative relation for diversified firms. Both Schaefer and Baker and Hall specify an inverse relation between executive incentive and risk aversion: thus, to the extent that CEOs of large firms are more risk-averse, their optimal incentive is lower. The results of the Schaefer (1998) and Baker and Hall (2004) studies need to be qualified in three respects. First, their pay-performance sensitivity measures do not recognize grant size in the formation of executive incentive. Although this circumvents interpretative difficulties in relation to absolute and relative incentive arguments, the omission deprives their analysis of a major decision variable: grant size is a key input in the optimal contracting models of Hall and Murphy (2000, 2002) and Choe (2003). A second qualification is that CEOs‘ private diversification is omitted as a variable by Schaefer and Baker and Hall owing to lack of data, but Baker and Hall experiment with different assumptions on how CEO wealth accrues. Finally, and more generally, their propositions with respect to the 148 The assumptions are that: (i) CEO wealth is proportional to all CEO compensation, (ii) CEO wealth is proportional to CEO stock ownership, and (iii) CEO wealth is constant. relation between pay-performance sensitivity (as defined) and CEO risk aversion and firm size hinge on the underlying positive relation between stock volatility and firm size. Given that small Australian firms have higher stock volatility than large firms, our aim is to test the robustness of the Schaefer (1998) and Baker and Hall (2004) models with respect to stock volatility when an opposite firm size effect is implied. Since their models rely on stock volatility and not firm size as a basis of argument, their interpretations should reverse when it is small firms that have higher stock volatility, as long as small-firm CEOs have lower absolute risk aversion than CEOs of large firms. It is therefore of interest to test the robustness of their results with a dataset where large firms exhibit lower stock volatility than small firms. In Australia, the resource sector which is characterized by high risk constitutes a larger share of the economy than in the U.S. A higher proportion of smaller Australian firms is resource-related relative to larger firms, so smaller firms exhibit higher stock volatility than larger firms. As a consequence, and other things equal, for Australian data we expect to observe an opposite outcome to these U.S. studies: that pay-performance sensitivity as defined by Hall and Murphy (2000, 2002) is expected to vary positively, and not inversely, with firm size. 3. Sample descriptives Our sample comprises 168 stock option grants made to 65 CEOs made by 51 listed Australian companies during the period 1987-2000. A wide array of industries is represented, including 30 resource stocks which are predominately small firms. Since no Australian executive compensation databases are available, all grant data were obtained from an ‗options‘ keyword search of all ASX-listed companies included in Huntleys‟ DatAnalysis service. Deletions were made for companies with quoted options, foreign companies and data inadequacies or inconsistencies. In Australia, as in the United States, shareholders must approve CEO stock option plans put to them by company compensation committees, usually in Annual General Meeting. During the sample period covering the late 1980s and the 1990s, ASX Listing Rule 10.14 prescribed shareholder approval by special resolution for issues of securities to related parties (which includes CEOs) by way of employee incentive schemes. The resolution must have been passed at a general meeting held no earlier than the last annual general meeting of the company. Issues of ordinary securities (the American equivalent is common stock) or claims thereon through such schemes and without ordinary shareholders‘ approval were capped at 15% of outstanding ordinary share capital (Listing Rule 7.1). Irregular grants outside such schemes similarly required shareholder approval (Listing Rule 10.11), but the 15% cap did not apply. The Corporations Act (s.205G) sets a maximum period of 14 calendar days 117 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 within which a company was to notify the ASX of any change, acquisition or disposal of company-issued securities held by directors, including stock options. Once shareholder approval is given, the compensation committee usually has discretion as to the frequency, size and timing of awards, as well as determination of the strike price. CEOs are invariably not members of their compensation committees, but this does not preclude CEO influence over their deliberations 149. Measures of key firm and CEO characteristics are as follows. Firm size is measured by the book value of total assets rather than firm value because asset sub-group values are available only at book. A firm is classified as small when total assets are ≤ $500 million, else it is classified as large. Capital intensity is the proportion of plant, property and equipment (at net book value) represented in the book value of total assets. This measure is preferred to depreciation/earnings before interest and tax because of variations in earnings due to non firm-specific events and differing accounting treatments. Similar to Coles, Daniel and Naveen (2007) firm complexity is the product of ln(1+Number of segments), ln(Total assets) and (1+Total assets/Total debt)150. Firm complexity is increasing in the number of segments (Rose and Shephard, 1997), total assets (Booth and Deli, 1996) and leverage (Klein, 1998). A firm is classified as diversified (=1) if its operations straddle two or more ANZSIC codes at the two-digit level. CEO risk aversion and private diversification are both proxied and measured on a relative scale. Risk aversion is MRP/5(σ2) where the market risk premium (MRP) is set at 7 per cent and σ is the standard deviation of stock returns for a given company (stock volatility). This metric is based on a measure commonly used by investment managers151. Private diversification is proxied in relative terms by ln1 (1 Percentageof stock owned beneficially by theCEO) , relying on the intuition that private diversification increases as the percentage of firm stock beneficiallyowned by the CEO decreases. Labor productivity is given by the coefficient on labor inputs obtained from a two-stage Cobb-Douglas estimation, where output is measured by Value-added, capital input is measured by net Property, Plant & Equipment (PPE) and labor input is measured by Total Assets less PPE; value added is ln(Market-to-book of assets Total assets) 1. Following Baker and Hall (2004) incentive strength is the product of labor productivity and payperformance sensitivity. Table 1 describes the characteristics of small versus large firms. The book value of total assets is preferred to firm market value as a size sorting variable for two reasons. First, fluctuating stock price volatility during the sample period often causes firms to move from one category to the other as the market value of equity fluctuates and, second, firm market value is influenced by the same factors that enter into the pay-performance sensitivity measure. Panel A shows that our small firms are less than one-tenth the size of our large firms, whichever size measure is used. The most consistent distinguishing characteristics are stock volatility and firm age. Small firms exhibit about double the stock volatility of large firms and are less than half the listing age of large firms. The stock volatility difference is attributable to the presence of a higher proportion of resource and high-tech stocks in the small-firm sub-sample. The relation between stock volatility and firm size is opposite to that exhibited by U.S. firms (Baker and Hall, 2004). Small firms also exhibit higher market-to-book of assets ratios (suggesting more growth opportunities) but have lower free cash flow which suggests a higher need than large firms for external financing. Market-to-book of assets and stock volatility are positively correlated for small firms (r = 0.21, p = 0.07) but inversely correlated for large firms (r = -0.40, p = .03). Interest coverage (representing financial risk) does not discriminate. The two remaining panels of Table 1 look at CEOrelated factors. Panel B shows conclusively that CEOs‘ relative risk aversion and private diversification are lower in small firms compared with large firms. This is an expected outcome because more risk-averse CEOs will tend to migrate to large firms which, in Australia, have comparatively lower stock volatility. Likewise, relative private diversification is higher in large firms than small firms because CEO shareholdings tend to be tiny in large firms. Panel C describes five option grant characteristics. Option grant value/total assets and option grant value/market value of equity are both consistently higher for small firms than for large firms. Analysis shows that both inequalities are influenced by higher small-firm grant sizes. In other words, option grants in small firms are worth more than option grants in large firms principally as a result of the higher stock volatility of small firms in the present sample. The option delta for small firms is significantly lower than that of large firms, notwithstanding their higher stock volatility. Grant size (as a percentage of the number of outstanding common) is significantly higher for small firms relative to large firms, while pay-performance sensitivity is lower152. The latter inequality is due to the relatively larger grants of small firms. 149 152 Yermack (1997) cites two examples of companies acknowledging management CEO influence over the terms and conditions of CEO awards, but no such instances were observed during collection of our sample. 150 The three components are unequally weighted because there are no a priori grounds for equal weights. 151 See Bodie, Kane and Marcus (2005). 118 As hypothesized by Hall and Murphy (2002), payperformance sensitivity and CEO risk aversion are positively related (ρ = 0.224, p=.001), implying that more risk-averse CEOs require higher pay-performance sensitivity to maintain given incentive. Pay-performance sensitivity and CEOs‘ private diversification appear inversely related as hypothesized, but not significantly so. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 To discriminate the characteristics of Australian firm smallness, firm complexity, capital intensity and corporate diversification, Table 2 reports four regressions on selected firm characteristics. In regression (1) small firms are shown more likely to have higher stock volatility, market-to-book and interest coverage but lower free cash flow and are more likely to be younger than large firms. Apart from stock volatility, the remaining descriptors are consistent with those of U.S. firms (Coles, Daniel and Naveen, 2008). Diversified firms are shown to have lower stock volatility and are older than more focused firms in regression (2). Regression (3) shows that more capital-intensive firms have higher stock volatility, interest coverage but lower free cash flow than less capital-intensive firms, while more complex firms are shown in regression (4) to have lower volatility, market-to-book and older in firm years. These relations are broadly consistent with those documented by Coles, Daniel and Naveen. More generally, corporate diversification, capital intensity and firm complexity exhibit different loadings on firm characteristics relative to small firms. 4. Analysis To determine labor productivity, a two-stage CobbDouglas model is estimated in which labor input is measured by ln(Total assets less PPE). Book values are used because market value is not available for PPE and all asset balances are measured at the latest pre-grant balance date. Since labor input is inferred from the balance of non-PPE assets, the complement (PPE) which measures capital input cannot be included in the same regression, so a two-stage estimation is performed to account for collinearity (refer Table 3). Output is measured by Value-added which is ln(Market-to-book of assets Total assets)-1. Labor productivity is given by the coefficient attaching to labor input. The two-stage model is estimated separately for four sectors: engineering & construction, agriculture, chemicals & pharmaceuticals, mining & energy and services, financial & retailing. The results are reported in Table 3. Labor productivity varies from 0.885 per cent for services, financial & retailing to 1.100 per cent for mining & energy for a 1.0 per cent change in labor input. In the remaining three sectors the valueadded change is below 1.0 per cent, but this is sustainable when combined with capital productivity. The high ranking of mining & energy is expected. As a preliminary step, the construct ‗incentive strength‘ and its components is regressed on CEO risk aversion and private diversification, along with a dummy variable for firm smallness which is included to capture any overlap with the former variables. A least squares specification assumes all the explanatory variables are exogenous. While this is true of firm size, there may be a degree of endogeneity in risk aversion if more risk-averse CEOs are attracted to large firms, but such an argument is thought unlikely to extend to private diversification. Stock volatility is not included owing to strong association with the both the small firm binary variable and CEO risk aversion, as measured. Results of three least square regressions reported in Table 4: in regression (1) the dependent variable is pay-performance sensitivity, in regression (2) it is labor productivity and in regression (3) it is incentive strength. Regression (1) shows that pay-performance sensitivity is unrelated to any of these variables. This result is contrary to Baker and Hall (2004) and Schaefer (1998) who posit a negative relation with risk aversion, and also Hall and Murphy (2002) who posit a positive relation with risk aversion. Thus, a neutral result does not constitute a problem. The negative relation between private diversification and pay-performance sensitivity posited by Hall and Murphy is also not found. Regression (2) is a rerun of regression (1) with labor productivity substituted as the dependent variable. Small firms are shown to have significantly lower productivity, in accord with Baker and Hall‘s (2004) observation that small-firm executives increase their productivity when moving to a larger firm. In addition, labor productivity is positively related to CEO risk aversion (and to a lesser extent private diversification) implying that CEOs are more productive as risk aversion increases, consistent with Baker and Hall. Following Baker and Hall, incentive strength is the product of payperformance sensitivity and labor productivity. Incentive strength (regression (3)) exhibits a similar relation with firm smallness and risk aversion. Hence, the suggestion is that labor productivity and not pay-performance sensitivity drives incentive strength through risk aversion (positively) and firm smallness (negatively). Private diversification appears unrelated, but this could be attributable to the proxy status of our measure. Given that Australian small firms have higher stock volatility than large firms, a robustness test is appropriate to determine whether incentive strength is determined by stock volatility or firm smallness. Since our measure of CEO risk aversion is highly correlated with stock volatility a substitute measure of risk aversion uncorrelated with stock volatility is employed in which beta risk is an instrument for stock volatility. The resulting measure is ln(1/CAPM-required return), which is uncorrelated with stock volatility (r = -0.090, p = 0.245). Regression (4) of Table 4 shows that even though stock volatility is significantly negatively associated with incentive strength, firm smallness retains its inverse significance with incentive strength as documented in regression (3). A potential problem with a least squares specification is that any endogeneity with respect to the explanatory variables is not corrected. Since there is a likelihood that less risk-averse CEOs prefer smaller firms that (in Australia) are less risky, to this extent firm smallness becomes endogenous. Likewise, as suggested by Hall and Murphy (2002) the degree of CEOs‘ private diversification also determines the level of pay119 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 performance sensitivity and indirectly a firm size preference if pay-performance sensitivity varies systematically with firm size. Following this reasoning, a series of two-stage least squares estimations is performed in which firm smallness is replaced with CEO risk aversion and private diversification plus an explanatory variable that is complementary to the dependent variable. In Table 5 we regress incentive strength and its components on firm smallness, CEO risk aversion and private diversification after allowing for the simultaneous association of firm smallness with CEO risk aversion and private diversification. Regression (1) shows that incentive strength (following Baker and Hall, 2004) is strongly negatively related to firm smallness. When pay-performance sensitivity is substituted for incentive strength as the dependent variable (regression (2)) the negative relation persists, but disappears when labor productivity is the dependent variable (regression (3)). The implication is that labor productivity is independent of firm size within an incentive context. Thus, for small firms it appears compensation committees need to focus on grant size for a given delta, to the extent the latter is exogenous. To determine whether it is grant size or option delta driving the negative relation between payperformance sensitivity and firm size, the option delta and grant size are added separately to the instrument set of regression (2). The results are reported in regressions (4) and (5). Both estimations confirm a firm size effect operates both through the option delta and grant size. The small firm coefficient is larger in regression (5) than either regressions (2) and (4) (small firm coefficient = -3.079 versus -2.234 and 2.280, respectively). This regularity suggests that grant sizes for small-firm CEOs are adjusted upwards to compensate for their lower deltas relative to large firms. In the absence of such an adjustment and other things equal, small-firm CEOs would be undercompensated relative to large-firm CEOs and migrate to large firms. We therefore advocate that executive option compensation models need to recognize a firm size effect. In the event that firm smallness proxies for attributes of small firm size, a robustness test is applied. Three such attributes are identified for analysis: firm complexity, capital intensity and corporate diversification. The latter two are suggested by Baker and Hall (2004), while the former is suggested by Coles, Daniel and Naveen (2007). The three attributes are subtly different. Complex firms are typically multi-segment and have a complex debt portfolio. Consistent with Hermalin and Weisbach (1988) and Yermack (1996), Coles, Daniel and Naveen (2007) argue that complex firms which are typically large are more difficult to manage and therefore require a broader range of executive inputs. Likewise, capital-intensive firms imply a broader skill set for CEOs compared with labor-intensive organizations. In both cases, we expect to observe stronger executive incentives. Diversified firms are likely larger than focused firms but need not be 120 complex or may not be capital-intensive and are expected to exhibit lower risk (stock volatility), so lower executive incentive is expected to be observed. The three attributes are discriminated by regressing (again in a two-stage framework) incentive strength separately on the three attributes while specifying CEO risk aversion, private diversification and firm smallness as instruments. Regressions (1) through (3) are reported in Table 6. Regression (1) on firm complexity is the only successful estimation. Given these results, we conclude that for a given level of CEO risk aversion incentive strength is influenced by firm complexity rather than capital intensity and corporate diversification. To determine how firm complexity interacts with pay-performance and labor productivity further two-stage estimations are performed, the results of which are reported in Table 7. Regressions (1) and (2) show that firm complexity is positively related with pay-performance sensitivity, but unrelated to labor productivity by virtue of the inadequate Durbin-Watson statistic. Thus, payperformance sensitivity (along with incentive strength) is also found influenced by firm complexity over and above firm smallness. To determine whether delta or grant size is driving payperformance sensitivity within the present structure for a given firm complexity, regression (1) is reestimated with delta and grant size independently added to the instrument set. The results reported as regressions (3) and (4) of Table 7, which show minimal differences from regression (1) indicating that the relation between pay-performance sensitivity and firm complexity is not affected by delta and grant size differences. The robustness of our findings is further established with respect to alternative measures of firm size, including market value of the firm and firm sales. Likewise, closely similar results are produced when substituting the alternative firm size measures in the measure of firm complexity. Instead of using a composite measure for complexity, we use the individual variables in our regressions and find that, as expected, the coefficients on all three variables are significantly positive with respect to pay-performance sensitivity and incentive strength, but not labor productivity. An alternative measure of private diversification that introduces benchmarking to absolute CEO private wealth specific to the host firm is also tried, being 1 ln(W) where W is the market value of firm stock beneficially-owned by the CEO. As with the relative measure, the intuition is that private diversification is more likely as investment in the host firm increases. 5. Summary and conclusions Baker and Hall (2004) and Schaefer (1998) propose a firm-size effect in relation to recurring executive compensation. Baker and Hall document empirically a weakly positive relation between firm size and various measures of incentive strength, comprising Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 the product of pay-performance sensitivity (as measured) and the marginal productivity of CEO effort. We test for the presence of a firm smallness effect on executive incentive in the context of CEO stock option grants. Our test metric is payperformance sensitivity as measured by Hall and Murphy (2002), which is option-specific. Descriptively, small (Australian) firms are characterized by higher stock volatilities and lower option deltas than large firms. Given lower smallfirm volatility, lower risk aversion of small-firm CEOs is to be expected. Relying on a proxy for private diversification, small-firm CEOs are also less privately-diversified than their large-firm counterparts. Executive productivity is proxied by labor productivity coefficients obtained from a twostage estimation of a Cobb-Douglas production function across four identifiable industrial sectors. There are several empirical findings. First, incentive strength is found strongly inversely related to firm smallness where the latter is characterized by instruments for CEO risk aversion, private diversification, pay-performance sensitivity and labor productivity. Our result therefore exhibits a stronger inverse relationship with respect to small firms than that posited by Baker and Hall (2004). Second, the small-firm effect persists when observing payperformance sensitivity as defined by Hall and Murphy (2002), but has no impact on labor productivity in the same incentive structure. The former result is consistent with the expectation of Baker and Hall and also Schaefer (1998) that small firms have lower pay-performance sensitivities, while the insignificance of a small-firm effect with respect to labor productivity does not support the U.S. studies. Pay-performance sensitivity is unaffected when the option delta and grant size are independently substituted as small firm instruments. Second, incentive strength is also impacted positively by firm complexity for given CEO risk aversion, but not by capital intensity and corporate diversification. Finally, we show that firm complexity, although correlated with firm size, exists separately as an incentive argument irrespective of the option delta and grant size. The implication of our findings is that executive compensation models need at least to recognize the small-firm effect and firm complexity when determining optimal compensation. Operationally, further research is required on the issue of whether optimal executive incentive models require adjustment for the joint productivity of labor and capital inputs. Specifically, the apparent insensitivity of labor productivity to firm complexity and firm smallness requires elaboration. 