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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008

CORPORATE OWNERSHIP & CONTROL

КОРПОРАТИВНАЯ СОБСТВЕННОСТЬ И КОНТРОЛЬ

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Corporate Ownership & Control

Корпоративная собственность и контроль

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EDITORIAL

Dear readers!

This issue of the journal is devoted to several issues of corporate governance. First of all, we introduce corporate governance practices in Australia. We have six papers considering corporate governance in Australia. We tried to do our utmost to have a good selection of paper on Australia. Therefore, you will enjoy reading papers on corporate board practices in Australia, stock market, corporate ownership structure, internal corporate governance and control. Corporate governance as a field of research in Australia develops fast. During last five years of publishing the journal Corporate Ownership and Control we published more than 35 papers of various experts in corporate governance from Australia. Our reviewers were very optimistic regarding the future perspectives of corporate governance research in Australia. For the second, this issue is truly international from the point of view that we tried to publish papers on corporate governance practices in many countries. Thus, we have papers on corporate governance in Germany, France, Brazil, Russia, Nigeria and Australia. For the third, we decided to come back to such special section in our journal as Corporate Board. This topic of research is very perspective to research from the point of view of importance of involvement of various groups of stakeholders in strategic decision-making. Financial crisis lasting at the financial markets worldwide demonstrated a weakness of the recent board practices from the pint of view of the board independence, accountability and responsibility.

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For the fourth, the Publisher, Virtus Interpress and Ukrainian Academy of Banking initiated a research project of corporate governance in banks and financial companies. The main objective of research is to develop a banking model of corporate governance taking into account the specifics of banking. It should be undertaken under the new scholar school of corporate governance – neoinstitutional school of corporate governance in banks. The main focus will be done toward the board functions, committees, independent directors as mechanisms of participation of various groups of stakeholders such as clients of banks, employees, professional associations, etc. in corporate governance in banks. We have already received a confirmation to take part in this research from Oxford University, Cambridge University, University of Manchester. Therefore, your participation would be very useful and we are open for your suggestions to participate.


CORPORATE OWNERSHIP & CONTROL Volume 6, Issue 2, Winter 2008

CONTENTS

Editorial

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SECTION 1. ACADEMIC INVESTIGATIONS AND CONCEPTS CORPORATE OWNERSHIP, CONTROL AND THE INFORMATIVENESS OF DISCLOSED EARNINGS IN RUSSIAN LISTED FIRMS

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Sheraz Ahmed Using ownership and financial dataset from UBS Brunswick, we show that the use of accrual based accounting in Russia has resulted in lower informativeness of earnings. Opportunistic earnings management hypothesis holds where majority shareholders (controllers) enjoy short-term benefits of manipulating accounting numbers. Interestingly, the returns (net of market) increase when use of discretionary accruals to manage earnings increases in firms controlled by either state or oligarchs. However, such relationship does not exist when ownership is accumulated without control. We also found that state-owned companies use less discretionary accruals than other control groups. We do not find any evidence supporting performance measure hypothesis where firms manage earnings by discretionary accruals to offset the over or under reaction of economic shock.

CORPORATE GOVERNANCE AND THE DYNAMICS OF OWNERSHIP OF GERMAN FIRMS BETWEEN 1997 AND 2007

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Bernhard Schwetzler, Marco O. Sperling On a sample of first layer as well as ultimate ownership (10% and 20% cut-off threshold) data for 11 years between 1997 and 2007 for German firms listed in the DAX, we examine the dynamics of ownership structure. We find that ownership concentration strongly declined. Further, foreign financial institutions became an important investor group with an increase of average stake from 0.4% in 1997 to 9.1% in 2007. We conclude that the quality of corporate governance increased and the Germany capital market became more open during that period.

IMPLICATIONS OF INSOLVENCY LAWS ON FIRMS’ GOVERNANCE. AN ANALYSIS FROM THE RELATIONSHIPS WITH CREDITORS IN FRANCE

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Nadine Levratto This paper aims at showing that ex post consequences of insolvency law are not the only one visible after a judge states that the amount of equity is not enough to repay all the debts. On the opposite, the judicial system that defines bankruptcy shapes the relationship between a firm and its stakeholders among which lenders play a specific role. Thus, the expectations of failure that are generally considered from a pure statistic point of view have to be enriched by the introduction of legal elements to

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 understand fully the strategic behaviour of lenders and borrowers. Such is the point we want to present here taking the French case.