2. References 20. 1. Bebchuk, Lucian and Jesse Fried. Pay without Performance, Harvard University Press, Cambridge, Massachusetts; 2004. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 21. Bodie, Zvi, Alex Kane and Alan Marcus. Investments, 6th Edition, McGraw-Hill, New York; 2005. Booth, James R. and Daniel N. Deli. Factors affecting the number of outside directorships held by CEOs. Journal of Financial Economics. 1996; 40; 81–104. Chance, Don M. Expensing Executive Stock Options: Sorting out the Issues, Working paper, Louisiana State University, Baton Rouge, E.J. Ourso College of Business Administration; 2004. Available at SSRN: http://ssrn.com/abstract=590324. Choe, Chongwoo. Leverage, volatility and executive stock options. Journal of Corporate Finance. 2003; 9. Cobb, Charles W and Paul H. Douglas. A Theory of Production. American Economic Review. 1928; 18 (Supplement); 139-165. Coles, Jeffrey L. Naveen D. Daniel and Lalitha Naveen. Boards: Does one size fit all? Journal of Financial Economics. 2008; 87; 329-356. Hall, Brian J. Six Challenges in Designing EquityBased Pay. Journal of Applied Corporate Finance. 2003;15; 21-33. Hall, Brian J. and Kevin J. Murphy. Optimal Exercise Prices for Executive Stock Options, The American Economic Review, Papers and Proceedings of the 112th Annual Meeting of the American Economic Association. May 2000; 209-214. Hall, Brian and Kevin J. Murphy. Stock options for undiversified executives. Journal of Accounting and Economics. 2002; 33; 3-42. Hermalin, Benjamin E. and Michael S. Weisbach., Michael S. Endogenously Chosen Boards of Directors and Their Monitoring of the CEO. American Economic Review, American Economic Association, 1998; 88; 96-118. Holmstrom, Bengt. Comments in L. Werin and H. Wijkander (eds.), Contract Economics. Cambridge; MA: Blackwell; 1992. Klein, April. Firm performance and board committee structure. Journal of Law and Economics. 1998; 41. Meulbroek, Lisa. The Efficiency of Equity-Linked Compensation: Understanding the Full Cost of Awarding Executive Stock Options, Financial Management. 2001; 30; 5-30. Morck, Randall, Andrei Shleifer and Robert Vishny. Management Ownership and Market Valuation: An Empirical Analysis. Journal of Financial Economics. 1988; 20; 293-315. Rose, Nancy L. and Andrea Shepard. Firm diversification and CEO compensation: managerial ability or executive entrenchment? The Rand Journal of Economics. 1997; 28; 489-514. Rosen, Sherwin. Contracts and the market for executives. In Contract economics, ed. Lars Werin and Hans Wijkander, Cambridge; MA: Blackwell; 1992; 181-211. Stulz, Rene. Managerial Discretion and Optimal Financing Policies. Journal of Financial Economics. 1990; 26; 3-26. Yermack, David. Higher market valuation of companies with a small board of directors, Journal of Financial Economics. 1996; 40; 185–212. Yermack, David. Good Timing: CEO Stock Option Awards and Company News Announcements. Journal of Finance. 1997; 52; 449-476. White, Halbert. A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity. Econometrica. 1980; 48; 817-838. 121 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Appendices Table 1. Characteristics of small versus large firms A firm is classified as small when total assets are ≤ $500 million, else it is classified as large. All financial variables relate to the fiscal period prior to grant. Firm value is the sum of market value of equity and the book value of debt. Market-to-book of assets is the sum of the market value of equity at grant plus the book value of debt, both divided by total assets of book. Stock volatility is measured by the annualized standard deviation of pre-award monthly stock returns over a minimum of 36 months prior to grant. Free cash flow is the ratio of operating cash flow less preferred and equity dividend payments to the book value of assets. Interest coverage ratio is the natural logarithm of earnings before net interest and tax on net interest. Firm age is the number of years since the date of listing. Relative CEO risk aversion is MRP/5(σ2) where the market risk premium (MRP) is set at 7 per cent and σ is the standard deviation of stock returns for a given company. Relative private diversification is proxied by ln1 (1 Percentageof stockownedbeneficiallyby theCEO) . Option grant value is the number of granted options multiplied by the Black-Scholes call value adjusted for dividends. The Option delta is the partial derivative of the call value with respect to the stock price adjusted for dividends. Grant size is the number of granted options divided by the number of outstanding ordinary shares. Pay-performance sensitivity is delta multiplied by the number of granted options. Mean Small firms Large firms 103 65 Number of grants Median t difference Small firms Large firms Z difference 103 65 Panel A: Firm characteristics Total assets ($m) Firm value ($m) Market-to-book (assets) Stock volatility (%) Free cash flow ln(Interest coverage ratio) Firm age (years) Resource stocks (%) 210.1 262.9 1.58 15.60 -0.02 1.46 12.7 36.9 2,791.4 2,954.4 1.07 7.29 0.01 1.85 29.4 12.3 -11.37*** -8.66*** 2.69*** 9.25*** -2.31** -1.23 -11.29*** 181.4 212.3 1.13 12.20 -0.01 1.67 11.0 2,462.9 2,376.2 1.00 6.80 0.01 1.71 33.0 -10.92*** -10.50*** 1.95* 8.41*** -2.30** -0.89 9.02*** Panel B: CEO characteristics Relative CEO risk aversion Relative private diversification 1.26 2.76 3.14 5.43 -9.01*** -6.05*** 0.96 2.27 3.03 5.55 -8.54*** -5.14*** 0.26 1.50 0.24 0.38 2.50** 3.25*** 0.04 0.06 0.01 0.02 3.70*** 4.10*** 1.33 0.48 0.35 2.69 0.13 0.67 -5.75*** 4.19*** -2.38** 1.39 0.24 0.16 2.34 0.05 0.21 -5.49*** 5.08*** -2.21** Panel C: Option characteristics Option grant value/Total assets (%) Option grant value/Market value of equity (%) Option delta Grant size (%) Pay-performance sensitivity (/million) *** ** * denotes two-tailed significance at the 1% level or better. denotes two-tailed significance between 1% and 5%. denotes two-tailed significance between 5% and 10%. Table 2. Regressions of firm ‗smallness‘ and associated properties on selected firm characteristics A firm is classified as small when total assets are ≤ $500 million, else it is classified as large. A firm is classified as diversified (=1) if its operations straddle two or more ANZSIC codes at the two-digit level. Capital intensity is the proportion of PPE represented in Total assets. Firm complexity is the product of ln(1+Number of segments), ln(Total assets) and (1+Total assets/Total debt). Stock volatility is measured by the annualized standard deviation of pre-award monthly stock returns over a minimum of 36 months prior to grant. Market-to-book of assets is the sum of the market value of equity at grant plus the book value of debt, both divided by total assets of book. Interest coverage ratio is the natural logarithm of earnings before net interest and tax on net interest. Free cash flow is the ratio of operating cash flow less preferred and equity dividend payments to the book value of assets. Firm age is the number of years since the date of listing. z (t) statistics are shown in parentheses for the logit (least squares) regressions. Logit (least squares) regression results are Huber/White-corrected (White corrected) for heteroskedasticity. Logit regressions Least squares regressions Dependent variable: Small Corporate diversification Capital Firm firm (=1) (=1) intensity complexity (1) (2) (3) (4) n=168 McFadden R2 0.611 0.469 Adjusted R2 0.099 0.477 122 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 2 continued Log likelihood F-statistic probability -43.590 -60.622 0.000 0.000 4.683 0.000 31.435 0.000 Constant -3.625** (-2.010) -0.816* (-1.817) 4.625*** (9.664) 8.020*** (9.114) Stock volatility 50.537*** (3.568) -4.730** (-2.002) 3.770** (2.456) -17.970*** (-4.669) Market-to-book (assets) 1.602** (2.350) -0.123 (-1.097) 0.157 (1.386) -0.431*** (-3.720) ln(Interest coverage ratio) 0.796** (2.116) -0.075 (-1.029) 0.258*** (2.741) -0.168 (-1.031) Free cash flow -13.378** (-2.249) 0.846 (0.567) -5.925** (-2.263) 3.058 (0.868) Firm age (years) -0.179*** (-3.015) 0.115*** (4.735) 0.011 (0.792) 0.164*** (6.129) *** ** * denotes two-tailed significance at the 1% level or better. denotes two-tailed significance between 1% and 5%. denotes two-tailed significance between 5% and 10%. Table 3. Two-stage least squares regressions of Value-added on labor and capital inputs Output is measured by Value-added which is ln(Market-to-book of assets Total assets)-1. Capital input is measured by ln(Property, Plant & Equipment) and labor input is measured by ln(Total Assets less Property, Plant & Equipment). All asset balances are measured at the latest pre-grant balance date. The simultaneous equations are: ln(Laborinput) 0 1 ln(Capitalinput) ln(Value - added) β0 1 ln(Laborinput) where the estimation of the second equation is reported below. t statistics are shown in parentheses. Regression results are White-corrected for heteroskedasticity. Industry classification: Mining & energy Services, financial & retailing 51 0.835 1.746 Agriculture, chemicals & pharmaceuticals 34 0.530 1.950 31 0.907 1.909 52 0.843 2.195 Constant 0.035 (0.148) 0.737 (1.257) 0.188 (0.655) 0.253 (0.703) Labor input 0.986*** (21.08) 0.950*** (7.954) 1.110*** (17.564) 0.885*** (17.136) N Adjusted R2 Durbin-Watson *** Engineering & construction denotes two-tailed significance at the 1% level or better. Table 4. Least squares regressions of incentive strength and its components on firm smallness, CEO risk aversion and private diversification Pay-performance sensitivity is delta multiplied by the number of granted options, where delta is the partial derivative of the call value with respect to the stock price adjusted for dividends. Labor productivity is the coefficient on labor inputs obtained from a two-stage Cobb-Douglas estimation, where output is measured by Value-added, capital input is measured by net Property, Plant & Equipment (PPE) and labor input is measured by Total Assets less PPE; value added is ln(Market-to-book of assets Total assets) - 1. All asset variables are measured at the latest pre-grant balance date. Incentive strength is the product of Pay-performance sensitivity and Labor productivity. A firm is classified as small when total assets are ≤ $500 million, else it is classified as large. t statistics are shown in parentheses. In regressions (1) through (3) relative CEO risk aversion is MRP/5(σ2) where the market risk premium (MRP) is set at 7 per cent and σ is the standard deviation of stock returns for a given company, whereas in regression (4) relative risk aversion is proxied by the natural logarithm of the inverse of the CAPM-required return. Relative private diversification is proxied by ln1 (1 Percentageof stockownedbeneficiallyby theCEO) . Stock 123 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 volatility is measured by the annualized standard deviation of pre-award monthly stock returns over a minimum of 36 months prior to grant. t statistics are shown in parentheses. Regression results are White-corrected for heteroskedasticity. Dependent variable: Pay-performance sensitivity (1) Labor productivity (2) Incentive strength (3) Incentive strength (4) 0.040 3.333 0.021 0.580 77.731 0.000 0.110 7.916 0.000 0.103 5.777 0.000 Constant 0.470 (0.438) 5.649*** (26.154) 7.166* (1.727) 4.312 (0.729) Small firm (=1) -0.607 (-1.205) -2.310*** (-12.531) -7.713** (-2.412) -8.967*** (-2.285) CEO risk aversion 0.519 (1.532) 0.154*** (2.892) 2.145** (2.034) 5.125** (2.064) Private diversification 0.074 (0.458) 0.047* (1.886) -0.002 (0.005) 0.125 (0.254) n=168 Adjusted R2 F-statistic Probability -20.287** (-2.499) Stock volatility *** ** * denotes two-tailed significance at the 1% level or better. denotes two-tailed significance between 1% and 5%. denotes two-tailed significance between 5% and 10%. Table 5. Two-stage least square regressions of incentive strength and components on firm smallness Pay-performance sensitivity is delta multiplied by the number of granted options, where delta is the partial derivative of the call value with respect to the stock price adjusted for dividends. Labor productivity is the coefficient on labor inputs obtained from a two-stage Cobb-Douglas estimation, where output is measured by value added, capital input is measured by net Property, Plant & Equipment (PPE) and labor input is measured by Total Assets less PPE; value added is (Market-to-book of assets – 1) multiplied by Total assets, where both variables are measured at the latest pre-grant balance date. Incentive strength#1 is the product of Pay-performance sensitivity and Labor productivity. CEO risk aversion is MRP/5(σ2) where the market risk premium (MRP) is set at 7 per cent and σ is the standard deviation of stock returns for a given company. Relative private diversification is proxied by ln1 (1 Percentageof stockownedbeneficiallyby theCEO) . A firm is classified as small when total assets are ≤ $500 million, else it is classified as large. Delta is the partial derivative of the call value with respect to the stock price adjusted for dividends. Grant size is the number of granted options divided by the number of outstanding ordinary shares. t statistics are shown in parentheses. Regression results are White-corrected for heteroskedasticity. Estimation of the second of the following pairs of simultaneous equations is reported below: Regression (1): Small firm β0 β1 CEO risk aversion β2 Privatediversification 3Pay performance sensitivity 4 Laborproductivity ε Incentivestrength 0 1Small firm 2 CEO risk aversion 3Privatediversification Regression (2): Small firm β0 β1 CEO risk aversion β2 Privatediversification 3Laborproductivity ε Pay performance sensitivity 0 1Small firm 2CEO risk aversion 3Privatediversification Regression (3): Small firm β0 β1 CEO risk aversion β2 Privatediversification 3Pay performance sensitivity ε Laborproductivity 0 1Small firm 2CEO risk aversion 3Privatediversification Regression (4): Small firm β0 β1 CEO risk aversion β2 Privatediversification 3Laborproductivity 4Optiondelta ε Pay performance sensitivity 0 1Small firm 2CEO risk aversion 3Privatediversification Regression (5): Small firm β0 β1 CEO risk aversion β2 Privatediversification 3Laborproductivity 4Grant size ε Pay performance sensitivity 0 1Small firm 2CEO risk aversion 3Privatediversification 124 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Dependent variable: Incentive strength n=168 Adjusted R2 Durbin-Watson Constant Small firm (=1) CEO risk aversion Private diversification *** ** * Labor productivity (1) Payperformance sensitivity (2) (3) Payperformance sensitivity (4) Payperformance sensitivity (5) 0.083 1.907 15.187*** (2.892) -15.568*** (-3.417) 1.080 (1.321) -0.343 (-0.703) 0.024 1.990 2.132*** (3.095) -2.234*** (-2.838) 0.298 (1.271) 0.004 (0.027) -1.193 0.266 11.977* (1.677) -8.507 (-1.234) -0.685 (-0.665) -0.222 (-0.723) 0.023 1.988 2.178*** (3.194) -2.280*** (-2.816) 0.292 (1.269) 0.002 (0.013) 0.003 1.952 2.994*** (3.495) -3.079*** (-3.017) 0.184 (0.879) -0.033 (-0.248) denotes two-tailed significance at the 1% level or better. denotes two-tailed significance between 1% and 5%. denotes two-tailed significance between 5% and 10%. Table 6. Two-stage least square regressions of incentive strength on properties of firm smallness Pay-performance sensitivity is delta multiplied by the number of granted options, where delta is the partial derivative of the call value with respect to the stock price adjusted for dividends. Labor productivity is the coefficient on labor inputs obtained from a two-stage Cobb-Douglas estimation, where output is measured by value added, capital input is measured by net Property, Plant & Equipment (PPE) and labor input is measured by Total Assets less PPE; value added is (Market-to-book of assets – 1) multiplied by Total assets, where both variables are measured at the latest pre-grant balance date. CEO risk aversion is MRP/5(σ2) where the market risk premium (MRP) is set at 7 per cent and σ is the standard deviation of stock returns for a given company. Relative private diversification is proxied by ln1 (1 Percentageof stockownedbeneficiallyby theCEO) . Firm complexity is the product of ln(1+Number of segments), ln(Total assets) and (1+Total assets/Total debt). Capital intensity is the proportion of PPE represented in Total assets. A firm is classified as diversified (=1) if its operations straddle two or more ANZSIC codes at the two-digit level. t statistics are shown in parentheses. Regression results are White-corrected for heteroskedasticity. Estimation of the second of the following pairs of simultaneous equations is reported below: Regression (1): Firm complexity β0 β1 CEO risk aversion β2 Privatediversification 3Pay performance sensitivity 4 Laborproductivity 5Small firm Incentivestrength 0 1Firm complexity 2 CEO risk aversion 3Privatediversification Regression (2): Capitalintensity β0 β1 CEO risk aversion β2 Privatediversification 3Pay performance sensitivity 4 Laborproductivity 5Small firm Incentivestrength 0 1Capitalintensity 2CEO risk aversion 3Privatediversification Regression (3): Corporatediversification β0 β1 CEO risk aversion β2 Privatediversification 3 Pay performance sensitivity 4 Labor productivity 5Small firm Incentivestrength 0 1Corporate diversifcation 2CEO risk aversion 3Privatediversification (1) (2) (3) 0.182 1.900 -0.399 1.525 0.311 1.689 Constant -8.015** (-2.249) 67.422*** (2.866) -6.187** (-2.057) Firm complexity 1.680*** (3.171) n=168 Adjusted R2 Durbin-Watson Capital intensity Corporate diversification -11.499*** (-2.825) 17.065*** (3.175) 125 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Table 6 continued CEO risk aversion 0.794** (2.026) 0.457 (0.488) 1.438** (2.515) Private diversification -0.267 (-0.800) 2.258** (2.454) 0.021 (0.051) *** ** denotes two-tailed significance at the 1% level or better. denotes two-tailed significance between 1% and 5%. Table 7. Two-stage least square regressions of incentive strength and components on firm complexity Pay-performance sensitivity is delta multiplied by the number of granted options, where delta is the partial derivative of the call value with respect to the stock price adjusted for dividends. Labor productivity is the coefficient on labor inputs obtained from a two-stage Cobb-Douglas estimation, where output is measured by value added, capital input is measured by net Property, Plant & Equipment (PPE) and labor input is measured by Total Assets less PPE; value added is (Market-to-book of assets – 1) multiplied by Total assets, where both variables are measured at the latest pre-grant balance date. CEO risk aversion is MRP/5(σ2) where the market risk premium (MRP) is set at 7 per cent and σ is the standard deviation of stock returns for a given company. Relative private diversification is proxied by ln1 (1 Percentageof stockownedbeneficiallyby theCEO) . Firm complexity is the product of ln(1+Number of segments), ln(Total assets) and (1+Total assets/Total debt). Capital intensity is the proportion of PPE represented in Total assets. A firm is classified as diversified (=1) if its operations straddle two or more ANZSIC codes at the two-digit level. t statistics are shown in parentheses. Regression results are White-corrected for heteroskedasticity. Estimation of the second of the following pairs of simultaneous equations is reported below: Regression (1) Firm complexity β0 β1 CEO risk aversion β2 Privatediversification 3Laborproductivity 4Small firm Pay performance sensitivity 0 1Firm complexity 2CEO risk aversion 3Privatediversification Regression (2) Firm complexity β0 β1 CEO risk aversion β2 Privatediversification 3Pay performance sensitivity 4Small firm Laborproductivity 0 1Firm complexity 2CEO risk aversion 3Privatediversification Regression (3) Firm complexity β0 β1 CEO risk aversion β2 Privatediversification 3Laborproductivity 4Small firm 5Delta Pay performance sensitivity 0 1Firm complexity 2CEO risk aversion 3Privatediversification Regression (4) Firm complexity β0 β1 CEO risk aversion β2 Privatediversification 3Laborproductivity 4Small firm 5Grant size Pay performance sensitivity 0 1Firm complexity 2CEO risk aversion 3Privatediversification Dependent variable: (1) Pay-performance sensitivity (2) Labor productivity (3) Pay-performance sensitivity (4) Pay-performance sensitivity 0.064 2.008 0.751 0.768 0.069 2.014 0.067 2.012 Constant -0.741 (-0.927) 1.936*** (11.488) -1.027 (-1.032) -0.853 (-1.042) Firm complexity 0.136*** (2.731) 0.311*** (15.154) 0.202*** (2.639) 0.162*** (3.180) CEO risk aversion 0.407 (1.429) 0.023 (0.553) 0.312 (1.480) 0.370 (1.364) Private diversification 0.052 (0.351) 0.036* (1.723) 0.029 (0.217) 0.043 (0.293) n=168 Adjusted R2 Durbin-Watson *** * 126 denotes two-tailed significance at the 1% level or better. denotes two-tailed significance between 5% and 10%. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 РАЗДЕЛ 3 КОРПОРАТИВНОЕ УПРАВЛЕНИЕ В АВСТРАЛИИ SECTION 3 NATIONAL CORPORATE GOVERNANCE: AUSTRALIA A PRINCIPLES-BASED ANGLO GOVERNANCE SYSTEM IS NOT A SCIENCE BUT AN ART Suzanne Young*, Vijaya Thyil** Summary Anglo governance systems rely of a number of controls to align shareholder and boards of director‟s interests. In general they are referred to as market control, regulatory control, and political and cultural control. Agency theory proposes that these control mechanisms are necessary as human nature is such that directors and managers act in a self-interested and boundedly rational manner in decision-making that can result in sub optimality. Notwithstanding that each country within the Anglo system accepts such controls are necessary they have their own foci and priorities, being a product of their own system‟s characteristics. This paper through interviewing a number of Australian business executives adds to the academic literature by providing evidence from the field of the important characteristics of the Australian governance system, the drivers of change and the effectiveness of the principles-based approach. It argues that debate needs to move beyond the principles versus rules approach to look at how firms can be provided with more guidance in operationalising some of the principles that appear to be key to governance effectiveness. It concludes that there is a need for a holistic model of governance that is broader than that focusing on the control/legalistic approach; that top management is important in setting and driving the in-firm governance agenda; that the public needs to be informed and educated about governance and its importance; and that disclosure still requires an improvement in quality. Key words: Corporate governance, Australia, regulation, principles * Corresponding Author Graduate School of Management, La Trobe University, Melbourne Australia 3086 [email protected] ** Graduate School of Management, La Trobe University, Melbourne Australia 3086 Introduction Anglo governance systems rely of a number of controls to align shareholder and boards of director‘s interests. Various models (see Robins, 2006; Easterbrook, 1996) are put forward in discussing these controls but generally we can refer to them as market control, regulatory control, and political and cultural control. Agency theory (Eisenhardt, 1989; Fama & Jensen, 1983) proposes that these control mechanisms are necessary as human nature is such that directors and managers act in a self-interested and boundedly rational manner in decision-making which can result in sub optimality. Each country within the Anglo system uses different control mechanisms to differing degrees. Each also has its own foci and priorities, characteristics and drivers of change. For instance in 127 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 discussing the types of regulatory controls, the USA governance system is referred to as rules-based whereas the Australian and UK system is referred to as principles-based (Clarke, 2007). Clarke (2007:162) argues that rules require all members to act according to minimum standards of practice, which to gain broad acceptance however become minimum acceptable practice; adding though that the introduction of tougher rules in USA has believed to have improved reporting and governance behaviour. In contrast a principles-based approach works to influence a broad set of practices designed to meet stakeholder needs. Some argue that a reliance on rules and compliance is fraught with peril whilst at the same time arguing that objective standards are required to facilitate meaningful comparative analysis, to bring about discipline and to ensure shareholders receive fair share of rewards (Dallas, 2004:23). This paper through describing the Anglo governance system and in particular the Australian system focuses on regulatory control and the various changes that have occurred over the last decade and contributes to the debate surrounding rules versus principles. In addition the paper through interviewing business leaders adds to the academic literature by including business-leaders‘ perspectives on governance, why and what is changing and whether the changes that have occurred will lead to improved effectiveness. Anglo Governance Systems Anglo governance systems operating in USA, UK and Australia have specific characteristics that in total are referred to as a market-based system. Corporations operating in this system, focus on shareholder primacy, and are subjected to the market, which operates to ensure both efficiencies and effectiveness of managerial and board decisions. The market evaluates the willingness and ability of corporations to pay investors and adjusts the current price of stock. As firms raise new money through debt they must pay the rate of return appropriate to current strategies and risk as judged by the market. This assumes that the general populace has faith in the market, and that shareholders are willing to invest. In this process it is assumed that managers make rational decisions and choose whether to make investment decisions and raise funds through debt or equity; and if shareholders have faith in the market they will purchase shares. As such it is believed that the discipline of the market is greater than the discipline of formal ‗governance‘ devices. Market control aligns shareholders, directors and managers interests in a number of ways: through the market for corporate control; through product markets and through labour markets. Corporate control operates in such a way that inefficient operating is reflected in share price and in takeover activity. It proposes that shareholders can exit the market if they lose faith in the market, and in particular can sell their shares in corporations if directors and managers make 128 decisions that reduce their wealth. In addition product markets also exhibit controls over managerial behaviour ensuring that corporations compete effectively in market for goods and services or risk losing business. Moreover labour markets act as a control device as any reduction in shareholder value due to management inefficiencies may lead to decreases in their employment opportunities. But in practice inefficiencies in market control have led to other actors in the governance system such as professional associations and government introducing professional and regulatory controls to broaden and strengthen the controls over the behaviour of directors and managers so that their focus on shareholder wealth is maintained and selfinterest pushed aside. Easterbrook (1996:70) explains: ―Entrepreneurs make promises to investors [and] if these promises are not optimal…then investors pay less and entrepreneurs …bear costs of sub-optimality. …[However} this mechanism depends on investors being able to evaluate promises made to them…so when markets are inefficient some substitute must be found‖. These include legislation, and professional, accounting and auditing standards, and organisational codes of conduct and ethics. Managerialists argue that strong legal rules are necessary to temper the enormous power that managers have and to ensure power is exercised consistently with the interests of shareholders (du Plessis, Mc Convill & Bagaric 2005:122-3). Clarke (2007:130) further explains that the Anglo governance system based on disclosure uses regulation to ensure that full information is provided to dispersed shareholders so that they can make informed investment decisions. But even with these varied controls, we have witnessed numerous frauds, corporate scandals, and failures of standards and codes. We have seen stock options being used as a vehicle for huge personal gains, profits being inflated to placate stock market analysts and, deception used to allay commentary by analysts on less than expected performance. Indeed researchers (see Robins 2006 for a full discussion) have claimed that governance structures actually lead to deceptive practices, with legal but unethical accounting tactics, and a belief that the ‗ends‘ justify the ‗means‘. As Paul Volcker US Federal Reserve (2002) stated ―in light of the Enron Affair and the seemingly endless barrage of news about other firms restating profits, artificially embellishing revenues and creating obscure ―special purpose vehicles‖ conveniently off their balance sheets, no one can reasonably doubt that there is a crisis in the accounting and auditing profession‖ (Robins 2006:36). Waring (2008) writes of corporate governance failures in liberal market economies as being based on organisations having a short-term business focus, perverse incentives and questionable managerial decision-making. Many examples of such activity have been written of over the past decade (see Robins 2006): Enron‘s auditor Arthur Andersen guilty of obstructing Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 a SEC investigation into Enron‘s collapse; deficient auditing practices evident with Arthur Andersen audits of Enron and HIH; internal audit of WorldCom finding top executives engaged in massive accounting fraud inflating company profit by at least US$7b; information about One.Tel‘s defective billing system withheld from the board and the resultant company collapse with a $2.4b debt; Harris Scarfe‘s voluntary liquidation after 6 years of inflated asset values and accounting irregularities; HIH‘s collapse with debt of A$5.3b with auditors claiming ignorance and executives being jailed. Regulatory Control A strong consensus emerged amongst policy makers and industry observers that existing management practices and government oversight were insufficient to promote a well-functioning and sound security market (Bertus, Jahera Jr. & Yost (forthcoming). This resulted in tightening of regulatory control in USA through the Sarbanes Oxley Act (SOX) 2002 and in amendments to the Corporations Act – Corporate Law Reform Act 2004 (CLERP 9) in Australia. The SOX has numerous features to strengthen control focusing on three areas: executive compensation, shareholder monitoring, and board monitoring (Holstron & Kaplan, 2005:71). Specific features include tightening of accounting standards and enhancing external auditor independence from management; improving the responsibility of CEOs and senior management; greater disclosure of internal controls and codes of ethics; certification by the CEO and CFO of all annual and quarterly reports; requirements of auditor independence; establishment of the Public Company Accounting Oversight Board (PCAOB); and new standards for company audit committees. In general the SOX Act 2002 is quite prescriptive in its approach in response to the failures mentioned above. In particular the CEO and CFO are required to give up any profits from bonuses and stock sales during the 12 months that follows a financial report that is then restated due to misconduct; executives have to report sales or purchases of stock within 2 days; greater disclosure is to be made of off-balance sheet financing and special purpose entities; improvements made in board monitoring; and overall increases in management and board responsibility for financial reporting and criminal penalties for misreporting. Commentators (Holstrom & Kaplan 2005:83) in speaking of the SOX Act 2002 have argued that board behaviour will be effected through heightened monitoring, and though not necessarily adversarial should lead to more independence and inquisition by the board of managerial actions. They conclude that despite the problems, the US corporate governance has performed very well and that any more regulation would be overtly costly and counterproductive and lead to inflexibility and fear of experimentation. Although others have questioned the effects, with Clarke (2007:161) reporting a survey of 274 finance managers which found that whilst 55% agreed that SOX increased investor confidence in financial reports, 44% agreed that financial reports were more reliable and 32% agreed that it helped prevent or detect fraud, only 14% agreed that the benefits exceeded costs. Indeed Zhang (2005, cf. Thomsen 2008:187) reports that in the first year of implementation there has been an increase in costs of at least 53% comprised of both internal and external costs plus audit fees. And it has been reported (see Thomsen, 2008:188) that additional costs has spurred organisations to delist from American exchanges and that regulation costs have led to reduced competitiveness in the US capital markets. Waring (2008:158) summarises the debate succinctly in stating ―there is an ongoing debate in the corporate governance literature as to whether Sarbanes-Oxley was an appropriate legislative response to these failures; a question only time and experience seem capable of resolving‖. In Australia, CLERP 9 has focused more narrowly on auditor independence, enhanced disclosure, transparent shareholder meetings and whistleblowing (Clarke, 2007:168). The legislation has strengthened financial reporting, ending an era of self-regulation in favour of the Financial Reporting Council; has introduced International Accounting Standards; has established the Corporate Governance Council; has reviewed the performance and accountability of regulatory authorities such as ASIC and APRA; and has established the group of 100 CFO‘s Code of Conduct (Robins 2006). The Act in a focus on audit reform provides auditing standards with the force of law; enhances disclosure of remuneration and links to corporate performance, with shareholders having a non binding vote and approval of termination payments; legislates for continuous disclosure of information that may materially effect share price; enhances shareholder participation through embracing technology, notice of annual general meetings, electronic proxy votes, and disclose of directors pre-positions; provides for protection of whistleblowers; and improves information in the prospectus. In addition, in 2002 the Australian Stock Exchange (ASX) introduced guidelines notwithstanding that these are not mandatory, listed companies must disclose the extent they are followed (see ASX 2007). These include statements of matters reserved to the board and delegated to senior management; independence of directors and Chair; disclosure of directors‘ tenure; establishment of code of conduct; and that non-executive directors should consider meeting independent of management. But even so, questions have been raised about whether legislative changes and voluntary guidelines such as these will bring about improvements in behaviours and conduct. Phil Chronican, CFO Westpac stated that technically, ―it has made no material difference. Previously I wrote to the Westpac board personally certifying the accuracy of the 129 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 company‘s accounts. Now that document is public and US criminal sanctions apply if I break the law. My workload has increased only slightly‖ (Schmidt 2003). A survey conducted by Deloitte Consulting of CFO‘s found that 50% said regulatory changes had not had a big effect on finance function and new rules were insufficient to prevent repeat of big corporate collapses like Enron and HIH (Robins 2006). Greg Larsen CEO Australian Society of Certified Practicing Accountants (ASCPA) argued: ―Fundamentally there is nothing wrong with Australia‘s financial system, which, in some cases is leading world best practice‖ (Harris 2002). Indeed accountants and auditors have resisted any external tightening of rules and regulations and criticised the rotation of audit teams (not firms) every 5 years, audit independence, and reporting of non-audit services (Robins 2006). Furthermore the Australian Directors of Corporate Governance International rejects the use of the ASX as a model and argues that it has a poor record on proposing governance reform. Others have commented that difficulties arise as ASX listing rules are non-binding and there are conflicts of interest as it is a listed company itself (Robins 2006). Robins (2006) adds more generally that Australian responses to corporate scandals are considered to be ―ill-coordinated and weak, when compared with apparent rigour of Sarbanes-Oxley‖. Explanations provided relate to the voluntary nature of codes of conduct compared to prescriptive legislation and the longer time-lines and incorporation of public debate and input from the accounting profession, businesses, shareholder organisations. Du Plessis, McConvill and Bagaric (2005:125) argue that whilst Australia‘s regulatory framework satisfies the OECD principles of good corporate governance on the two bases of promotion of transparent and efficient markets, and consistency with rule of law principles, it fails on the third which is clear articulation of division of responsibilities among the different supervisory, regulatory and enforcement authorities. Clarke (2007:147-8), and Digman and Galanis (2004:26) add that there is some evidence that this continuing division of regulatory powers has diminished the power of regulation, limited the pressure on company disclosure relative to other countries and resulted in a hands-off approach to infringements. Notwithstanding, Clarke (2007:162) argues in support of the historical principles-based system of UK, Canada, Hong Kong and Australia over the rulesbased system of USA. The former sets minimum standards of practice which it is claimed simply leads to the creation of new and imaginative ways to get around the rules; whereas the latter, in not setting standards, encourages improvement over time in order to meet the expectations of the stakeholder community at large. Although Clarke (2007:167-8) does add that Enron, HIH and One-Tel failures did lead to further reforms of corporate governance through CLERP 9. In addition, in questioning 130 whether further reforms will reduce the frequency and extent of corporate failure, he concludes (p.169) ―the capacity of the system for reform and regeneration is very real, but also the apparently inherent instability and volatility in this increasingly market-based system‖. Clarke (2007) also adds that the increasing demand for Corporate Social Responsibility (CSR) is another pressure on the governance system. Support for this comes from Waring (2008) who argues that in the Anglo governance systems, legal duties and responsibilities of directors should be enlarged to include enhancing and balancing stakeholder interests. Others (Robins 2006; Buffini 2002) in arguing for a broader, but not regulatory, approach claim that Governance has to move beyond checklist templates; and that it is impossible to regulate for ethics. Graeme Samuel (ACCC) states that governance requires the right mix of personalities, expertise, commitment and leadership; that over-regulation will kill entrepreneurial spirit, crush innovation, shift resources towards compliance rather then staying ahead (Samuel 2003). Clarke (2007:266) concludes that ―as pressures to conform to international standards and expectations increase, the resilience of historical and cultural differences will continue‖. On the same theme, Young and Thyil (2007; 2008) argue that in attempting to understand governance models an holistic view is more appropriate; one which reflects its multidisciplinary nature, reflecting macro factors such as cultural, historical, legal and national frameworks as well as micro factors such as vision and strategy, behaviours and codes, leadership and stakeholders. And Mayer (2000) concludes that ―there is no single dominant system [and]… there may indeed be benefits to diversity, particularly in light of our current state of ignorance about the comparative merits of different systems [and] … regulators should be …encouraging the emergence of different types of financial and corporate arrangements rather than being restrictive‖. Whether based on rules or principles, each country‘s governance system reflects its own history, culture, legislature, social systems and environment. Method The sample for this study consists of seven interviews in six Australian corporations in public, private and government enterprises, operating in the brewing, mining, accounting and superannuation industries. The choice of the companies was based on convenience sampling. Simultaneously, a broad representation was ensured. Senior key executives in these organizations were interviewed using a semistructured interview schedule. (Appendix A contains the schedule used). Interviewees were first phoned to explain the research, and a plain language statement and consent form, as approved by the Ethics Committee, were forwarded to them. The questions Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 were exploratory in nature and Patton (1990:424) has summarized the importance of qualitative enquiry: ―The emphasis is on illumination, understanding, and extrapolation rather than causal determination, prediction, and generalization‖. Questioning was used to uncover deeper meanings and underlying reasons and interpretations from multiple sources. Each interview lasted for approximately one hour and was audio-taped. The transcriptions were sent to the interviewees for verification of accuracy. The verification fulfilled the need for credibility checks and ensured that the information was reflective of the participants‘ meanings and the interviewer did not introduce bias. Table 1 presents the sample used. Table 1. Sample of organizations and position of executives interviewed 1 Category of Organisation Mining Company A 2 3 Mining Company B Superannuation Fund 4 Australian Government Enterprise Brewery A – 1 5 6 7 Brewery A – 2 Accounting & Consulting Firm Position of Executives interviewed Principle Advisor on Environment Company Secretary Executive Manager – Investments & Governance Corporate Secretary Director of Communications Company Secretary Executive Director AABS –RCIP As the information produced by qualitative methods is voluminous, content analysis, as proposed by researchers such as Patton (1990:381), was used to identify, code and categorize its primary patterns. The data was coded according to the major themes, namely, perception of Australian corporate governance systems, the factors driving the evolution of corporate governance in Australia, the current governance models, factors that impacted on the governance systems of the organization, the nature and extent of the influence of the international environment on the Australian corporate governance system, effectiveness of existing corporate governance structures in Australia, and major concerns among the public regarding governance issues. Several minor themes emerged from the coding based on the major themes and they are presented in the findings and discussion. Findings and Discussion The Principles-based Nature of the Australian Governance System Generally respondents spoke in favour of the principles-based system of Australia with additional comments such as: „there seems to be a greater emphasis on the spirit of the law rather than the letter‟ (Brewery 1); and whilst it is continuously evolving, currently it is ‗a mix of what is prescribed in legislation and the principles-based approach of the ASX‟ (Australian Government Enterprise). To explain the principles-based approach further, managers remarked: We tend to be a little bit more of, „you need to do these things and provided that you do these things within these boundaries you will be okay‟ (in Australia), if we don‟t comply we are happy to explain why, whereas theirs (USA) is you must comply. There is no debate (Mining Company B). The US system is dominated clearly by Sarbanes Oxley and the legislation that takes that name and sections which require certifications or sign offs. The design, operation or effectiveness of internal controls is assessed in some detail. The level of work required to comply with the SOX regime is far greater than what would be required in alternative systems, as I say in the UK or in Australia (Accounting & Consulting Firm). In formulating their governance frameworks, initially the firms interviewed simply followed the basic tenets and structures required by the ASX and the regulatory bodies, but over time, have realized the flexibility inherent in the system and started to customize it according to their own requirements. The following remark by one respondent portrays the learning process the firms went through (and are still going through) during the period of evolution of governance in Australia. I mean the biggest pain was when everyone had to write their corporate governance statements. They all looked the same. I think that is starting to change. I do think that people are starting to get the confidence that they can break out a little bit of the formula‟ (Mining Company B). The changing and fluid nature of governance was highlighted by all respondents in an unanimous view that governance evolves as the market evolves and it is not possible to reach a state where it could be termed as being ‗exactly right‘. As one respondent said, „it is not a science it‟s more of an art‟ (Brewery A1). This also links with the inherent flexibility of a principles-based approach in that principles are able to be interpreted to suit the firms‘ situation. However, in integrating governance with the firm‘s operations a challenge is to see it as a valueadd to business operations rather than simply being an underpinning structure based on a check-box system. For instance the government business enterprise manager stated: basically governance is embedded in the system so we don‟t really have to think about it. But as a check each year the board audit committee or the risk committee will get a report which indicates what the requirements are, how and when they where met, just to make sure that nothing has been overlooked. In this vein, even though the two large mining companies had an established governance model, the 131 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 remaining 5 firms did not have a specific governance model; although they emphasized that governance was part and parcel of their regulatory, administrative and financial frameworks. Industry characteristics may be a driver in the formalization of the mining industry‘s governance system with risk management being so important alongside stakeholder and environmental concerns which are often played out in the media. Mining companies are well aware of the risks associated with not being proactive in this area, and simply responding to concerns as they arise is fraught with danger. In summary, although the respondents were clear that Australian governance was more principles than rules-based, findings confirm that the businesses are unclear about the connotation and scope of governance agenda. Whilst some were of the opinion that the Australian governance system was ‗quite narrow‟ (Superannuation Fund), others felt that ‗it probably leads the world‟ (Mining Company B). The remark of one respondent echoes the general perception of current governance systems. I mean, it depends on what you are talking about with governance. Are you talking about the ASX corporate governance council stuff? Are you talking about the fears? Are you talking about social perceptions of companies? It really is a difficult thing to ask (Brewery A2). These remarks highlight the fact that firms are clearly missing an holistic viewpoint of governance, thereby pointing to the relevance and timeliness of this paper. The flexibility accorded by the principlesbased approach whilst often lauded by firms, also means that firms need to go through a trial-and-error process until they identify a system that is right for them. Based on the data, at this stage the firms, bar those operating in the mining industry, are unsure about the need for a governance system that is greater than that prescribed as a minimum by regulation and accounting controls and lack a pro-active response to heightened calls for an increasing emphasis on governance. The view of it being ‗narrow‘ for instance shows that firms are not looking for a wider stakeholder perspective of governance but focusing on regulation and accounting controls as the basis of their framework. Effectiveness In general, respondents were of the opinion that Australian governance processes and implementation