CORPORATE GOVERNANCE, BANKRUPTCY LAW AND FIRMS' DEBT FINANCING UNDER UNCERTAINTY

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Bruno Funchal, Fernando Caio Galdi, Paulo C. Coimbra This paper examines the relationship between corporate governance level and the bankruptcy law to such debt variables as firms’ cost of debt and amount of debt under uncertainty (in the Knight´s sense). First we find that the better the corporate governance and the harsher bankruptcy law, the lower the cost of debt. Second, we find that better governance and a harsher bankruptcy laws have a positive effect on debt. As consequence, firms increase their set of investment projects financed by creditors. Finally, uncertainty has a negative effect on terms of debt (higher interest rate and smaller set of financed investment projects) and such effect is stronger for firms with worse corporate governance and for economies with a bankruptcy law that is lenient to debtors.

SECTION 2. CORPORATE BOARD BOARD LEADERSHIP STRUCTURE AND FIRM RISK-TAKING BEHAVIOUR

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Yi Wang, Trevor Wilmshurst In this paper the conceptual frameworks, which make different predictions about the effect of board leadership structure on firm risk-taking behaviour, are examined. From a sample of 243 Australian listed firms, it is found that leadership structure does not have any significant influence on firm risk; higher blockholder ownership or lower dividend payout is related to increased performance variance. This research suffers from some limitations; the archival study of the functional background of board chairman may not reveal the underlying relationship between the board of directors and firm risktaking behaviour. We only test the influence of leadership structure on performance variance; further research could investigate the potential impact of board composition on firm risk-taking propensity.

BOARD LEADERSHIP: ANTECEDENTS AND PERFORMANCE OUTCOMES

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Yi Wang, Bob Clift In this paper several theories, which make different predictions about the effect of board leadership structure on firm performance, are tested. The results indicate that, for Australian listed companies, there is no strong relationship between leadership structure and subsequent performance. It is reported that companies with higher blockholder ownership or lower managerial shareholdings tend to have an affiliated chairman; firm with higher managerial shareholdings tend to have an executive chairman. The evidence suggests that there is no one optimal leadership structure; each structure, which could be an outcome of a rational choice process influenced by other governance characteristics of individual firms, may have associated costs and benefits.

THE BOARDS FUNCTIONAL EMPHASIS - A CONTINGENCY APPROACH

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Sven-Olof Collin We present a contingency approach to the board’s functional emphasis, considering a fourth function in addition to monitoring, decision making, and service or resource provision. The additional function is conflict resolution (or principal identification). The approach contrasts with mainstream research by assuming that the firm is a nexus of investments, avoiding the empirical assumption that the shareholder is the sole principal. We derive propositions that are not restricted to any empirical category of a corporation, and address praxis implications for managing functional disharmony.

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NON-GOVERNMENTAL ORGANISATIONS (NGOS) BOARDS AND CORPORATE GOVERNANCE: THE GHANAIAN EXPERIENCE

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Samuel Nana Yaw Simpson This paper seeks to examine the Boards of NGOs in line with best corporate governance practices using evidence from Ghana. Data collected were analysed using a comparative case approach which involved a comparison of the Boards of the four (4) main categories of NGOs in Ghana to ascertain whether they exhibit differences or similarities. NGOs in Ghana exhibited some weaknesses ranging board appointment to other board characteristics which depart from international best practices. Besides, there are no reference guides for NGO Board or codes on governance for NGOs in Ghana like in other countries. Therefore, there is the need to develop codes/by-laws or reference guidelines for NGOs, supported by an enabling environment to realise the full potential of NGOs.

SECTION 3. NATIONAL PRACTICES OF CORPORATE GOVERNANCE: AUSTRALIA CORPORATE GOVERNANCE, BOARD RESPONSIBILITIES, AND FINANCIAL PERFORMANCE: THE NATIONAL BANK OF AUSTRALIA

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Ameeta Jain, Dianne Thomson This paper examines board responsibilities and accountability by management and Board of Directors in relation to the National Australia Bank’s (NABs) performance. The evidence suggests that NABs poor performance was consistent with a lack of accountability, poor corporate governance and board dysfunction associated with fraudulent currency trading and the subsequent AUD360 million foreign currency losses. The NAB’s performance is investigated by utilising accounting-based measures of profitability and cost efficiency as proxies for performance. Following the foreign currency trading losses in 2004 the NAB under-performed the other major Australian banks in terms of profits, cost to income ratio and growth in assets.