are far better than in the USA, although they tended to believe that the regulation path of the USA was in response to the severe collapses that occurred and hence understandable. In discussing whether the rules-based approach will achieve the intended outcome one Consulting Firm observed, I doubt it. Cost benefit analysis suggests that the costs far outweigh the benefits of it. An American company will fail again and SOX is not a 132 guarantee that, that won‟t happen. An interesting point of debate will be what will happen when that company does fail and was it fully SOX compliant or was it not? Contrast that with the Australian system where I think there is only one mandatory requirement within the governance rules there and that‟s the composition of the audit committee for an ASX 300 listed entity. And beyond that, Australian companies are free to find their own solution… I think it is the more realistic approach. As I say, there is no silver bullet or no magic wand that will prevent failures happening. And I think the American approach is very much tick- the-box. I think the approach followed by the „comply or explain‟ countries is more realistic and more flexible for the different needs of different organizations, at different stages of their development‘ (Accounting & Consulting Firm). The flexibility of a principles-based approach means that it lends itself open to interpretations by the firms. This means that the implementation and outcomes can be extremely varied and problematic. This phenomenon is explained by the Accounting & Consulting Firm. Let me give you an example. The Remuneration principle is asking you to make sure that you have a remuneration strategy properly embodied through a committee. There is external benchmarking that would go on there. But there needs to be a clear link between reward and recognition. How that is transpired is that we now have remuneration reports within annual reports which run up to 10-12 pages, which at times you might need a degree in Quantum Mechanics to understand. The question is, are these reports adding any value? Is anyone reading the detail of them? Certainly executive pay is a hot topic. And people want to make sure that, especially if a company is struggling, that failure is not rewarded. But whether that translated to, as I say, a12 page remuneration report full of graphs and statistics than actual real models, I don‟t know. So, I would question whether that has been an effective interpretation of the principles. Respondents suggested that one way to ensure increased effectiveness was for the regulatory bodies to highlight lapses and present them for public discussion. For instance, notice this viewpoint, ASX may have rules but it waives it too easily or it does not actually follow up on them. …same with the likes of ASIC. But even if they do not take the punitive route, talking about it at least and highlighting these issues more will be an advantage (Superannuation Fund). Disclosure and Transparency In discussing the specifics of governance, disclosure was the primary factor discussed even though its influence was seen to be problematic. Disclosure has been highlighted in the previous section as being an important consideration in operationalising the Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Remuneration Principle and in bringing important issues to the notice of the public. Another firm highlighted the importance of disclosure and transparency in adapting their governance system for firm-specific factors. We looked at what other companies were doing… market leaders and other fast-movingconsumer-goods (FMCG) companies around disclosure, and …also how they were integrating those considerations into their enterprise management framework… And I think what we have ended up with … is the most relevant bits of that external experience and married it with our own sort of approach... We have not just cut and pasted it, we have grafted bits onto our own fundamental governance process…which is very much built around the board and the board committee and the enterprise risk framework…We haven‟t altered the fundamental structure but we have introduced some new agendas and some new criteria…(Brewery A1). But in the case of proactively providing greater transparency and disclosure, the findings reveal that even though there is a push from investors is not necessarily being picked up by firms. Whilst on one side, „investors are demanding higher standards both individually and institutionally‟ (Accounting & Consulting Firm), on the other side, the findings point to quite a bit of apathy. Respondents mentioned that there is not much incentive for firms to become more transparent and provide greater disclosures than what is mandated by law, as the customers and general public do not seem to be interested in knowing more about governance, nor do they want to actively participate in the running of the firm. As the Superannuation Fund states, None of our members except for one or two companies have any interest in how we vote. And therefore why am I incurring this additional cost if my members aren‟t actually interested… We have enough trouble getting them to look at their statements … I think that the vast majority of them quite frankly just have too many other things in their life. .. there is a whole group of people who probably don‟t even read the financial section in The Age (an Australian newspaper). ..As long as they are getting their dividends, the vast majority will probably be happy. .. but if they see something that is not specifically aimed at improving the profitability of their company in a specific visible sense than that‟s when you get people arching up against it. Notwithstanding this comment, there is a change that is occurring in this arena with more active participation in the horizon, as Australian shareholders realize that their voice matters. As Mining Company B observed, I think shareholder activism has definitely become a much bigger thing in this country. I mean more people own shares, it is just the bottom line. I think that the Australian Shareholders Association has done a lot. I think that people actually understand now that they can have a significant influence. And in regard to specific issues around disclosure of executive remuneration there is evidence of demands and impetus for action arising from the public due to media exposure on specific acts of companies. For instance, five out of the seven respondents mentioned that excessive compensation, remuneration and retirement payouts were one area where the public outcry was greatest, and that it was invariably a result of the media coverage and information dissemination. And in this area the comment presented earlier of the 12 page Remuneration Report highlights the problematic nature of disclosure in this area. The investors and public appear to be reactive, rather than proactive, with quite a narrow focus. Their activism is limited to issues after their occurrence and after they have been highlighted, rather then exhibiting voice in influencing aspects of governance that effect business value and then through that the remuneration of executives. Holistic Nature of Governance These views are in line with other comments in this paper that urge the regulators and experts to discuss governance issues in the public forum or through the media to educate the general public and increase their awareness. Findings reveal that governance should be viewed in a more holistic perspective reflecting a multitude of firm-specific factors and not just simply as a regulations/ principles conundrum. For instance, interviewees believed that it is leadership that drives the corporate responsibility agenda top-down, and that organisational culture, strategy and committee structures are important in achieving this. As the Superannuation Fund observed, If the CEO and the directors don‟t believe in the environment‟s importance then why would you expect them to say to their staff it is important. Sustainable Development (SD) was driven by the chairman. It would not work unless it was driven from the top. And now I guess as the SD committee is responsible, it is almost like part of the business. We have the committee up the top to continue to drive it. But, you really needed that person, that character to drive it (governance)…You needed that top level commitment‟ (Mining Company B). The governance systems and processes should also align with the culture of the firm. Respondents‘ remarks on the above themes are detailed below. I defy anyone to put in any set of rules that would have stopped those idiots… Basically the fault of HIH was that they had a board of dorks… and no amount of corporate governance rules, regulations, reporting, no amount of checks and balances you could have put over the top to avoid those problems. Those people and (their) organisation culture (mattered) (Brewery A2). 133 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 The ethical stance and moral codes of conduct of individuals, especially top management are also important in this regard. If you have got the right sort of people in the place you are not going to have a problem. If they have the right moral fibre, you are just not going to have a problem (Brewery A2). I mean like the HIH. All that behavior was already illegal. It was already outside the rules of listed companies and good disclosure and ethical business management practices. It is not as if that was perfectly acceptable behavior and attitudes have moved on. The fact is the rules were there but they weren‟t being followed (Brewery A1). Governance systems need to be customized to the firm, taking into consideration factors such as firm size. Whilst large firms find that instituting the governance systems is worth the effort, small firms perceive it as a burden. For example, an executive from Mining Company B, a large Australian firm with global operations, remarked: I think from our perspective (we are) a big company. It (our firm) has been able to do those things without any problems. I think that for smaller companies, I would have found it difficult. People have struggled. And another consideration spoke of was the importance of board structures in implementing effective governance. There is still the vast majority of companies that have flawed board structures, in particular. And I think if you have a flawed board structure it is unlikely the best things are going to flow through. You are unlikely to have best practice governance deeper within the business (Superannuation Fund). This section highlights the broad nature of characteristics that practitioners believe effect and influence the governance framework. Best practice governance needs to expand from an either/or ‗regulation-only‘ approach or a ‗principles-only‘ approach, and incorporate behaviours, values and ethics. Key drivers of Australian governance systems Governance systems are not static and their fluidity is influenced by many factors in the environment. Firstly, from a control perspective, the new corporations law (CLERP 9) is clearly an impetus for change and has put greater liability on companies and greater focus on governance. As Mining Company A states there is ‗liability for directors, for our board to be liable for not implementing the policies that the companies espouse‘. Secondly, moving away from compliance, broadening the perspective from the shareholder primacy to a stakeholder view of the firm has been an important recent development. This is considered to be a „relatively embryonic driver‟ (Superannuation Fund) and as the respondent explains, there appears to 134 be an active approach by firms to communicate such a perspective to other firms they deal with, ‗to get them to realize that there is a broader issue rather than just the shareholders‟ (Superannuation Fund). But, the interesting point to note is that this issue isn‟t actually driven by any moral or ethical type guidelines, but it is because the landscape has actually changed in that companies can no longer act solely for their shareholders with complete disregard for other stakeholders because of what we now term the social license… If they actually undertake activities which endanger that social license then it actually creates quite a real risk to their business (Superannuation Fund). Thirdly, firms are being held accountable for putting rhetoric into practice. As Mining Company A mentions, there is a „reputational driver in terms of whether or not the policies that we talk about are actually being implemented and are we improving our performance‟. This driver is the cause for sustainability reporting according to this firm. Another advantage of this reputational driver lies in the outcomes, such as being regarded as an employer of choice and from being recognized as a leader in their sector. As Mining Company A explains further, it will give us access to land for us to develop mines on, to people who might want to work for the company who actually understands about environmental degradation and is doing something about it, or understands about how to minimize climate change impact, or understand about water use. The young people today want to work with companies who actually are doing what they say and are contributing more broadly to society, in fact contributing to society‟s transformation to sustainable development. I think one thing is that we are an Australian icon therefore you know that makes a big difference. We are very conscious of the fact that we are watched and that we are to lead, and that people will follow or criticize. The size of a company and who you are makes a very, very big difference (Mining Company B) If this firm is regarded as a responsible water manager we will be invited in because we might have some solutions to contribute … For any new strategies, they are not about doing good in the world they are about business driver. Certainly there is the quid pro quo, by doing your business well and being a responsible water manager. That is the benefit to the environment. But the actual real purpose of it is access to water for this firm. These expectations on business are a big driver (Mining Company A). This emerging public pressure is evident as ‗investors demand higher standards both individually and institutionally‘ (Accounting & Consulting Firm, Brewery A1 and Brewery A2). But, it is as yet unclear as to the whether their demands will metamorphose into action on the part of both companies and investors. As Brewery A1 mentioned, Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 there is a large disconnect in terms of what people say they are interested in and what their behaviour indicates that they‟re interested in…whether or not they are genuine reflections of genuine interest, it‟s a bit hard for me to say. I have a strong sense, that there is a reasonable dose of fashion on the CSR side. Even though firms appear to be in the process of assessing what actions are considered socially responsible, there is a lack of consensus on what is socially acceptable. I think there is a risk that we will be saying a company should be doing one thing and the retail investor will be saying another…So, the hard part for any company, and anyone else trying to factor that in, is what is now socially acceptable and what will evolve and not be. That‟s the key issue. Something might be legal here in Australia but will there be other pressures which stop it being a sustainable business structure…it is all about assessing risk and factoring it into your company, rather than saying this is right and this is wrong, and if it is wrong you just don‟t touch it (Superannuation Fund). Fourthly, the normal evolution of firms and the growth and maturity of societies and economies they operate in push changes in governance. As one respondent mentioned while discussing governance drivers, I think it‟s the normal evolution of corporations and the corporate structure. And I say that because if you go back to the start of the last century and companies and company meetings, board meeting and relations between senior members and junior management and the workers are formal and very structured. As the century wore on… and as… we are now much more informal, no less structured in a way. And governance is just part of the same. It‟s the way corporations and societies develop over time (Brewery A1). The company has grown up and realized that there is a need for checks and balances (Brewery A2). Interesting, the well publicized corporate collapses did not get mentioned as key drivers, to the extent expected. There were a couple of responses to the effect that, „I think there is a combination… I suppose of domestic and international collapses‟ (Australian Government Business Enterprise). But in general, the view is summed up by one respondent, „I think the (international) influence has actually been pretty low, pretty light‟ (Superannuation Fund). In summary, a range of drivers are pushing the evolution of governance systems. As one respondent stated, it comes from governments, it comes from shareholders, it comes from the initiative of a country, it came out of HIH. I think we are very much part of the global economy and the Enrons and things like that. That being said it is quite different in America to the way it is in Australia but I certainly think it was pushed more by accountability. About, you know, boards having to be accountable to their shareholders... (Mining Company B). It is interesting to note the range of factors influencing governance and that the changes are not a simplistic and reactive approach to company collapses. Implications and Conclusion An important implication is the need for organizations to operate from a holistic perspective on corporate governance, moving beyond the tick box mentality to analyzing key drivers and variables that are key to governance effectiveness in their own contexts. As Letza et al. (2008) argue, corporate governance is a social, processual and relatively enduring reality driven by both internal impetuses and external environmental dynamics, rather than a pure economic or fixed reality, and hence cannot be studied in isolation from non-economic factors such as power, legislation, culture, social relations and institutional contexts. This paper illustrates this crucial perspective in several instances, with interviewees talking of the importance of taking into account factors such as the organization type and stage of development, ethics, reputation, and the media and public in developing their own governance framework. Young and Thyil (2008:102) have elaborated on this holistic perspective of governance and argued that a multidimensional approach is required that extends the analysis from a prescriptive regulatory approach that limits actions, to one that is more descriptive and provides an explanation of why actions occur and decisions are made. They argue that an emphasis on control and regulation will not stop governance failures if not set within a governance framework that encapsulates regulation, labour product and capital markets, and behavioural, cultural and ethical considerations. The next important implication is the evolving nature of governance and need for customization by the firms. It is important that firms understand their environment, both internal and external, and map the implications of environmental change on their governance frameworks. As emphasized clearly in the ASX corporate governance principles and recommendations (2007:3), „corporate governance practices evolve in the light of the changing circumstances of a company and must be tailored to meet those circumstances‟. It is evident from these interviews that the mining companies understand the implications of their environment and the increasing importance of corporate social responsibility on risk and reputation and embed these considerations in their governance frameworks. In this vein, the findings highlight the debate around the importance and effect of CSR and sustainability as a driver of governance, and raises questions about the level and practicability of incorporating CSR into the principles-based approach 135 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 to governance. We have seen principles formed around the stakeholder perspective in governance codes in UK and Australia, but operationalising them and integrating into the governance framework and the firm‘s strategy and operations still is problematic. Whilst Waring (2008) argues for the stakeholder approach to be given more weight through regulation and incorporation into directors‘ duties such an approach is not supported by the interviewees in this research. Another important conclusion that emerged from this study is that the principles-based approach is clearly favoured in Australia over the rules-based approach. As Solomon (2007:169) argues in talking about the UK principles-based approach: ―there is a persisting belief that genuine changes in corporate ethicality and attitude can only be achieved through a voluntary framework, which allows individuals to think about issues at hand‖. Interviewees were clear in not wanting further regulation over and above that required in areas of financial and auditing controls. But the interview data lacks conclusive evidence of the causal chain between principles and effectiveness possibly due to the small sample or due to a lack of knowledge or understanding on the part of the interviewees. More research with a larger sample is required to understand the right mix of rules and principles and whether principles could be broadened to include more direction on behaviors, culture, leadership, values and ethics. In driving governance from the top and integrating it with the company‘s culture, governance practices would prove to be more robust. Here leadership styles and role modeling of behaviour are considerations raised in the interviews as important in operationalising and embedding governance practices. Moreover in considering the link that interviewees discussed between board structural models and ethical behaviour it is worth noting the lack of best-practice models in the Australian principles-based approach. Furthermore the position of ASX and ASIC are found to be confusing in their roles as both guiders and monitors. In Australia the Corporations Act focuses on compliance and rules (albeit not as wide reaching as SOX 2002) whereas the role of other bodies is problematic. And when debate occurs in the media and business circles on the topic of strengthening ASX and ASIC‘s monitoring activities, it always reverts to a discussion of whether more rules are actually required. This paper has highlighted the very narrow view of governance held by the general public with their focus on excessive compensation, unreasonable remuneration and unethical behaviour. Furthermore, expansion of the public‘s knowledge of governance is limited by the information asymmetry between those within the organisation and the public who rely principally on the media as their information source. This phenomenon is not limited to Australia and can be observed in many other countries. More guidance on disclosure is worth considering as a way to inform 136 the public, in particular shareholders, to enhance their involvement before catastrophic and noteworthy events occur. Other questions then arise such as who should take responsibility for accurate and relevant disclosures? Benston, Bromwich and Wagenhofer (2006) observed that when an accounting principle requires judgment and interpretation the implementation will vary, hence it is difficult to state it as a standard. The authors similarly recommended that firms be provided with more guidance and concluded that the ‗optimal standards‘ are somewhere in the continuum between ‗principles-only‘ and ‗rules-only‘, and thus not an ‗either-or‘ approach. Moreover, Eccles et al. (2001, cf. Boesso and Kumar, 2007) observed that a company with an effective corporate governance system would, by providing access to relevant and high quality information, make an effort to invite new forms of stakeholder engagement. Boesso, G., and Kumar, K (2007) further argued that whilst investors' information needs, which were based on business complexity, appeared to affect the volume of voluntary disclosures across country contexts, they did not appear to affect the quality of disclosures. Thus the onus appears to be squarely on the company to not only provide timely disclosures but also to increase the quality and range of disclosure. Taking responsibility themselves at the company level for the quality and relevance of disclosure is likely to quieten the call for greater regulation. If we are not to proceed along the path of more regulation then, in discovering what leads to best practice in a principles-based approach, research is warranted on the effects of the drivers, including shareholder voice and public perception, on the evolution and effectiveness of corporate governance systems. Also a greater understanding is needed of the effects of top management styles and organizational culture on in-firm governance practices, as well as best-practice board structures and its impact on board and management behaviour. In addition, company disclosure and its relationship to governance effectiveness and stakeholder engagement is an important area of further study. In conclusion the debate needs to move beyond the principles versus rules approach to look at how firms can be provided with more guidance in operationalising some of the principles that appear to be key to governance effectiveness. References 1. 