OWNERSHIP STRUCTURE AND CORPORATE PERFORMANCE: AUSTRALIAN EVIDENCE

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Julian Fishman, Gerard Gannon, Russell Vinning This paper seeks to analyse the relationship between ownership structure and corporate performance for fifty firms listed on the Australian Stock Exchange during 2002-2003. The study initially tests a two equation model similar to that in the existing literature, but is distinguished from prior literature by subsequently reclassifying leverage. By categorising leverage as an endogenous variable, an examination of the relationship between ownership and performance is undertaken through ordinary least squares and two stage least squares analysis of a three equation econometric model. Interestingly, empirical results illustrate the fact that managerial ownership impacts negatively on firm performance which is consistent with the management entrenchment hypothesis.

ORGANISATION CHANGE AND ITS IMPACT ON AUSTRALIAN BUILDING SOCIETIES’ PERFORMANCE

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Dianne Thomson The paper examines the relation between changing ownership structure and performance of Australian building societies. An analysis and discussion of the theories of organizational development and change is undertaken to explore the mutual building societies’ motivation for change. The financial performance measures, provided by financial ratios of the major mutual building societies in Australia, are examined to assess the behaviour of building societies under different governance structures in the 1980s and 1990s. The theoretical and empirical literature has suggested that mutual deposit-taking institutions should have lower profitability and higher operating expenses than their publicly listed counterparts.

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INFORMATION LEAKAGE AND INFORMED TRADING AROUND UNSCHEDULED EARNINGS ANNOUNCEMENTS

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Campbell Heggen, Gerard Gannon This paper presents an empirical study of information content and trading behaviour around unscheduled earnings announcements – comprising of profit upgrades, profit warnings and neutral trading statements – made by ASX-listed companies during 2004. The contention is that informed trading impacts on the stock returns and trading volumes of listed entities, and hence abnormal returns or trading volumes observed prior to an announcement provide evidence of information leakage. The paper models a range of factors that potentially influence firm disclosure practices and contribute to the level information asymmetry in the market during the pre-announcement period.

SUBSCRIPTION DETAILS

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РАЗДЕЛ 1 НАУЧНЫЕ ИССЛЕДОВАНИЯ И КОНЦЕПЦИИ SECTION 1 ACADEMIC INVESTIGATIONS & CONCEPTS

CORPORATE OWNERSHIP, CONTROL AND THE INFORMATIVENESS OF DISCLOSED EARNINGS IN RUSSIAN LISTED FIRMS Sheraz Ahmed* Absrtact Many problems of corporate governance in Russia are beyond the scope of classical agency theory because of highly concentrated ownership structures. Using ownership and financial dataset from UBS Brunswick, we show that the use of accrual based accounting in Russia has resulted in lower informativeness of earnings. Opportunistic earnings management hypothesis holds where majority shareholders (controllers) enjoy short-term benefits of manipulating accounting numbers. Interestingly, the returns (net of market) increase when use of discretionary accruals to manage earnings increases in firms controlled by either state or oligarchs. However, such relationship does not exist when ownership is accumulated without control. We also found that state-owned companies use less discretionary accruals than other control groups. We do not find any evidence supporting performance measure hypothesis where firms manage earnings by discretionary accruals to offset the over or under reaction of economic shock. Highly leveraged firms tend to have positive relationship between earnings management and returns, whereas, both size and growth reflect negative informativeness of earnings. The results describe the concentrated ownership structure in Russia where controlling owners not only, achieve personal targets by over or under-statement of disclosed earnings but also get positive response from the market. This market benefit however, can only be achieved with effective control. Keywords: Ownership structure, earnings management, accruals, disclosure quality, Russia, corporate governance *Department of Finance and Statistics. Hanken School of Economics, Helsinki, Finland. TEL: +358 41 5014 501 FAX: +358 9 4313 33393. Email: [email protected]