2. 3. Australian Stock Exchange (ASX), 2007, Corporate Governance Principles and Recommendations, 2nd edn., ASX Corporate Governance Council, Australia Bertus, M., Jahera Jr. J.S. and Yost, K., (forthcoming) ‗Sarbanes-Oxley, Corporate Governance and Strategic Dividend Decisions‘, Corporate Ownership and Control. Benston, G.J., Bromwich, M., and Wagenhofer, A., 2006, ‗Principles- Versus Rules-Based Accounting Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. Standards: The FASB‘s Standard Setting Strategy‘, ABACUS, Vol. 42, No. 2, pp. 165-188 Boesso, G., and Kumar, K., 2007, ‗Drivers of Corporate Voluntary Disclosure: A Framework and Empirical Evidence from Italy and the United States, Accounting, Auditing & Accountability Journal, Vol. 20, No. 2, pp. 269-296 Bufffini, F., 2002, ‗Accounting Loophole on Options Ends‘, The Australian Financial Review, No. 7, November, p. 5 Clarke, T., 2007, International Corporate Governance: A Comparative Approach, Routledge, Oxon Dallas, G., 2004, Governance and Risk: An Analytical Handbook for Investors, Managers, Directors & Stakeholders, Mc Graw Hill, USA Digman, A. and Galanis, M., 2004, ‗Governing the World: The Development of the OECD‘s Corporate Governance Principles‘, European Business Law Review, 10(9/10), pp. 396-407 Du Plessis, J., McConvill, J. and Bagaric, M., 2005, Principles of Contemporary Corporate Governance, Cambridge, Australia Eccles, R.G., Herz, R.H., Keegan, E.M. and Philips, D.M.H, 2001, The Value Reporting Revolution, Price Waterhouse Coopers, New York, NY Easterbrook, F., 1996, ‗International Corporate Differences: Markets or Law?‘ in D. Chew & S. Gillan (eds.) Corporate Governance at the Crossroads: A Book of Readings, Mc Graw Hill/Irwin New York, pp. 64-70 Eisenhardt, K.M., 1989, ‗Agency Theory: An Assessment and Review‘, Academy of Management Review, Vol.14, no.1, pp.57-74. Fama, E. and Jensen, M., 1983, ‗Separation of Ownership and Control‘, Journal of Law and Economics, No.26, pp.301-25. Holstrom, B. and Kaplan, S., 2005, ‗The State of U.S. Corporate Governance: What‘s Right and What‘s Wrong?‘ in D. Chew & S. Gillan (eds.) Corporate 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. Governance at the Crossroads: A Book of Readings, Mc Graw Hill/Irwin New York, pp. 71-83 Letza, S., Kirkbride, J., Sun, X., and Smallman, C., 2008, ‗Corporate Governance Theorising: Limits, Critics and Alternatives‘, International Journal of Law and Management, Vol. 50, No. 1, pp. 17-32 Mayer. C., 2000, ‗Corporate Governance in the UK‘, Hume Papers on Public Policy, Vol. 8, No. 1, pp. 54– 69 Patton, M. Q., 1990, Qualitative Evaluation and Research Methods, Sage, Newbury Park, CA. Robins F., 2006, ‗Corporate Governance after Sarbanes-Oxley: An Australian Perspective‘, Corporate Governance, Vol. 6, no. 1, pp. 34-48 Solomon, J., 2007, Corporate Governance and Accountability, 2nd. Edn., John Wiley and Sons, England Samuel, G. 2003, ‗Ticking Boxes is not Good Governance‘, The Australian Financial Review, No. 21, May, p. 63 Schmidt, L., 2003, ‗Business as Usual‘, Business Review Weekly, no. 10, April, p. 18 Thomsen, S., 2008, An Introduction to Corporate Governance: Mechanisms and Systems, DJOF Publishing, Copenhagen Volcker, P., 2002, ‗A Litmus Test for Accounting Reform‘, The Asian Wall Street Journal, No. 22, May, p. A11 Waring, P., 2008, ‗Rethinking Directors' Duties in Changing Global Markets‘, Corporate Governance, Vol. 8, Iss. 2, pp.153-164 Young, S. & Thyil, V., 2007, ‗Employees as a Component of Governance Models: Divergence between Rhetoric, Systems and Practice‘, Proceedings of AIRAANZ Conference 2007 Diverging Employment Relations Patterns in Australia and New Zealand, February, Auckland, CD. Young, S. & Thyil, V., 2008, ‗A Holistic Model of Corporate Governance – A New Research Framework‘, Corporate Governance, Issue 8, No. 1, pp. 94-108. Appendix A. Interview schedule 1) 2) 3) 4) 5) 6) 7) 8) 9) How would you describe the Australian corporate governance system? What are the factors driving the evolution of corporate governance in Australia? What corporate governance models have been useful for you in your organization? To what extent have existing corporate governance structures concerning listed companies in Australia been found to be ineffective? On what grounds? How has the Australian governance system been influenced by the international environment? What is the level of public awareness over the importance of effective corporate governance? What are the major concerns among the public regarding corporate governance issues? Can you describe the factors that have impacted on your organizational corporate governance system? Can you describe the evolution of governance in your organization? 137 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 THE IMPACT OF CORPORATE GOVERNANCE LEGISLATION ON THE MARKET FOR CORPORATE OWNERSHIP Joseph Canada*, Tanya Benford**, Vicky Arnold***, Steve G. Sutton**** Abstract Over the past few years, the number of corporate scandals and failures throughout the world has escalated, prompting new legislation designed to enhance corporate governance. While the efforts to legislate corporate governance policies are designed to protect the public interest, they have altered the relationship between shareholders and management (Canada et al. 2008). Rather than be subjected to new corporate governance requirements, many companies have indicated an interest in not being traded on the various stock exchanges and have chosen to alter their corporate structure. The purpose of this study is to examine how a company‟s decision to shift corporate ownership and/or corporate control in the face of new corporate governance legislation and regulatory requirements can alter the traditional markets for ownership and control. In order to examine this issue, the paper first develops a typology for predicting the type of organizational restructuring that might occur. This typology incorporates factors from prior research and disentangles the market for ownership from the market for corporate control. The typology is then used as a basis for an in-depth examination of an organization whose corporate structure changed in response to mandated changes in corporate governance. The results provide evidence that corporate governance legislation can potentially induce incumbent management to voluntarily compete in the market for ownership, notwithstanding the associated exposure in the market for managerial control. Keywords: corporate governance, legislation, corporate ownership *University of Central Florida **University of Central Florida ***University of Central Florida and The University of Melbourne ****University of Central Florida and The University of Melbourne Introduction In the face of growing corporate scandals and corporate failures on a global basis, governments and regulatory bodies are increasingly weighing corporate governance legislation and other regulatory standards to help alleviate similar problems in the future. For instance, in the United States (U.S.) the failures of Enron and WorldCom fueled new corporate governance requirements under the mandates of the Sarbanes-Oxley Act of 2002 (SOX). In Australia, similar failures like HIH and OneTel led to the passage of Corporate Law Economic Reform Program, review number 9 (CLERP 9) with its new corporate governance requirements. In Europe, a similar reaction evolved from the European Union in the face of the Parmalat and Cirio scandals with a number of regulations and directives—most notably the Transparency Directive, the Market Abuse Directive, and the Prospectus Directive (Ivaschenko and Brooks 2008). All of these efforts to legislate corporate governance policies made under the auspices of the public interest have altered the relationship between shareholders and management (Canada et al. 2008). In 138 many cases, the regulations have altered firm‘s business models; and, particularly in the U.S., there have been concerns raised regarding the impact of SOX mandates on global competitiveness (Arnold et al. 2007; Katz 2006; Reason 2006). A number of companies have indicated an interest in not being traded on the various stock exchanges rather than be subjected to the corporate governance requirements articulated under this new legislation. Research confirms the presence of a number of related concerns that appear to have led to a significant increase in delisting activity on U.S. exchanges (Graham et al 2005; Leuz et al. 2008). The evidence suggests that new corporate governance regulation is altering company ownership decisions. The purpose of this study is to examine how a company‘s decision to shift corporate ownership and/or corporate control in the face of new corporate governance legislation and regulatory requirements can alter the traditional markets for ownership and control. The research reported in this study focuses on the SOX legislation in the U.S. and its impact on corporate ownership and corporate control. Within the U.S. stock exchange environment, publicly traded firms wishing to delist their stock can Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 either go-dark or go-private. Firms that go-dark can continue to trade in over-the-counter markets, but to qualify, they must (1) have less than 300 shareholders at the current time, or (2) have had less than 500 shareholders and less than $10 million in assets for each of the prior three years. Firms that meet either of these criteria can delist without changing their current ownership, management team, or corporate governance structure. However, for larger firms, going-dark is not an option; these firms must goprivate if they wish to delist, meaning the company‘s shareholders forego their ownership interest in a broad sale of ownership to a private individual or a private group of owners. Much of the prior research that has examined factors impacting public to private transactions (PTP) as well as more general corporate ownership change transactions employs a market for corporate control perspective, where management teams compete to gain managerial control of a firm (Fama 1980; Jensen and Ruback 1983; Robbie and Wright 1995; Weir et al. 2005; Leuz 2008). The market for corporate control incents incumbent management to maximize shareholder value as a means of securing their (incumbent managers) control rights and serves as an external corporate governance disciplinary mechanism for poorly performing management or self interested management (Walsh and Kosnik, 1993). However, the market for corporate control models prevalent in the extant literature do not explicitly distinguish between competition for ownership and competition for managerial control. For example, management buy-out decisions (competition for ownership) are viewed as a defensive measure to forestall hostile takeovers (i.e. competition for managerial control) (Jensen and Ruback 1983). However, not all management buy-out decisions are a function of competition for managerial control as some may be in response to new corporate governance regulations; thus corporate governance regulation arguably influences ownership transfer decisions. Analysis of the impact of new corporate governance regulations necessitates adopting a broader view that considers the interplay between the market for managerial control (where incumbent and potential management teams compete for managerial control) and the market for ownership (where incumbent and potential owners compete for ownership rights). The theoretical contribution of this paper lies in distinguishing a market for ownership and its impact on the market for managerial control. By disentangling the market for ownership from the market for corporate control (i.e. separately considering the market for ownership and the market for managerial control), we provide a general typology for predicting the type of organizational restructuring. This typology incorporates the differential impact of various factors that prior research has shown to impact these markets. Using an in-depth case study, we explore how SOX has changed the competitive landscape within the market for ownership. The results provide evidence that SOX can potentially induce incumbent management to voluntarily compete in the market for ownership, notwithstanding the associated exposure in the market for managerial control. The remainder of this paper is presented as follows. The following section reviews prior research that informs the markets for managerial control and ownership, as well as provides the theoretical development for the overall research typology. The third section reports the findings of the case study within the framing of the research typology. The fourth and final section summarizes the findings and discusses the implications for future research. Literature Review Corporate governance structures are presumably designed to align managerial interests with those of the owners through corporate control (Jensen and Meckling, 1976; Fama and Jensen, 1983). These governance structures may be either internal (i.e. composition of the board of directors, type of ownership and incentives) or external (i.e. the market for corporate governance). However, just as there is a market for managerial control, there is also a market for ownership (e.g. initial public offerings (IPOs), management buy-outs, management buy-ins) (Robbie and Wright 1995). The interaction between the market for corporate ownership and the market for managerial control dictates the degree of organizational restructuring that occurs with shifts in either control or ownership (Figure 1). [Insert Figure 1 about here] The Market for Managerial Control The market for managerial control is often described as the market where management teams compete for control of firm resources (Jensen and Ruback, 1983). The managerial competition model shown in Figure 1 suggests that the more competitive the market for managerial control the more likely a change in management will occur. For example, owners will consider alternative management teams more attractive when current management is underperforming or acting too self-interested (i.e. a mis-alignment between management and owners as depicted in Figure 2). This same rationale has been used by corporate raiders as a justification for hostile takeovers (Walsh and Kosnik 1993). Hostile takeovers involve unwanted changes in ownership; however, the market for managerial control does not require a change in ownership to achieve a change in management, as current owners may replace incumbent managers just as easily as new owners. When the market for managerial control is less competitive due to barriers to entry (e.g. substantial managerial ownership), effecting management change becomes more difficult. 139 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 [Insert Figure 2 about here] The Market for Ownership Just as owners can shop for new management, management can shop for new owners. The more competitive the market for ownership the more likely such a change in ownership will occur. For example, large blocks of family stock ownership weaken the market and make ownership change less likely, while large blocks of institutional stock ownership make the market more competitive and ownership change more likely. This relationship is depicted in Figure 2. A change in ownership is generally effected in one of three ways, incumbent management purchases the firm (management buy-out), a new management team purchases the firm (management buy-in) through a hostile take-over, or a synergistic merger occurs where the acquiring firm retains incumbent management (Robbie and Wright 1995; Jensen and Ruback, 1983; Walsh and Kosnik 1993; Weir 1997). Management buy-outs represent an effort on the part of incumbent management to use ownership as a means of neutralizing competition in the market for managerial control (Weir et al, 2005, Jensen and Ruback, 1983). Management buy-outs are not always easily accomplished, though, as announcements of management‘s intention to take a company private may trigger competing bids from outside interests. Announcements of potential management buy-ins or synergistic mergers may similarly trigger competing bids. Thus any signaling of an increase in the market for ownership can escalate competition in the market managerial control through an increased pool of prospective owners (Weir et al. 2005; Schwert 2000). To broaden the understanding of the interaction between the markets for managerial control and ownership, it is necessary to consider factors that can impact the relative competitive strength of these markets. Extant research suggests that company performance, owner/management misalignment, ownership structure, board independence, free cashflow, and growth potential are factors that differentially affect the markets for managerial control and ownership (Jensen and Ruback, 1983; Weir et al, 2005). Using two lenses, the market for managerial control and the market for ownership, can broaden the understanding of how these various factors impact takeovers, buyouts, public to private transactions, and other forms of organizational restructuring. Company Performance The market for managerial control plays a role in the disciplining of poor managers (Walsh and Kosnik, 1993). Poor performance weakens management‘s position in the market for control as well as the shareholders‘ position in the market for ownership. The impact of performance on the market for managerial control is easily established. Poor performance conflicts with the maximization of shareholder wealth and provides owners with a significant motive to find new management. Conversely, strong performance incents current 140 owners as well as any potential new owners to retain the skills and expertise of the incumbent management team, thus, weakening competition in the market for managerial control (shown in Figure 2). Company performance and stock price are closely correlated. Poor performance reduces both the stock price and the cost of taking over ownership of the firm, while also reducing the wealth of the existing owner and their ability to fend off hostile bids. As prices reflect poor performance and potential owners believe performance can improve, the firm becomes attractive, which increases competition in the market for ownership. Strong performance, on the other hand, weakens competition in the market for ownership as stock prices reflect firm value. Owner/Manager Misalignment As shown in Figure 2, misalignment between managers and owners increases competition for both managerial control and ownership. When conflicts of interest become apparent, owners look for new managers while management may seek new owners. This type of misalignment often leads to a change in management, ownership, or both. Examples can be found in Bruining et al (2004), where strategic disagreements between a parent company and its subsidiary led to a management buyout, and in Virany and Tushman (1986), where the owners desiring new strategies brought in new top management to provide that new strategy. Strategic disagreements create competition in both the managerial control and ownership markets. Ownership Structure Large blocks of ownership improve the market position of the owners who possess them. With Family Ownership, large blocks of family ownership will increase owners‘ ability to oppose acquisition attempts; and, the commensurate desire by such owners to retain control of a family business can further tighten control and fend off ownership competitors. Thus, family ownership of large blocks of stock is inversely related to competition in the market for ownership (Figure 2), which is consistent with Davis and Stout‘s (1992) finding that family ownership is inversely related to acquisition. As shown in Figure 2, with Managerial Ownership, large blocks of managerial owned stock improves the position of managing owners while weakening the position of outside owners in the market for ownership. Accordingly, inside ownership can escalate the competition for ownership by increasing the probability of management buyouts (Weir et al, 2005). Inside ownership also improves management‘s position in the market for managerial control reducing the risk that owners will make decisions that are deleterious to management. With Institutional Ownership, institutional owners invariably choose the highest offer; and, abnormal returns are consistently associated with acquisitions and mergers (Jensen and Ruback, 1983). Accordingly, large blocks of institutional ownership are associated with a higher probability of acquisition Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 (Shivdasani, 1993), thereby escalating competition within the market for ownership. Board Independence The primary purpose of the board of directors is to align the performance of senior management with owners‘ interests (Fama, 1980). Independent directors reduce information asymmetry and improve the position of outside owners, while boards that are controlled by insiders are far more likely to serve the interests of management as opposed to shareholders. Independent board chairs and directors are also found to decrease hostile takeovers and management buyouts (Weir 1997; Luez et al., 2008). Thus, independent directors reduce competition within the market for ownership, while simultaneously escalating competition within the market for managerial control, also shown in Figure 2. Growth Potential The literature has consistently found that growth potential is inversely related to changes in ownership (Weir et al, 2005; Coles, 2008; Luez, 2008), suggesting that poor growth potential increases the competition in the market for ownership. Why would owners compete to buy a firm with low growth or future prospects? Weir et al. (2005) explains that Tobin‘s Q (their proxy for growth potential) represents the growth potential as perceived by the market and Luez et al. (2008) proxies for growth potential with past asset growth. This is where the growth paradox takes hold. These proxies are strong indicators of the growth potential perceived by the market, but neither of these proxies represents the growth potential as perceived by the buyer. If potential buyers believe that the market is undervaluing a firm‘s growth potential, the result is the creation of a desirable buy situation and explains the association between low growth variables and ownership changes. As shown in Figure 2, growth potential also indirectly impacts the market for managerial control through the market for ownership. Market perceptions of weak growth potential escalate competition in the market for managerial control as new owners will likely replace incumbent management in an effort to realize the firm‘s growth potential. Free Cash Flows Free cash flows153 signal a misalignment between owners and managers interests (Jensen, 1986). Owners would normally prefer that excess cash flows be redistributed to owners in the form of dividends. Managers, on the other hand, have incentives to invest in expansion projects (even at unfavorable discount rates since top management pay usually increases with sales growth (Murphy, 1985)). Thus free cash flows signal a misalignment between owners and management interests which can escalate competition 153 Jensen (1986) defines free cash flows as those in excess of the cash needed to fund all projects with positive net present value when discounted at the relevant cost of capital. in the market for managerial control (shown in Figure 2). Jensen (1986) argues that managers of firms with free cash flow will use it as a hedge against hostile takeovers. To avoid a hostile takeover, management may use free cash flows to pay dividends, thereby reducing the misalignment between owners and management interests, or they may use free cash flows to facilitate a management buy-out (Lehn and Poulsen, 1989). If management announces their intent to take the firm private, there are