1. Introduction Accounting earnings that according to value relevance theorem, reflect the true economic performance of a company, should be priced mechanically into the market value of equity. Dechow (1994) explains the importance of disclosed earnings as a summary measure of the performance of a firm by a large variety of users. Unexpected high earnings increase stock market returns and abnormally low performance decrease returns. This reported performance should be priced accurately and timely resulting in the direct relationship of accounting performance and market

returns. There are alternative views as well describing the reasons why this relationship does not hold. First, the conflicts between shareholders (providers of finances) and managers (users of finances) in an agency theory perspective have effect on the quality of disclosed earnings. Managers may extract private benefits by manipulating the actual performance of a firm and thus may expropriate the value of shareholders (see e.g. Berle and Means, 1932; Jenson and Meckling, 1976). This owner-manager conflict in a diffused ownership environment transforms into conflict between majority shareholder (control group)

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 and minority shareholders (see e.g. Fan and Wong, 2002) in a concentrated ownership environment. Managers in this case, combine their incentives of manipulation with majority shareholder to extract private benefits of control. There are however, costs associated with earnings management such as market reaction of equity price and legal threat from monitoring agencies. This cost-benefit analysis and the extent of ownership concentration determine the extent of earnings management. Controlling owners may commit low equity investment while maintaining tight control of the firm, creating a separation of control and ownership. Burkart et al. (1997) show entrenchment as an agency cost of separation of ownership and control if there is separation between voting and cash flow rights i.e. when voting rights and cash flow rights diverge, the lower cash flow rights may fail to provide sufficient incentives alignment to mitigate the entrenchment effect. Earnings become less informative about stock prices when control exceeds ownership. Therefore, the type of controlling shareholder and extent of control (voting rights) also explains the variations in cross sectional firm performance and relevance of disclosed performance indicators. (see e.g. La Porta et al. 1999; Claessens et al. 2000) and thus explains the quality of earnings. Second aspect of low quality of earnings describes the institutional and legal framework of a country affecting the firm-level quality of disclosures. According to Fan and Wong, (2002), globalization and harmonization of International accounting standards may have increased the quantity of accounting information but investors still have reservations about the quality of that reported information. It is commonly believed that rapid transition and globalization have an adverse effect on the quality of earnings. However, recent studies by Ball et. al. (2000) and Ali and Hwang, (2000) argue that in addition to accounting standards, features of the institutional environment such as corporate governance and legal systems can also explain the differences in the properties of accounting information across countries. The purpose of our study is threefold. First, to detect earnings management with respect to different control groups, second, to test the value relevance of disclosed earnings in line with both performance measure and opportunistic earnings management hypotheses and finally to test hypothesis about the incentives for different control groups in managing the company’s reported earnings. This study also tries to understand the causes and circumstances of significant under valuation of Russian firms in line with value relevance theorem, which predicts a direct relationship between firm’s performance and stock market return. The study contributes in different ways; first, it provides evidence on a link between earnings management and corporate control in Russia. It also provides evidence of the adverse effects of inefficient measures of privatization undertaken in

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Russia. Finally, the results support the role of government and its enforcement agencies to protect the rights of minority shareholder and to improve the investor confidence. We do realize the benefit associated with earnings management when there is no divergence between cash and voting rights. Gaining effective control of a firm enables the controlling owner to entrench themselves by diverting the resources for private benefits. Once the effective control is obtained any increase in voting rights does not further entrench the controlling owner. Moreover, higher cash flow rights in the firm cost more to divert the firm’s cash flows for private gain. Gomes (2000) argue that the high ownership concentration can also serve as a credible commitment that the controlling owner is willing to build a reputation for not expropriating minority shareholders. The entrenchment effect of controlling owner is mitigated by alignment effect. The market reacts to announcements and information is incorporated prior to actual disclosure. Hence, investors form their portfolios on the basis of available information and then managers try to meet those expectations in order to gain the investors’ confidence and as a result the value of investments increases. Cohen et al. (forthcoming) provides some insights about the positive aspects of earnings management however, they also find the earnings management during and after Sarbanes Oxley Act related to dramatic increases in the fraction of compensation derived from executive options. In Russian case, the most significant determinant to explore is the extent of earnings management in a pyramidal and cross-holding structure. Keeping in view the entrenchment and alignment effects of concentrated ownership in Russia, earnings management in Russian listed firms is a significant way of extracting private benefits. Mega scandal of Yukos Oil Company strengthened the urge for big private firms to disclose as much as possible information to the outside world than ever before (see e.g. Black et al. 2006). The Yukos scandal highlighted the earnings management practices of large-scale private companies for tax evasion and Govt’s inefficient policies to interfere or to stop expropriation 1 . There may be many factors driving managerial practices, like value enhancing measures before IPOs and SEOs, private benefits extraction including management entrenchment plans, performance based wages, insider trading and other compensation plans which remain beyond the scope of this paper. We present the explanations for differential informativeness of earnings on stock market returns. 1

The financial statement of Yukos oil in 1996 showed revenue of $8.60 per barrel, about $4 per barrel less than it should have been. Mikhail Khodorkovski skimmed over 30 cents per dollar of revenue while stiffing his workers on wages, defaulting on tax payments, destroying the value of minority shareholders and not re-investing in Yukos´ oil fields (see Black et al. 2003 for more details)

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Our results show that state-owned companies have relatively better quality of earnings. The hypothesis about the entrenchment (short and long term goals of oligarchs and state of extracting benefits) from the direct analysis of earnings management and ownership structure is supported whereas, the alignment effect to minimize the entrenchment effect is not shown. We further show that opportunistic earnings management hypothesis seems prevalent in Russian listed firms. The negative correlation of discretionary accruals with stock returns shows that companies are involved in earnings management where controlling shareholder manage accruals generally to hide poor performance or postpone a portion of unusually good current earnings to future years in line with Healy (1985), DeAngelo (1986) and Guy et al. (1996). Companies do not use discretionary accruals to offset the over-reaction of nondiscretionary accruals as we do not find any significant positive or negative relationship of nondiscretionary accruals and stock returns. Finally, pooled regression analysis shows that given the type of controlling owner, the earnings correlate positively with market adjusted returns whereas the levels of cash flow rights of oligarch and foreign corporations decrease stock returns at a given level of earnings management. We do not find any evidence of accepting the alignment effect hypothesis since the divergence between cash flow rights and voting rights (VC) do not show any significant relationship with stock returns at any level of earnings management. This paper continues as Section 2 presents the motives and bases of our hypotheses on the basis of previous literature. Section 3 describes the emergence of concentrated ownership environment in Russia and how few control groups got powers of major Russian companies during privatization stages. Section 4 describes data and methodology used in the study followed by Section 5 where we present the results of our analysis and paper concludes with section 6. 2. Motivation and Hypotheses Russia provides testing ground to check the impact of weak shareholder protection on the value relevance of reported earnings. The strong affiliations between large owners and managers persist in Russia. The expropriation of minority rights has been common by large shareholders. They can divert the resources of the firm for private benefits and hence dilute the value of shares held be outside minority shareholders. This section discusses the factors that helped shape the concentrated ownership structure in Russia and how this ownership structure may have entrenchment and incentive alignment mechanisms to manipulate the reported performance (see e.g. Morck et al. 1988). Furthermore, we discuss the second hypothesis about earnings informativeness of stock market returns with both performance measure and opportunistic hypothesis about earnings process and finally we

discuss the hypothesis about relationship between ownership structure and earnings informativeness. 2.1. Hypothesis about Ownership Concentration and Earnings Management In economies where the state does not effectively enforce property rights, the enforcement by individual owners plays a relatively more important role in determining the valuation of the shares. A bulk of property rights literature provides a general framework for analyzing the determinants of corporate share ownership structure. This strand of literature emphasizes the roles of customs, social and legal systems in determining the property right structure and governance systems (see e.g. Coase, 1960; Demsetz, 1964; Cheung, 1970, 1983 and Eggertsson, 1990). The owner of a share is entitled to three categories of property rights that include (i) voting right -owner has the decision right over the utilization of corporate assets, (ii) cash flow right - the owner has a right to earn income and (iii) transfer right – owner has a right to transfer to another party. The effective enforcement of these property rights determines the value of a share. Schleifer and Vishny (1997) and LaPorta et al. (1999) argue that investors’ rights attached to the security they are buying are important while valuation of their shares especially when managers (control group) act in their own interest. Fan and Wong (2002) discuss that in economies, where the state does not effectively enforce property rights, the enforcement by individual owners plays a relatively more important role. Shleifer and Vishny (1997) further elaborate that the benefits from concentrated ownership are relatively larger in countries that are generally less developed, where property rights are neither well defined nor protected. The benefits include incentives of control, contracting and entrenchment activities. Berle and Means (1932) and Jensen and Meckling (1976) argue that insiders do not have full cash flow rights but significant controlling rights of the firm, which intensify the need to analyze the ownership structure with respect to earnings management and valuation to measure the extent of agency problem. This conflict of interest between outside shareholders and managers who own a small portion of equity in a diffused ownership environment (U.S, UK and other western economies) shifts away to conflicts between the controlling owner (possess more than 50% of voting rights) and minority shareholders in concentrated ownership environment like Russia. In this case, the controlling shareholder controls and manages the sources of companies to achieve both entrenchment and alignment incentives by depriving the rights of minority shareholders. The control group join powers with management of the company to divert the resources and manipulate the reported earnings. It further leads to significant under valuation of companies. Thus it is important to