typically counter bids by other interested purchasers, which then escalates competition in the market for ownership (Weir et al. 2005). There is also anecdotal evidence that managers with inside information on the true value of the firm participate in these leveraged buyouts at seemingly high premiums, only to quickly increase the firm‘s value beyond that of the buyout premium (Bruining et al. 2004; Lehn and Poulsen 1989). Corporate Governance Regulation and the Market for Ownership Evidence regarding the impact of SOX on ownership is paradoxical. On the one hand, corporate concerns regarding the cost of SOX compliance and its impact on global competiveness are well documented (Arnold et al. 2007; Katz 2006; Reason 2006; Graham et al. 2005). Consistent with these concerns is evidence suggesting SOX may have caused increased corporate deregistrations (Marosi and Massoud 2007; Leuz et al. 2008) which in turn supports theory that corporate governance regulation can change ownership decisions as shown in Figure 2. However, there is also evidence that foreign firms that cross list on U.S. exchanges (voluntarily incurring SOX related costs) increase firm value (Doidge et al., 2004; Karolyi 2006). Thus, if global competiveness is a concern for U.S. firms, why would foreign firms voluntarily cross list on U.S. exchanges? Arnold et al. (2007) find evidence that SOX can negatively impact an organization‘s supply chain response time. For firms who primarily compete with other domestic U.S. firms, the increased response time should not change the firm‘s competitive position (i.e. supply chain response time increases across all firms and all supply chains). However, for firms whose major competitors are not subject to the same corporate governance regulation (i.e. in the case of SOX, firms not listed on U.S. exchanges), increased response time can degrade the U.S. listed firm‘s financial performance. When there is a gap between a firm‘s actual financial performance and their potential financial performance (e.g. supply chain performance absent SOX), there is an increased likelihood of a change in ownership (i.e. escalating competition in the market for ownership). Analysis of Competing Market Forces This study employed a case methodology to investigate contextual factors that may induce incumbent management to voluntarily compete in the 141 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 markets for ownership and managerial control. The organizational restructuring typology presented in the prior section was used to inform the data collection and analysis of case data. This study used a combination of publicly available data and semistructured interviews. Interviews were conducted with a member of senior management and an independent director. Overview Smith Company154 was a medium-sized company in an industry where supply chain performance had a direct and significant impact on financial performance. Smith Company was an accelerated filer and, like most companies facing the new corporate government regulations, incurred substantial SOX related start up costs. Smith Company‘s founder was the CEO, chairman of the board of directors, and the single largest shareholder (approximately 20%). During the 1st quarter in the year of the buyout, the CEO proposed a leveraged buy-out of Smith Company, advising the board of directors that he felt SOX compliance was too costly. The board formed a special committee to review the offer and the special committee proceeded to hire an investment banking firm to both review the current offer and to solicit additional offers. Although the initial offer fell apart and was replaced with a management buy-out offer, Smith Company was ultimately sold to the highest bidder, a private equity firm. Case Results The following analysis systematically considers each of the factors in the developed typology for analysis with the intent of understanding the predictive ability of each factor on the markets for managerial control and ownership for Smith Company during the time period immediately following the painful corporate governance regulatory compliance process. Each market is analyzed in isolation and then applied in concert to derive expected outcomes (type of restructuring). Finally, the predicted outcome and actual outcome are compared and analyzed in detail. Free Cash Flows and the Market for Ownership As noted earlier, free cash flows represent cash that should be distributed to shareholders, but is retained by management and invested in unprofitable projects. Jensen (1986) explains that free cash flows arise when firms reach their optimal size; however, Smith was forced to outsource some of its business due to a lack of resources. Furthermore, using the Weir et al (2005) formula for free cash flows, Smith‘s percentage of free cash flows is 1.0%, which is below the 4.56% mean of Weir‘s non-acquired sample. Although Smith improved its cash position three consecutive years, no dividends were distributed and neither the interviews nor the publicly available data hinted that 154 We use Smith Company to refer to our case study company in order to protect the identity of the individuals and organization that voluntarily participated in the study. Anonymity is required under institutional review board agreements in regard to the participating human subjects. 142 shareholders were unhappy with the investment of cash. This suggests that free cash flows did not impact Smith‘s market for ownership.. Ownership Structure and the Market for Ownership Large blocks of institutional ownership are often directly associated with acquisitions, but in the case of Smith Company there were not any institutional investors who owned large blocks of shares. In fact, the CEO owned the largest number of shares— increasing the probability of a management buyout. Smith‘s CEO is also the founder, distinguishing Smith Company as a family owned business. Prior research generally finds that family owned businesses are less likely to sell. The lack of large blocks of institutional ownership combined with substantial managerial/family ownership provides the CEO/founder a distinct advantage in the market for ownership (i.e. reducing competition). Owner/Manager Mis-alignment and the Market for Ownership Smith Company displayed no signs of owner/manager misalignment prior to entering the bidding process. The initial offer by the CEO followed a lackluster quarter in which the stock price dropped dramatically. An analyst following the company estimated the initial offer was undervalued approximately 25%. The initial offer was later withdrawn when financing fell apart and it was replaced with a management buy-out offer that was 5% higher than the initial offer but less than a competing offer acquired from a private equity firm. The board accepted the management buyout offer, but an institutional shareholder and the private equity firm sued Smith Company for ignoring the better offer. The private equity firm won the suit and acquired Smith Company after several additional rounds of bidding. Thus, in this case, competition in the market for ownership contributed to an owner/management mis-alignment that had not previously existed. Corporate Governance Regulation and the Market for Ownership SOX compliance, a requirement for most publicly held firms in the U.S., negatively impacted Smith‘s supply chain performance and response time. Prior to the CEO‘s decision to take Smith Company private, senior management had indicated that SOX compliance placed the organization at a distinct competitive disadvantage in the global marketplace. As a result of these challenges, the regulatory environment of SOX enhanced the appeal of private ownership. Expected Growth and the Market for Ownership Smith Company consistently grew with increasing profit margins until the year immediately preceding the acquisition. During the year prior to the acquisition, the prognosis for future performance faltered as Smith endured limited growth in revenue and declines in earnings, profit margins and stock price. Low growth potential increases competition for ownership when potential buyers believe that the growth potential is undervalued. As noted earlier, one Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 analyst viewed the initial offer for Smith Company as undervaluing the firm by 25% even though the offer placed a 20% premium on the current market price. Board Independence and the Market for Ownership Two indicators of board independence are well established. First, CEO‘s that also hold the chairman of the board position pose a significant threat to board independence. Second, a high proportion of executive board members indicates a lack of board independence. There are mixed signals coming out of Smith Company. Smith‘s CEO also held the board chairman position, weakening the board‘s independence. However, all other board members were independent, including the existence of a financial expert, providing evidence of a fairly independent board. An independent board should decrease the probability of a successful opportunistic bid and thereby dampen the competition for Smith‘s ownership. Company Performance and the Market for Ownership As discussed earlier, although Smith Company‘s prior performance was strong, with solid growth in sales, earnings and profit margins, the performance in the two quarters preceding the initial offer were relatively weak. This weak financial performance was reflected in poor stock performance, enticing potential bidders to enter the market for ownership. Smith Company’s Overall Market for Ownership Review of the various factors within the typology suggests that Smith Company‘s market for ownership was competitive, especially during the two quarters preceding the initial offer. The escalated competition for ownership was primarily driven by the market‘s undervaluation of Smith Company‘s growth potential, which was associated with the lackluster performance of the prior two quarters. Based on the typology, vulnerability in the market combined with large managerial ownership should prompt a management buyout attempt in an effort to protect managerial control. The fairly independent board was the only defense to this type of expected takeover. Independent Board and the Market for Managerial Control The discussion on market ownership established that Smith Company‘s board was fairly independent, which should escalate the competition for managerial control. Smith Company‘s poor performance, in the two quarters preceding the initial offer, should motivate shareholders to look for better management. However, the CEO‘s role as chairman of the board indicates some trust in his judgment. A bad quarter or two, given the past performance, should not prompt an active search for new management. Owner/Manager Misalignment and the Market for Managerial Control Prior to the solicitation of bids for acquisition of the company, there were no signs of owner/management misalignment, thus minimizing competition in the market for managerial control. Indeed, even after competitive bidders were brought into the process, such bidders were not interested in replacing the senior management team, further minimizing competition in the market for managerial control. Strong Company Performance and the Market for Managerial Control Smith Company‘s financial performance was stellar during the previous five years. Even during the two lackluster quarters, Smith Company did not lose money—rather they just underperformed in comparison to analysts‘ expectations. Accordingly, long-time shareholders had experienced substantial gains in stock price over this robust period. Even with the relatively poor recent performance, shareholders who had owned their stock for the full five year period saw 400% growth in the valuation of their stock. Overall, such performance should generally satisfy owners and solidify management‘s control. Managerial Ownership and the Market for Managerial Control By virtue of management‘s large ownership position in Smith Company, management‘s interest would be well-represented among the interests of owners. Combined with influence the CEO possessed as the chairman of the board, the CEO‘s interests were also very well-positioned. Given the CEO was the founder, there was clearly no desire to relinquish control even if there was tremendous monetary gain to be had. This overall influence should dampen much of the competition for managerial control. Smith Company’s Overall Market for Managerial Control Most of the factors in the typology suggest that the competitive pressure for control of Smith Company should be very docile. However, given that Smith Company‘s market for ownership is highly competitive, this docile position does not necessarily indicate that the market for managerial control is static. Entering the market for ownership directly impacts the likelihood of change in the market for managerial control. Thus, it would not be surprising for Smith Company‘s management to be at a risk notwithstanding the factors supporting incumbent management‘s control. Predicted Organizational Restructuring Given the interacting market forces shown in Figure 1, a highly competitive market for ownership combined with a docile competition in the market for managerial control should result in a change in ownership while management is retained. The most popular form of this type of change is the management buyout. Recall that large managerial ownership, poor growth potential (as perceived by the market), and a non-independent board increase the probability of a management buyout. In this case the board is the x-factor. Almost the entire board is independent, yet there are signs that the CEO may have considerable influence. This suggests a management buyout, but there are other possible acquisitions that could produce a similar type of restructuring. Another firm could acquire Smith Company and keep the current management team. 143 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Smith Company‘s difficulty with SOX would provide private buyers the ability to offer a higher premium than buyers that have to comply with SOX. Overall, the typology suggests a public to private transaction that would retain management, most likely a management buyout. Predicted Outcome versus Actual Outcome The typology depicts conditions that are consistent with a management buyout. However, Smith Company was actually acquired by a private equity firm other than the group led by the CEO. With the factors so strongly predicting a management buyout, the resulting private acquisition raises questions as to how Smith Company became an acquisition target. The process that produced this acquisition is complicated and provides a rich environment to discuss the interplay of the market forces. Board independence, managerial ownership, growth potential and regulatory compliance drove the competition for Smith Company‘s ownership. Strong performance, on the other hand, secured most management positions within the firm as five of the eight senior managers were retained after the acquisition was completed. After two disappointing quarters for Smith Company, the CEO/founder put together a team of equity investors to purchase Smith Company back. The combination of large managerial ownership and low growth potential spawned this bid. The market appears to have overreacted to the apparent halt in Smith Company‘s growth. Amidst a spurt of acquisitions in the industry, the CEO became concerned that this undervaluation would make Smith Company a takeover target. Interviews with key members of Smith Company revealed that the CEO was very concerned with retaining control. His response to the threat of takeover was to attempt a management buyout. As the typology suggests, the forces in the market for ownership resulted in a management buyout attempt. The success of such a buyout is contingent upon the board agreeing to the terms. Non-independent boards suffer from managerial influence and hence may accept a buyout offer that does not maximize shareholder value. Smith Company‘s board was largely independent and acted independently in setting up a special committee to handle the acquisition bidding process. The special committee proceeded to hire an independent investment firm to analyze the offer. Despite the aura of independence, the CEO‘s influence as board chairman was apparent when the board approved the CEO‘s offer and agreed to termination fees. The offer, which was an increase over the CEO‘s initial offer, gave a 30% premium over the recent trading price, but the trading price was at its lowest point in a year. However, this offer still undervalued the firm by approximately 20%. The competing bidder sued Smith Company alleging that the CEO abused his influence to stifle the competing bid. The courts upheld the competing bidder‘s case and terminated the acceptance. 144 Subsequent to the buyout termination, a bidding war commenced. Understanding that going private held strong potential for substantial operating gains as SOX compliance could be avoided, both bids rose dramatically. The private equity firm outbid the CEO led buyout group. On the other hand, no public firm ever entered the bidding process even though mergers and acquisitions were rampant in the industry. The most plausible reason for the absence of a public company bidder is the fact that it was highly unlikely that a public firm could have outbid a private firm in this scenario. Avoiding SOX compliance provided gains to the private bidder that a public bidder could not incorporate into their offer. After such a conflicting battle for ownership, management turnover would seem inevitable. This expectation of management control changes was further supported by the fact that the private equity bidder owned a competitor company that could also manage Smith Company. However, the private equity firm valued Smith Company‘s industry expertise and current business relationships. The strong performance of the management team secured management‘s positions within the firm despite the hostile change in ownership, although the CEO/founder did resign. Conclusions This paper posits a market for ownership that interacts with the market for managerial control. Prior studies on takeovers, management buyouts, and management succession have approached each activity as a single action with conflicting results. For example, Jensen (1986) posits that management buy-outs are a defense mechanism within the market for corporate control, while Weir et al (2005) find that the market for corporate control does not impact public to private ownership restructuring decisions. The current paper argues that private to public restructuring is a function of the market for ownership rather than the market for managerial control. The two market perspective provides an umbrella under which evidence from different research streams can be unified. The case employed in this study provides some evidence that the typology holds predictive validity. Case archival materials supplemented by interviews provide evidence that the theoretical explanations are valid. Specifically, the case sheds light on the explanation of association of growth potential and ownership changes. Weir et al (2005) support the theory that undervaluation plays a role in this association and calls for evidence to better understand its role. The case analysis explicitly finds that the undervaluation of Smith Company contributed to the competition for its ownership and provides additional contextual explanations for this outcome. The case study also demonstrated the ability of corporate governance regulation to affect the market for ownership. The proponents of SOX did not intend to provide private equity owners with an advantage in Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 the market for ownership. Indeed, the passage of SOX was intended to increase the public confidence in the stock market and maintain the flow of investment funds to the market (Canada et al, 2008). An analysis of the available data reveals that no publicly held firms participated in the market for Smith Company‘s ownership even though the industry was rampant with mergers at the time. The most plausible explanation is that public buyers had to contend with potential SOX avoidance gains as a barrier to entry. The paper has several limitations. As with all case study research, generalizability is an issue and hindsight is almost always better than foresight. However, the authors strove to be objective, knowing that the outcome of the case could influenced the structure of the interviews and evaluation of the case data if the research team was not careful to construct interview questions a priori and maintain a somewhat structured approach to the interview based on predefined questions. Still, we have a sample of one company and future research should seek to supplement this study utilizing a larger sample of companies as archival data becomes more readily available. 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Journal of Business Finance and Accounting, 32(5) 145 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Appendices Competitive Market for Ownership Owners Change Owners Change Management Retention Management Change Owners Remain Owners Remain Management Retention Management Change Docile Docile Competitive Market for Managerial Control Figure 2. Type of Organizational Restructuring Figure 2. Antecedents of Organizational Restructuring 146 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 РАЗДЕЛ 4 УГОЛОК ПРАКТИКА SECTION 4 PRACTITIONER’S CORNER THE SOX 404 PROCEDURE; IS IT STILL SO REPELLING TO FOREIGN ISSUERS? Marina Stefou* Abstract The need for effective and competitive financial markets is reflected in the internal control procedures of listed companies. The recent banking crises and the famous financial scandals have revealed the need for strong internal control mechanisms. Such mechanisms improve firms performance, reduce information asymmetry and are expected to raise firms value. However, due to the inherent limitations of internal control achievement of the financial reporting objectives cannot be absolutely ensured. A great reform in the internal control mechanism was introduced by the controversial Article 404 of Sarbanes-Oxley Act of 2002. This paper lays out the internal control provision described in SarbanesOxley Act, presents the extraterritorial effects on foreign issuers, compares and summarizes overall findings towards ensuring a better financial environment with regard to the international and European corporate governance framework applied. Keywords Corporate Governance, Sarbanes-Oxley Act 2002, internal control mechanism, extraterritoriality, foreign issuers and effective implementation *ECGTN Marie-Curie Fellow Researcher, ECGI, University of Genoa-Genoa Centre for Law and Finance (CLFGE),Ph.d Candidate Panteion University of Athens, LL.M 2005, LL.B 2003 Law School of Athens Via Balbi 22, 161 26 Genoa, Italy [email protected], I would like to thank Professor Guido Ferrarini for his important comments and guidance. This paper was accomplished under the scope and the financial support of the European Corporate Governance Training Network (ECGTN) research project. Introduction The Sarbanes-Oxley Act of 2002, also known as the Public Company Accounting Reform and Investor Protection Act of 2002 or ‗SOX‘, is a much-discussed and controversial law of the United States. It was issued as a rather strict yet prompt response of the American Congress to scandals like Enron and WorldCom, that caused the decline of public trust in accounting and reporting practices155. The SarbanesOxley Act includes provisions for the financial instruments and their trading as well as requirements on additional disclosure. It has been characterized as 155 ―This failure of corporate governance, [compounded by] an enduring bear market, approaching mid-term elections and uncertainty about terrorism and war, placed the federal government under extraordinary pressure to act‖ according to Greene, E. & Boury, P.M., (2003) ‗Post Sarbanes Oxley Corporate Governance in Europe and the USA: Americanisation or Convergence?‘, 1 INT L J. Disclosure and Governance 21,22. 