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 understand the effect of concentrated ownership on earnings management activities before making direct assessment of earnings informativeness. In line with previous research, we try to investigate earnings management in a highly concentrated ownership environment where few control groups prevail in the market. We test entrenchment effect of control by analyzing the correlations of controlling owner type and discretionary accruals. Additionally, we look into the alignment effect of control i.e. if the divergence between voting and cash-flow right is associated with earnings management. One possible factor to minimize the entrenchment effect of majority shareholder is to get the sufficient voting rights. Once the controlling owner obtains effective control (> 50% voting rights) of the firm, any increase in the voting rights does not further entrench the controlling owner but her higher cash flow rights in the firm mean that it will cost more to divert the firm’s cash flows for private gains. Hence, we hypothesize that both levels and types of controlling owner explain the earnings management practices of companies. In Russia, there are three main control types in 90% of the Russian listed companies. These are State, Oligarchs and Foreign corporations. Managers in Russia are associated with controlling shareholder so we expect the managers’ stake in ownership to have the same relationship with quality of earnings as of controlling shareholder. State in Russia owns many of the oil and gas, power and energy firms and has long term goals to enhancing value of those companies. The state owned companies tend to be involved in positive (income enhancing) earnings management because state owned companies have incentives to increase the valuation to get maximum pay offs in case of privatization. Most of state owned companies are the potential targets of being privatized; hence state has incentives to do positive earnings management. On the other hand, oligarchs who already control the firm expecting to have a lower fear of being taken over so they go for short-term goals of tax management. Therefore, we expect oligarchs owned companies to be involved in negative (income decreasing) earnings management. Companies owned by foreigners may exhibit similar short-term earnings management for tax evasion or self-dealing through their holding companies. Same arguments hold in case of levels of cash flow rights of these majority shareholders. The entrenchment effect decreases with the increase in the level of ownership stake beyond the minimum level needed for effective control and thus has lower private benefits to divert company resources when cash flow rights increase. 2.2. Hypothesis about Earnings Management and Stock Returns In an external corporate governance context, weak legal system and corporate governance mechanism of

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the country also play significant role in determining the value of the companies, especially in emerging markets. La Porta et al. (2002) argue that the absence of strong legal protection and other external governance mechanism in many emerging economies increase the problem of agency conflicts between insiders and outsiders. Similarly, Hung (2001) shows that the use of accrual based accounting negatively affect the value relevance of financial statements. However this negative effect does not exist in countries with strong shareholder protection. Hence, it is important to understand the causes and circumstances of significant under valuation of firms in line with value relevance theorem in transition markets. In this section, we shall discuss the two different value relevance theorems of disclosed earnings. Accounting earnings that according to value relevance theorem, reflect the true economic performance of a company, should be priced mechanically into market value of equity. Unexpected higher earnings increase stock market returns and vice versa. Performance measure hypothesis claims that reported performance should be priced accurately and timely resulting in the direct relationship of accounting performance and market returns. Managers use discretionary accruals part of the total earnings to produce a reliable and more timely measure of firm performance than cash flows (e.g., Watts 1977, Watts and Zimmerman 1986, Beaver 1989, Dechow 1994, and Dechow et al. 1996). Opportunistic earnings management hypothesis states that managers use discretionary accruals opportunistically to hide poor performance or postpone a portion of abnormally good performance for future periods (e.g. Healy 1985 and DeAngelo 1986). In an efficient market, capital market participants use all available information to form unbiased expectations of future cash flows in setting security prices. The disclosed earnings contain accruals and cash flows. The earnings would also follow a random walk process similar to that of prices if current accruals would anticipate future cash flows to the same extent as the market and prices would equal the present value of the current earnings. Guy et al. (1996) argue that the estimated earnings coefficient in regression with future earnings is smaller because of the deviations from the random walk property and because of the market’s anticipation of future earnings beyond the information in the past time series of earnings. To develop predictions under the performance measure hypothesis, we assume that discretionary and nondiscretionary accruals anticipate future cash flows to the same extent as the capital market. Accruals, that are discretionary from the standpoint of the application of U.S. Generally Accepted Accounting Principles (GAAP) are also hypothesized to anticipate future cash flows because of the influence of efficient contracting and control mechanisms. Under the performance measure hypothesis, managers employ

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 discretionary accruals to include as much of the impact of current economic events into current reported earnings as possible. Assume that current earnings over-react and thus successive nondiscretionary earnings changes are negatively serially correlated. The performance measure hypothesis predicts that managers use discretionary accruals to eliminate the overreaction. Reported earnings include the shock’s net effect in the current period. Reported earnings then follow a random walk and reflect long-term earnings expectations, consistent with the performance measure hypothesis. Discretionary accruals under the performance measure hypothesis assuming a shock to the underlying earnings process are always perfectly (positively or negatively) correlated. So, we expect discretionary accruals to correlate with stock returns. The sign of the correlation under the performance measure hypothesis depends on whether nondiscretionary earnings include an over- or underreaction to the economic shock. If they include an over-reaction, a discretionary accrual with an opposite sign offsets the shock and the discretionary accrual correlates negatively with the shock and stock return. On the other hand, if nondiscretionary earnings underreact to the shock, the discretionary accrual magnifies that under-reaction. Thus the discretionary accrual correlates positively with the shock and stock return. Under opportunistic earnings management hypothesis the discretionary accrual is expected to reverse in future periods and nondiscretionary earnings are also expected to decline. This produces negative serial correlation in successive earnings changes. The opportunistic discretionary accrual seeks to undo the shock to the underlying earnings process. The opportunistic accruals smoothen earnings temporarily. For example, in the case of a bad-news current shock, unless underlying earnings exhibit a reversal in the future, the manager potentially faces “accrual bankruptcy” and low future earnings. This outcome is likely because the current period’s opportunistic accruals must reverse and there are limited opportunities for the manager to prevent a reversal, particularly if earnings are forecasted to exhibit a further decline. The problem is, however, mitigated in the case of a bad shock if the firm has employed conservative accounting policies in the past. On the other hand, if the current shock is good, and the firm has pursued conservative accounting policies in the past, the likelihood of facing “accrual bankruptcy” is exacerbated. If nondiscretionary earnings overreact (i.e. earnings next period are expected to reverse), then the discretionary accrual that partially offsets the shock is consistent with the performance measure hypothesis. Thus, in the case of earnings overreaction to economic shocks, the performance measure and opportunism hypothesis cannot be discriminated. Under the opportunistic management hypothesis, the discretionary accrual offsets the shock to nondiscretionary earnings. Therefore, it correlates negatively with stock returns.