147 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 the ―most far-reaching reform of American business practices since the time of Franklin Delano Roosevelt‖156. SOX established new law, amended the existing one and created the Securities and Exchange Commission (hereinafter ―the SEC‖) rule making and stock market listing standards. The passing of the SOX marks the departure from the lenience that foreign issuers had enjoyed in the past towards the general trend consisting in making the U.S. capital markets more attractive to foreign issuers 157. The Act‘s implementation, as Armour and McCahery outline158, aims at restoring the integrity of the audit process by strengthening the oversight of accounting profession while, at the same time, it establishes measures especially designed to address corporate governance counter failures. The Act contains 11 articles ranging from additional corporate board responsibilities to criminal penalties and requires SEC to implement rulings on the requirements related to the compliance with the new law. It includes many reforms aiming at improving and enhancing financial reporting, as well as at regulating the accounting and auditing profession. One of the major key provisions of the Act is the creation of the Public Accounting Oversight Board ( hereinafter ‗PCAOB‘), a quasi– public accounting board 159 that oversees audits of public companies, subject to the securities laws 160. Its principal purpose is to protect the interests of investors and to safeguard public interest in the preparation of ―informative, accurate and independent audit reports‖. Another key provision, article (or section) 404 of SOX, became effective on November 15, 2004 for domestic issuers whereas for non-US issuers, it became effective on July 15, 2007 161 (after SEC‘s permission for expansion162). Section 404 is SOX‘s most controversial new provision and it is so much-discussed that it has become a synonym for SOX itself163. The enactment of Section 404 requires SEC registrants to report on the effectiveness of the internal controls over financial reporting, the management to assess and evaluate the annual internal financial reports and lastly, the auditors to attest the validity of these reports. Section 404 requirement for management evaluation and reporting on the internal controls had also been proposed by the SEC (to be later withdrawn) in 1979 in the Securities Exchange Act Rel.164. At that time -as the case is presently- this requirement for management assessment was faced with wide controversy and criticism. Objections concerning Section 404 derive from the compliance costs that companies had to bear during the first two years, as a minimum, of the implementation of the Act. However, as research has shown165, after three years of enforcement, the resulting financial burden is greater for small companies, whereas as regards large companies, Section 404 is claimed to be a much needed reform that generates more accurate internal company control which finally supports a costeffective internal control procedure. An important aspect concerning internal control requirements is that, whether federal or state, these requirements are incoherent unless and until it is welldefined for whose benefit they exist and to what 161 156 Finch, J. (2002), ―US clean-up angers Hewitt‖, Guardian October 8, available at: www.guardian.co.uk/ 0,3858,4517263-103676,00.html 157 Shin, S.J., (2007), ‗The effect of the Sarbanes-Oxley Act of 2002 on foreign issuers listed on the U.S. capital markets‘, 3 NYU J. Law and Business, 706 158 Armour J. and McCahery, J. ‗ After Enron: Improving Corporate Law and Modernizing Securities Regulation in Europe and the US, Amsterdam Center for Law and Economics Working Paper 2006-07 available also at : http://ssrn.com/abstract/=910205 159 According to Prof. Cunningham, the PCAOB reveals a flaw in the corporate governance system as a result of a mixture of state and federal law regulations, see Cunningham, L. , (2004), ‗ A new Product for the State Corporation Law Market: Audit Committee Certifications‘1 Berkeley Bus. L. J. 327, 331. Also for a legal criticism for the process of PCAOB standard setting see Nagy, D., (2005). ‗Playing Peekaboo with Constitutional Law: The PCAOB and its Public/private Status‘, 80 Notre Dame L. Rev. 975 160 ‗The PCAOB is a sort of a new federal watchdog for regulation of the accounting profession‘, see Eisenberg, M., (ed), (2004), Corporations and Other business organizations statutes, rules, materials and forms, Foundation Press, 747. 148 SEC 404 Release. Non domestic private issuers are considered non-accelerated filers, where accelerated filers are defined in 1934 Act, and because they had greater difficulty in preparing the management report on internal control over financial reporting at first they were expected to fill in the 404 report by the end of July 15, 2006. But finally the SEC permitted one more year of expansion in order for them to meet all the necessary requirements. 162 See Securities and Exchange Commission Releases Nos.33-8760;34-54942, Internal Control over Financial Reporting in Exchange Act Periodic Reports of NonAccelerated Filers and Newly Public Companies, (Dec 15, 2006), 71 FR 76580 (Dec 21, 2006). 163 Congress reached the conclusion that executive certification would be more meaningful and persuasive to investors if those executives had reasonable grounds to believe that the internal financial controls on the process are solid. 164 Securities Exchange Act Rel. No. 15772,44 Fed. Reg. 26702 (April 30, 1979). 165 Prentice, R.A., (forthcoming), „Sarbanes-Oxley: The Evidence Regarding the Impact of Section 404‘, Cardozo L. R, available at : http://sssrn.com/abstract=991295, also Skouvakis, A. (2005), ―Exiting the Public Markets: A difficult choice for Small Public Companies Struggling With Sarbanes-Oxley‖, 109 PENN.St. L. R. 1279. As it is commonly expressed, the small companies at the time SOX was issued were not expected to be able to afford the cost of compliance and therefore, they might have preferred to go private or dark. Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 end166. Shareholders should be the beneficiaries of internal accounting controls legislation and it is claimed that the Act was released in accordance to their needs167. Another difficult question to answer is the extent to which controls relating to reporting blur into controls over general legal compliance or operational decision making168. This paper presents in brief the basic provisions of Section 404, as already applied in practice; Section 404 benefits are balanced against costs, while an effort shall be made to answer the question whether the wide controversy raised with regard to foreign issuers listed in US is well-justified. Simultaneously, three main objectives are emphasized: i) the main aspects of internal control procedures after implementation of Sarbanes-Oxley Act 2002 from a legal and a critical perspective, ii) the extraterritoriality of the internal control provision for foreign issuers listed in the US and their reaction to the Sarbanes-Oxley provision after the first year of its implementation and iii) the positive and negative aspects of the effectiveness of internal controls, the measures undertaken by foreign issuers and the possible ways in which European firms can benefit from a strong internal control regime. A. Section 404 Procedure 1. Section 404 Provisions ni General Regardless of their size, companies are exposed to risks in order to realize high profits 169; It is selfevident that the larger and more complex a firm is, the more are the risks that the firm is faced with. Firms are also required to manage the risks involved in their long -term operation. To efficiently manage these risks, companies must firstly assess the risks taken, then measure and control them and finally, monitor them170. Risk management is the company tool for assessing risks. Financial reporting render risk management possible and reveals eventual material weaknesses of the company. Revealing and reporting material weaknesses is one of Sarbanes-Oxley‘s Act primary concerns171. In Statement on Auditing 166 Langevoort, D.C., (2005), ‗Internal Controls After Sarbanes-Oxley: Revisiting Corporate Law‘s Duty of Care as responsibility for systems‘ available at: http: //papers.ssrn.com/sol3/papers.cfm?abstract_id=808084. 167 Clark,R.C., (1986), Corporate Law, Little Brown (ed.) 168 Ibid. 169 Deloach, J., (2004), The new risk imperative –an enterprise wide approach, Handbook of business strategy . 170 Selim, G. and McNamee, D., (1999), ‗The risk management and internal auditing relationship: Developing and validating a model‘, 3 Int. J. of Auditing, 163 171 According to SEC, material misstatements is one of the principal ways of inducing readers of financial reports in taking wrong decisions concerning investments in a company, lending money to the company or any other Standards No. 60 ‗material weakness‘ is defined as a reportable condition in which the design or operation of one or more of the internal control components doesn‘t reduce to a relatively low level the risk that misstatements caused by errors or frauds in the amounts that they would be material in relation to the financial statements being audited may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions172. The SEC hasn‘t taken any position whatsoever on how many significant deficiencies constitute a material weakness; this is left entirely to the companies and their auditors to judge on a caseby-case basis depending on the particular facts and circumstances. However, the PCAOB, through the new Auditing Standard No. 5, which replaced the much-discussed Auditing Standard No. 2 (see analysis below),tries to limit the meaning of material weaknesses to the most evident weaknesses that can seriously affect the company‘s performance and lead to a ‗non-depicting the reality‘ financial reporting of the firm. Section 404 vested the management with the obligation to assess the financial report, certify the disclosure and control the reliability of periodic financial reports. Issuers are required to publish in their annual reports information concerning the scope and adequacy of the internal control structure and the financial reporting procedures. The effectiveness of such internal controls and procedures is also assessed. Ιn the same report, following management‘s assessment, the registered public accounting firm attests and reports on the assessment of the effectiveness of the internal control structure and the financial reporting procedures. The relevant procedures used by most companies are IT-based, while companies rely on electronic management of the data, documents and key operational processes. Therefore, it is obvious that Information Technology plays a vital role in internal control evaluation. To determine the IT control system which should first be included in the procedure, management must identify and document control at process level. Companies tend to adopt evaluation criteria in order to improve comparability between the standard used by the companies to conduct their annual internal control evaluations. Chief Information Officers (―CIO‘s‖) are responsible for the security, the accuracy and the reliability of the data analysing systems. The scope of Section 404 is to ensure that management is efficient when assessing internal controls and is informed in detail on the internal control procedures, adopted by the internal control committees, the auditors and the IT section. financial decision, see http://www.sec.gov/rules/pcaob/3449544.htm 172 See also PCAOB release 021/ 2006-2007 (19/12) available at: http://www.pcaobus.org/Rules/Docket_ 021/2006-12-19_Release_No._2006-007.pdf 149 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 According to Section 404, the evaluation of internal expenditures of the registrant are being made only in control financial reporting and the identification of accordance with authorizations of management and any material weaknesses must be assessed by the directors of the registrant and management. The elimination of any material iii. Provide reasonable assurance regarding prevention weaknesses which could keep the company away or timely detection of unauthorized acquisition, use or from meeting the financial targets set at the beginning disposition of the registrant‘s assets that could have a of the year constitutes the management‘s material effect on the financial statements‖. responsibility. In order to avoid such misstatements at The definition of ICFR is in accordance with the an early stage, management must gather sufficient description of accounting controls in Section 13 (b) 2 evidence, so as to address the risks related to: B of the 1934 Securities Act 175. The procedure i. each financial reporting element, and includes, at first, the financial reporting whereby the ii. controls underlying each element173. financial statements of the company are certified and any existing weaknesses, material and trivial ones, are 2. Internal Control over Financial depicted. Consequently, the management‘s task Reporting (ICFR) involves the assessment of this financial reporting that (i) Definition of Internal Control over specifically covers the matters referenced in Section Financial Reporting (ICFR) 103 of SOX. Then, the company‘s public registered accounting firm attests and reports over the financial Internal control concerns the accuracy of the financial statements. The reference made to the assurances statements produced174 and the provision of greater regarding the use of disposition of a company‘s assets assurance to the investors regarding the integrity of in clause (iii) clearly proves that the safeguarding of the firm‘s management. The definition of internal assets constitutes an element of ICFR. control was traditionally focused on the accounting The company‘s management, with the assistance profession. Under Section 404, it received a broader of the CEO and CFO, evaluates the effectiveness of meaning focused on clarifying the company‘s internal the company‘s internal control over financial control that an auditor should consider when planning reporting as of the end of every fiscal year. The and performing an audit of the company‘s financial annual 404 report on IFCR should include 176: statements . - a statement of the management‟s responsibility for According to Section 404, internal control over establishing and maintaining adequate internal financial reporting (hereinafter ―ICFR‖) is: ― a control over financial reporting for the company; process designed by, or under the supervision of, the - a statement identifying the framework used by the registrant‘s principal executive and principal financial management in order to perform the required officers, or persons performing similar functions, and evaluation of the effectiveness of ICFR as of the end effected by the registrant‘s board of directors, of the company‘s most recent fiscal year; management and other personnel, to provide - the management‘s assessment of the effectiveness reasonable assurance regarding the reliability of of ICFR as of the end of company‘s most recent fiscal financial reporting and the preparation of financial year, including a statement as to whether the statements for external purposes in accordance with company‘s internal control over financial reporting is generally accepted accounting principles and includes indeed effective. The assessment must include those policies and procedures that: disclosure of any material weaknesses in the ICFR i. Pertain to the maintenance of records that in detected by the management177. reasonable detail accurately and fairly reflect the - a statement that the registered public accounting transactions and dispositions of the assets of the firm that audited the financial statements included in registrant the company‘s annual report has issued an attestation ii. Provide reasonable assurance that transactions are report on the management‘s assessment of the recorded as necessary to permit preparation of company‘s internal control over financial reporting 178. financial statements in accordance with generally The role of the management is crucial for the accepted accounting principles, and that receipts and compliance with Section 404. The management is responsible for including in its annual statement (usually the 20-F for foreign and domestic issuers and 173 Gaynor, M., ‗Improving Sarbanes-Oxley Section 404 Implementation‘, SEC, available at www.sec.org 174 Empirical studies confirm this theory by indicating that firms with poor internal controls tend to restate earnings more often, be the subject of more SEC accounting and auditing enforcement releases, face more frequent SEC enforcement actions and be worse performers and systematically riskier than comparable firms, seeBryan, S. & Lilien, S., (2005), ‗Characteristics of Firms with Material Weaknesses in Internal Control: An Assessment of Section 404 of Sarbanes Oxley 24‘ available at : http://sssrn.com/abstract=682363 . See also, Prentice, R. supra ftn.11. 150 175 As also mentioned in SEC‘ s 404 release. According to Item 308 of Regulations S-K and S-B. 177 If there is at least one material weakness the management is not allowed to conclude that the company‘s overall internal control over financial reporting is effective. 178 17 C.F.R §§228.308 and 229.308, Item 15 of Form 20-F, 17 C .F.R. §249.220f (2005) and Form 40-F, 17 C.F.R. §249.240 f, General Instruction B (6) (2005) 176 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 the 10-K for domestic issuers179) an internal control report that: - states the responsibility of the management for establishing and maintaining an adequate internal control structure and procedures for financial reporting - includes the assessment of the most recent fiscal year of the issuer on the effectiveness of ICFR. To fulfil these requirements, the management should undertake a comprehensive approach that includes thorough planning and evaluation of its internal controls system. There are a number of methods that a company can choose in developing and fulfilling the aforementioned responsibilities. The company‘s relevant documentation varies as Section 404 does not prohibit any form of documentation, thus, enabling use and combination of many different forms of documentation which could guarantee a more complete internal control and an accurate and up-to-date assessment of the management. The SEC hasn‘t provided any checklist to follow as it encourages flexibility in the documentation and the reporting procedure, in general. The form of the documentation depends on the company‘s size, complexity and documentation approach policy. Some indicative forms of documentation are: the company‘s policy manuals the accounting models process models memoranda flow charts procedural write-ups self-assessment reports job descriptions forms and decision tables and generally, any other item that the company considers as appropriate documentation. This evidence should document the company‘s controls while its effectiveness should also be tested. It is important that management allows sufficient time for the completion of this process, so that the appropriate basis may be created in view of ensuring an assessment which responds to any identified deficiencies. Early identification of deficiencies provides the management with sufficient time to correct them and determine the operating effectiveness of the controls prior to year-end reporting. For the evaluation of the evidence of ICFR, it is proposed that evidence is gathered from on-going 179 The management‘s assessment in practice is usually placed near the management‘s discussion and analysis (MD&A) disclosure or immediately preceding the financial statements. Most companies include the report either in Item 9A of form 10-K or in their glossy annual report either immediately before or after the financial statements or immediately after MD&A. Section 404 does not require the assessment to be signed by the CFO and CEO of the company. However, some companies are having their CFOCEO‘ s sign their management report. monitoring activities whereas the internal control is deemed more effective when there is centralized operation of controls and the number of the personnel involved is limited180. Apart from the documentation itself, the language used should be more generally understandable in order to avoid possible problems arising from foreign filers181 . (ii) The Auditing Standards used for the ICFR In 2004, PCAOB issued Auditing Standard No. 2 (hereinafter ‗AS-2‘), which requires auditors to perform their own independent assessment related to internal controls over financial reporting and issue a report verifying the management‘s prior assessment over ICFR. AS-2 defines auditor obligations with respect to the opinion and evaluation of management‘s ICFR. AS-2 also sets ―de facto standards‖182 with respect to management‘s own evaluation, since should the management fail to adhere to these standards, this would result in a negative auditor opinion. AS-2 was very expansive in breadth and depth of the internal controls audit 183 as testing was expanded on all base-level data, generated by daily business operations, as well as on the corporate governance process. It is clear that internal control must have a broad and in-depth operation; however, there has been question on whether limits should be set in testing, since AS-2 provides for the execution of all kinds of internal control testing, thus, generating overwhelming costs for the companies184. As a reaction to compliance costs and the burdensome application of Audit Standard AS-2, PCAOB recently adopted Audit Standard-No.5 (hereinafter ‗AS-5‘) with the aim to guide auditors towards verifying more effectively internal control weaknesses during financial statement audits, and at the same time, eliminate unnecessary costly procedures. The SEC 180 Supra. ftn.9. The language used may also create a problem in the documentation of 404 as accelerated filers with locations outside US have experienced challenges in addressing languages differences, see Deloitte‘ s report on SarbanesOxley Section 404: Compliance Challenges for Foreign Private Issuers (2005). 182 Supra ftn.5. 183 Ibid. 184 As Langevoort analyzes : ―Perhaps the key sentence in the entire standard, however, comes in paragraph 9 of AS-2: a significant deficiency in controls arises when there is one or more flaws in the control system such that ―there is more than a remote‖ likelihood that a misstatement of the company‘s annual or interim financial statements that is more than inconsequential. Something is considered remote only when chance of its occurrence is ―slight‖- amore than a remote risk, then, is anything more than a slight one. According to paragraph 10 of AS-2, a material weakness is one or more significant deficiencies that create a ―more than remote‖ likelihood that a material misstatement in the financials will not be prevented or detected‖, supra ftn.12. 181 151 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 was much in favour of the new auditing standard 185 as it makes audit scalable, it eliminates unnecessary controls and, consequently, costs less, since it detects only significant deficiencies. The PCAOB observed that the audit of internal control had significant benefits under AS-2, including higher quality of financial reporting, while it also noted that the effort to conduct an effective audit appeared greater than necessary. As a result, AS-5 is now designed to achieve the following objectives: to have the audits on internal control focused on the most important matters, i.e. evaluating the areas where there is reasonable possibility of containing a material misstatement, pointing out the significance of fraud risk and anti-fraud measures and explaining the impact that entity-level controls can have on the evaluation of other controls to include only the most necessary requirements for an effective audit, i.e. focusing on the multilocation of risk rather than risk coverage, risk assessment at assertion rather than at control level and finally, not requiring auditors to evaluate the management‘s assessment process to have audit properly fitted to the size and the complexity of the company audited to simplify the text of the Standard, by providing more general principles rather than detailed requirements in English language for ensuring general understanding of the meaning of the key terms and of important concepts. Consequently, due to the experience gained until the present day and the cost-related complaints about over-controlling and exceeding costs, PCAOB issued the new standard, so as to enable auditors and management to focus on the most important matters that have to be tested, i.e. those matters which could eventually lead to material weaknesses. The provision of general principles instead of detailed guidance is also in favour of the companies, since it is strongly connected with the size, the complexity, the internal function of the company and its perception of the control system. The ultimate goal of the new standard is to eliminate unnecessary work and ―right-size‖ the audits of internal controls, thus, succeeding in making them more cost-effective. The 404 internal control procedure renders the management responsible for the picture drawn by the internal control testing of the company. The purpose of the procedure is to increase the reliability of financial reporting and to improve the balance between compliance costs and benefits. The efficiency of the internal control is promoted by allowing management to focus on material control items, including the role of entity–level and general information technology controls. 185 See SEC Release 144-2007, ‗SEC Approves PCAOB Auditing Standard No. 5 Regarding Audits of Internal Control Over Financial Reporting; Adopts Definition of "Significant Deficiency. 152 3. Management’s Assessment and Evaluation 0f The Preferred Frameworks The decision on the evaluation framework to be used lies on the management. This is a key-element for management‘s assessment and it is important that the control framework on which the evaluation was based is clearly specified. The Management is responsible for using a suitable and well-recognized, commonly accepted control framework, established by a body or group that has followed due-process procedures, including the broad distribution of the framework for public comment186. The appropriate documentation concerning the management‘s decision and assessment of ICFR will enable the independent auditor to understand the management‘s process as well as to plan and perform the related audit procedures. Although every firm can, based on its size and objectives, apply whichever control framework seems more appropriate for it, provided that it is widely recognized as trustworthy, the SEC did note that the Committee of Sponsoring Organizations of the Treadway Commission‘s Internal Control Integrated Framework (1992), also known as COSO framework-report), satisfies the SEC‘s criteria. In addition, SEC noted that there are also other suitable and acceptable evaluation standards outside the US, such as The Guidance on Assessing Control, published by the Canadian Institute of Chartered Accountants, and the Turnbull Report, published by the Institute of Chartered Accountants in England and Whales. An evaluation framework is suitable when: it is free from bias it permits reasonably consistent qualitative and quantitative measurement of a company‘s internal control it is sufficiently complete and more specifically, the factors that could alter a conclusion about the effectiveness of the company‘s internal controls are not omitted from the evaluation framework it is relevant to an evaluation of internal control over financial reporting. Moreover, Section 404 rules do not purposely specify the method or the procedures which should be followed for an accurate evaluation. The SEC recognizes that these methods should vary from company to company. The assessment of ICFR must be based on procedures sufficient to evaluate firm‘s design and test its operating effectiveness. In September 2004, COSO released a draft of a document entitled ―Enterprise Risk Management Framework‖. This framework doesn‘t replace the commonly used 1992 COSO report; it incorporates it. It is designed to raise a consistent risk and control awareness throughout the enterprise and to become a commonly accepted model for discussing and evaluating the organization‘s risk management processes. “The Enterprise Risk Management 186 E.g. 17 C.F.R. §§240.13°-15 (c) and 240.15 (d)-15 (c) (2005). Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 Framework expands on internal control providing a more robust and extensive focus on the broader subject of enterprise risk management. While it is not intended and does not replace the internal control framework but rather incorporates the internal control framework within it, companies may decide to look to this enterprise risk management framework both to satisfy their internal control needs and to move toward a fuller risk of management process” 187 . B. The Debate about Section 404 and The Foreign Issuers 1. Do They Finally Deregister Because of 404? Listing in the US used to be, among other reasons, a matter of prestige 188 for EU issuers. The main benefits consisted briefly in: the increased liquidity 189 the decreased expose to domestic market risk 190 the increased visibility 191 the reduction of the cost of capital (with uncertain duration of this effect though) 192 obtaining acquisition currency the financial benefits offered by US public market and the notion that listing in a stricter disclosure environment than that of the home country exchange could guarantee future earnings 193. Section 404 is the cornerstone of internal control for US-listed companies. Companies have reported that SOX 404 improved the accuracy of their financial statements, while it also increased their reliability, thus, protecting investors‘ and shareholders‘ interests. 187 Enterprise Risk Management Framework-Integrated Framework, Executive Summary, released by COSO in September 2004, available at : http://www.coso.org/ Publications/ERM/COSO_ERM_ExecutiveSummary.pdf. 188 Jackson, H. and Pan, E.,B( forthcoming) ‗Regulatory Competition in International Securitities Markets: Evidence from Europe in 1999- Part II ‘, Bus.Law and Pagano, M. et al, (2001) ‗ The Geography of Equity listing: Why do companies list abroad? ‘ Centro Studi in Economia e Finanza , W.P. No 28. 189 Karolyi, A., (1996), ‗ What happens to stocks that list Shares Abroad? A survey of the evidence and its managerial implications‘, 34 NYSE W.P. N096-04. 190 Karolyi, A., ibid and , Foerster,S.R., and Karolyi, A., (1999) , ‗ The effect of market segmentation and Investor Recognition on Asset Prices: Evidence from Foreign Stock Listing in the United States‘, 54 J. FIN. 981 191 Baker, K. et al., (1999), ‗ International cross-listings and visibility‘ 192 Errunza, V.R. and Miller,D.P., (2000), ‗Market Segmentation and the Cost of Capital in International Equity Markets‘, 35 J.Fin & Quantitative Analysis , 577, Stulz, R. M., (1999), ‗Globalization of Equity Markets and the Cost of Capital‘ NYSE W.P. No. 99-02 193 Cheung, S. and Lee, J., (1995) „Disclosure environment and Listing on Foreign Stock Exchanges‘, 19 J. Banking and Finance, 347 It involves rationalizing internal controls and evaluations, i.e. which controls are important to keep and which to remove, standardizing and centralizing key controls in view of increasing efficiency and redesigning the control structure. As much-discussed in theory and in practice, Section 404 created new control environment requirements for companies without, however, setting, in a direct manner, clear discriminations depending on the company size. Indirectly, it reveals the dilemma for a company whether it is large enough to bear the costs of the new internal control requirements or whether it is small enough and stay private or even go dark. Section 404 was, at first, a threat to the companies‘ annual costs but, as time has shown, this is not the one and only reason that companies delist from NYSE or do not go public or prefer another stock market for issuing an IPO. The controversy about Section 404 shed light to the deregistrations from NYSE and NASDAQ. Yet the results are still not clear enough in order to support that SOX and Section 404 are the primary reasons for which companies prefer other public markets or delist from US exchanges. There has been significant research about the impact of SOX οn companies. What seems to be evident in more research papers is the fact that the companies which delist from the US exchange are the smaller and the weaker ones, i.e. the ones which cannot bear the costs created by SOX. SOX 404 undoubtedly imposed new compliance costs to the firms; Zhang 194 concludes that SOX has imposed significant net costs on firms. However, the picture is far more vague with regard to the companies which go private or dark following SOX‘s implementation. It should be noted, however, that NYSE and NASDAQ had already changed their requirements by the time SOX was passed as well as that many changes to US corporate practices would have taken place independently of the enhancement of SOX , due to the market pressures and the changes caused by the scandals. According to Kamar et al.195, it is clear that the burden imposed by SOX mainly induced small companies to go private, while large companies were little affected. Small firms are expected to have more ineffective internal controls than larger companies 196 and lack of in-house staff to respond to more complex 194 Zhang, I., (2007), ‗The Economic Consequences of the Sarbanes-Oxley Act of 2002‘, Carlso School of Management W.P., University of Minnesota. 195 Kamar, E. et al., (2006), ‗Going Private Decisions and the Sarbanes/Oxley Act of 2002: A Cross Country Analysis, Univ. S. Calif. Ctr. In Law, Econ & Org. Research Paper No. C06-05 also available at:http://ssrn.com/ abstract=901769 196 Doyle, J. et al, ( forthcoming), Determinants of weaknesses in internal control over financial reporting and the implications for earnings quality‘, Journal of Accounting Research. 153 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 internal control procedures. Leuz et al 197 show that going dark firms are smaller, more distressed, have weaker performance and governance than public and private companies. As Leuz et al show, the increase in SEC deregistration after SOX is primarily driven by firms that went dark rather than private and this was much a result closely linked to the extension of the compliance with the 404 procedure. On the other hand, there is no significant increase shown in going private in the months after the passage of SOX. Moreover, Litvak 198 outlined that SOX reduced the value of cross-listed firms, especially in the event of small ones, while lower returns to cross-listed firms regardless of the firm size were observed. However, the major weakness of the research on the impacts of SOX is the difficulty to separate the effect of SOX, and especially of Section 404, from that of contemporaneous factors, such as the financial market liquidity as Kamar et al. mention in a recent paper 199. As a result, the multitude of reasons affecting the deregistration decisions of the firms makes it difficult to cite SOX as the only factor of deregistrations. The concerns about the results that 404 would have were smoothed over with time; immediately after the release of SOX, small firms went private in order to avoid the initial compliance costs, while investors, shocked by the innovative nature of the Act, reacted with fear, especially during the first year of its implementation. For foreign issuers though, the experience of US companies and the foreseen expansion time contributed to ensure adequate preparation for the 404 filing and better scheduling of internal control mechanisms. The reaction to the 404 implementation is also relative; the higher the firm‘s level of disclosure and corporate governance regime is, the less benefit from externally imposed regulation. However, European cross-listed companies did not state that they already had the same disclosure level with the level required by SOX, while US had, traditionally, even before SOX, through the Securities Acts and the class action enforcement, better investor protection. Berger et al 200 show that stock market reaction to SOX is more positive for firms from countries with poor enforcement of investor rights underlining that SOX improves the protections of outside investors in those firms. After SOX‘s implementation, auditor industry specialization constrained the significant increase in audit fees that arose during the first year of SOX‘ s implementation201. Auditor industry specialization reduced the cost burden of SOX during the first year of implementation and consequently, lead industry expertise to efficiencies. The American experience gained until the present day was valuable for foreign issuers. Moreover, according to Prentice arguments, “the harshest criticism of SOX are overblown” 202 as empirical studies so far indicate that together Sections 302 and 404 are providing investors in US markets with the most reliable financial statements in history which benefits issuers by reducing their capital costs and benefits investors by reducing their risk. The establishment of Section 404 enables achievement of the goals of SOX, aiming at diminishing managerial opportunistic behaviors, by interposing independent directors on audit committees, company lawyers and other parties in this process 203. 2. Challenges to Foreign Issuers Since the passage of SOX, Karmel 204 pointed out two possible directions; either foreign issuers deregister and move to London or corporate governance standards converge into US models, something which could lead to a worldwide harmonization of standards. It could be maintained that until the present day, foreign issuers have taken, for different reasons, both directions. Nevertheless, the latter scenario seems more likely. The fact that the majority of foreign issuers did fill in the 404 management assessment over internal control report reflects their will to stay in the US stock markets and bear the costs, anticipating, probably, long-term benefits. Firms have, by now, the knowledge, the background and the proper in-house staff to implement a timely and accurate internal control procedure, while it should also be underlined that 404-related costs are significantly lower after the first year of implementation. On the other hand, delisting from NYSE and NASDAQ or preferring to launch an IPO in a stock market outside the US should not be considered as SOX‘s only consequence. The Paulson Committee‘s Interim Report of 2006 concluded that US is losing its competitive leading position as compared to stock markets and financial 197 Leuz, C., Triantis, A. and Wang, T., (forthcoming). ‗Why Do Firms Go Dark?‘Causes and Economic Consequences of Voluntary SEC Deregistrations, Journal of Accounting and Economic 198 Litvak, K., (2007), ‗Sarbanes-Oxley and the crosslisting premium‘ 105 Michigan Law Review. 199 Kamar, E. et al., (2007), ‗ Sarbanes-Oxley‘s Effects on Small Firms: What is the Evidence?‘, In the Name of Entrepreneurship? The Logic and Effects of Special Regulatory Treatment for Small Business, S. Gates and K. Leuschner (eds.) RAND 2007. 200 Berger, P.H., Li, F. and Wong, M.H.F., (2006) ‗The Impact of Sarbanes-Oxley on Cross-listed Companies‘, W.P. University of Chicago and University of Michigan 154 201 Fleming, D.M. & Romanus, R.N., (2007), ‗Auditor Industry Specialization and Audit Fees Surrounding Section 404 Implementation‘, Texas Review 202 Supra ftn. 3. 203 Hazard, G. & Rock, Ed., (2004), ‗ A New Player in the Boardroom: The Emergence of Independent Directors‘ Counsel‟, 59 Bus.Law 1389, Fisch, J. & Gentile, C., (2003), ‗The Qualified Legal Compliance Committee: Using Attorney Conduct Rules to Restructure the Board of Directors‘, 53 Duke L.J. 517. 204 Karmel, R., (2004), ‗ The Securities and Exchange Commission Goes abroad to Regulate Corporate Governance, 33 Stetson L. REV. 849 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 centers abroad and the main reason is the ‗shift of regulatory intensive balance‘ towards what might be deemed ‗excessive‘ regulation of US markets 205. According to this report, the 404 compliance costs have been excessive and have reduced US markets competitiveness. The picture is mixed and that is supported by Kamar, Berger and Litvak. Firms with strong internal controls reduce their capital costs significantly. It is noted that the disclosure regime should not strive for breadth and completeness, since these costs are unnecessary and are simply targeted towards problems in the framework of which transparency helps overcome principal-agent problems. As a result, the benefits of the internal control system are measured based on how well it helps monitor and control the behavior of the firm‘s senior managers206. Furthermore, due to its various benefits, additional investment in internal controls may be justified207. Until issuance of Section 404, small firms, in particular, did not use to report their internal control weaknesses. SOX enables the creation of a compliance culture in modern financial reporting methods. However, according to Kahan, if the law tries to change accepted norms too significantly, this hard shove may well be self-defeating where a gentle nudge it might have been the best solution208 . Under Section 404, there are challenges for foreign issuers; for SOX supporters, the overall Act constituted a chance to enhance financial reporting and disclosure and to render executives more accountable towards the shareholders. Before Section 404, the management did not require extensive internal control expertise and, thus, companies were much exposed to possible financial risks and frauds. With respect to foreign issuers, the beneficiaries of the internal control procedures should be specified. Independent directors are responsive mainly to the current generation of shareholders contrary to debtholders or outside investors. The beneficiaries of a strong system of internal control include outside investors interests, to whom neither the directors nor the management have any loyalty whatsoever. As it was noted in paragraph 6 of AS-2 PCAOB‘ s standard, government regulators are specific beneficiaries of internal control system as well. The challenges that foreign issuers are faced with regarding 404 have been diminished after foreign 205 Committee on Capital Markets Regulation (Paulson Committee) Report of 30 November , 2006. 206 However, this system is far narrower than the system proposed by PCAOB‘ s AS-2 standard, though the standard has an agency cost embedded in it. 207 The question of whether securities regulation affects non-investor constituencies as well as investors is shown in Williams, C.,(1999), ‗The Securities and Exchange Commission and Corporate Social Responsibility‘, 112 Harvard L. Rev 1179. 208 Kahan, D.M, (2000), ‗Gentle Nudges vs. Hard Shoves: Solving the Sticky Norms Problem, 67 U. Chi. L. REV. 607, 614 issuers first 20-F filing. However, it is significant to introduce appropriate audit committees, independent from the management overseeing financial reporting as required by AS-2. Another significant issue is that IT and internal control mechanism and evaluation framework be designed in such as way so as to respond to the geographical multi-location of a foreign issuer‘s subsidiaries. Nevertheless, what is more crucial about foreign issuers is the duplicative reporting standards for foreign firms. The SEC requires all listed corporations to report in conformity with US GAAP or to reconcile IFRS with US GAAP if they use IFRS as many foreign chartered corporations and all EU-based corporations do. As a result, foreign companies bear also significant additional reporting or reconciliation costs. The SEC recently proposed that foreign issuers be allowed to file financial statements, prepared in accordance with IFRS, without any reconciliation with US GAAP and has issued a ‗concept release‘ on allowing US firms to do the same 209. The SEC has taken many steps in order to keep foreign issuers in US markets, with the AS-2 and the concept for IFRS and US GAAP being its most significant steps until the present day. The gained experience on SOX 404 and the fear of loosing its competitiveness made SEC and PCAOB react in a timely manner. Another proposal of financial economists group roundtable210 is the adoption of a statutory amendment for turning 404 into a voluntary provision; if a company chooses not to comply with the market, its explanation of non-compliance and the value of the company will be assessed accordingly. Τhen, it is estimated that investors will put a lower value on a non-compliant company, a fact which will constitute an incentive for the company to meet the 404 requirements if the expense is worthwhile 211. Conclusion Listing in US is not as much prestigious as it used to be in good old times. US competitiveness was not exempted from the latest financial banking crisis. The decline in US stock markets should not be attributed only to SOX and especially to Section 404. There is evidence that foreign issuers delist, do not go public at all or go dark; although there is evidence that the compliance costs were higher than expected, a company‘s decision to deregister is driven to a great extent by many financial and strategic management reasons rather than merely by SOX. The SEC is by now well-aware of the situation and is now prone to 209209 SEC Concept Release ‗Allowing US issuers to Prepare Financial Statements in Accordance With International Financial Reporting Standards, Release No. 33-8831 (August 7, 2007) available at: http://www.sec.gov/ rules/concept/2007/33-831.pdf 210210 Financial Economists Roundtable (FER), Statement on the International Competitiveness of US Capital Markets, September 7, 2007.he 211 Ibid. 155 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 more regulatory openness and flexibility with regard to foreign issuers. SEC‘s international strategy should draw a distinction between the healthy aspects of regulatory competition and regulatory arbitrage 212. The next challenge should be the transatlantic regulatory dialogue in accounting and auditing. As marked by Khachaturyan and McCahery213, measures should be left sufficiently flexible in order to accommodate the wide range of firms and corporate law regimes; the more innovative and adaptable a legal system is, the more likely it will be to supply firms with measures that they require while ensuring an adequate level of investor protection. Deregistration in 2003, after the implementation of SOX, was much observed in London as well as in other stock exchanges. LSE gained a relevant competitive advantage as a pioneer of the ‗comply or explain rule‘ in corporate governance, however NYSE and NASDAQ offer the advantage of better enforcement of the rule, public and private. In the EU, there is considerable wariness about giving regulators strong powers in the area of corporate governance as this could lead to rigidity and destroy flexibility 214 . Section 404 of SOX is the Act‘s most criticized article; however, if the internal control is carefully scheduled in advance following performance of thorough tests and use of the necessary mechanisms, the financial disclosure of the firm is of high quality, and, consequently, of better corporate governance. The aim related to maximizing the firm‘s value and having an efficient market is met as market efficiency has profound implications on disclosure policy. It is also argued that the real benefits of disclosure are better depicted in the process of capital allocation among firms 215 . There is much literature on 404 SOX and it will continue to be, as the need for obtaining a clearer picture on its benefits is well discernable. Every change is costly, even for large capitalization companies. 404 created many costs, however, the firms which have complied with SOX enjoy a valid and accurate internal control system, which can be beneficial for the market performance of the firm, 212 Tafara, E. and Peterson, R. (2007), ‗ A Blueprint for Cross-Border Access to US investors: A new International Framework‘, 1 Harvard International Law Journal, Vol. 48 213 Khachaturyan, A. and McCahery, J. (2006), ‗ Transatlantic Corporate Governance Reform: Brussels Sprouts or Washington Soup?‘, Amsterdam Centre for Law and Economics W.P. 2006-02 also available at : http://ssrn.com/paper=893790 214 See Ftn. 149 in Cearns, K. and Ferran, E. (2008), ‗NonEnforcement Led Public Oversight of Financial and Corporate Governance Disclosures and of Auditors, ECGI W.P. No. 101. 215 Fox, M., (1997), ‗Securities Disclosure in a Globalizing Market: Who Should Regulate Whom?, 95 Mich. L. Rev. For a contrary argument see Stout, L. 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Williams, C., (1999), ‗The Securities and Exchange Commission and Corporate Social Responsibility‟, 112 Harvard L. Rev. 42. Zhang, I., (2007), ‗The Economic Consequences of the Sarbanes-Oxley Act of 2002‘ Carlso School of Management W.P., University of Minnesota 157 Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008 SUBSCRIPTION FORM TO "CORPORATE OWNERSHIP & CONTROL" AND "CORPORATE BOARD: ROLE, DUTIES & COMPOSITION" Copy this form and follow guidelines to fill it up. I would like to buy (underline what you choose): For individual subscribers: 1. Journal of Corporate Ownership & Control: 1.1. Printed version of the journal and version on CD - US$248 / €210. 1.2. Printed version of the journal and its electronic version - US$238 / €190. 1.3. Printed version of the journal - US$220 / €180. 1.4. Version on CD - US$180 / €150. 1.5. Electronic version - US$165 / €140. 2. "Corporate Board: role, duties & composition": 2.1. 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