2.3. Ownership Structure and Earnings Informativeness In order to develop hypothesis about ownership structure and informativeness of reported earnings, we need to discuss couple of arguments in line with entrenchment alignment and information effects. The controlling entrenched owner not only controls the firm but also operates its reporting policies reducing the credibility of the reports. Their credibility is expected to be even lower when the difference between cash flow rights and voting rights increases (Fan and Wong, 2002). The outside investors do not trust reported earnings because the tendency of majority or controlling owner of manipulating performance is directly related to their stake in ownership. The controlling owner may manipulate earnings for expropriation purposes. Gaining effective control of a firm enables the controlling owner to entrench themselves by diverting the resources for private benefits. The levels of cash flow rights with or without effective control will reduce the reputation of disclosed information. The entrenchment effect of controlling owner is mitigated by alignment effect. Once the effective control is obtained any increase in voting rights does not further entrench the controlling owner. Moreover, higher cash flow rights in the firm cost more to divert the firm’s cash flows for private gain. Thus effective control and the type of controlling owner have an association with informativeness of disclosed earnings. In line with Gomes (2000) we expect that controlling owner is willing to build a reputation for not expropriating minority shareholders. If the controlling owner unexpectedly extracts more private benefits when she holds a substantial amount of shares, the minority shareholders knowing this will discount the stock price accordingly and majority owner’s share value will be reduced. Thus control may have incentives of concentration for a minimum level of voting rights required for effective control. We expect the earnings informativeness to be reduced with levels of ownership in line with entrenchment effect while the type of effective controller (i.e. the simple majority of voting obtained by a control group) should enhance the informativeness of reported earnings. Furthermore, the divergence between voting rights and cash flow rights has both entrenchment and alignment effects. When the controlling owner is entrenched by his/her voting power and there is large separation of the voting and cash flow rights, the credibility of the accounting information is reduced. 3. Development of Concentrated Ownership in Russia The ownership of listed companies in Russia is concentrated towards few groups who own most of the shares. This concentration was often achieved through poor privatization campaigns by the state

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 during the earlier years of transition after the fall of communism. These privatization modes included voucher privatization and share-for-loan schemes, which triggered the economy towards a massive but inefficient privatization of previously state-owned corporations. In late 90s the control over many of the Russian companies was transferred away from the state to big private industrial groups, which were mostly domestic with a few exceptions. The notorious share-for-loan scheme to give loans to government in exchange of shares was not well-managed and none of the loans were ever paid back to investors (industrial groups). It resulted into acquisition of ultimate ownership of the companies by these few groups. It helped in creation of many oligarchs in Russia which now control a significant stake in largest Russian companies in all sectors especially in the oil, power and ferrous metal sectors. This unequal distribution of assets finally resulted into big scandals like Yukos and Gazprom. However, the state remained the most influential control group in Russia along with the oligarchs. The gap between oligarchs and state widened during President Putin’s tenure starting in 1999 because of the extra incentives extracted by strategic owners. These investors then tried to manipulate the actual performance of the companies in order to hide information from the state authorities. This resulted into another move by the state to have state representatives in the board of most of the privatized companies so that the actual performance can also be monitored. Unfortunately, this even did not work properly because of the incentive constraints of these state nominees and their own personal benefits. Even another phase of re-statization of many privatized firms in earlier stages did not bring about the desired results. In fact, it allowed even state owned companies to hide and manipulate the significant accounting information from the general and minority shareholders. Various control measures include imposing restriction on acquiring more than 20% of a particular company by open market. It needs state approval to gain more than 20% as well as for every additional 5%. If a particular individual (legal entity, group of companies) acquires 30% or more of a company, the buyer(s) must offer to purchase all shareholders’ stakes at the weighted average market price over the previous six months or the current market price, whichever is higher. However, this requirement may be waived if 75% of shareholders of a company approve the relevant amendment. There is no federal law imposing restrictions on different classes of investors. Companies may opt to amend the charter to limit a single entity from holding more than a certain proportion of charter capital, although this is very rare. Few companies in Russia place restrictions on foreign participation like Gazprom limits foreign ownership to 20% of charter capital. Foreigners may only buy shares through a depository receipt and do not have access to the underlying shares. However,

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so-called “grey-scheme” enables foreigners to hold more shares because some Russian domiciled overseas may have even more holdings than the 20% limit through indirect investments. There are also certain laws limiting the foreign ownership in particular company especially in prime entities like UES, with the purpose to retain the national interests alive in these companies. Hence, despite of all these efforts to improve the situation regarding separation of ownership and control in Russia, the fundamental question that “does ownership structure matter when only few groups control the bigger industrial sectors? Or when oligarchs control the highly pyramidal corporate structure in Russia?” still stays unanswered. 4. Data and Methodology We use Modified Jones (1991) model used by Dechow et al. (1995) to measure the level of discretionary (sometimes called as abnormal) accruals from annual financial reports of 98 listed firms at Russian Trading System (RTS) over the period of 1999-2004. The financial data is extracted from Brunswick UBS “Russian Equity Guides” and Thomson One Banker database. Ownership data is collected from different sources including Russian Equity Guides published by Brunswick UBS, SKRIN, Amadeus and sometimes directly from companies’ annual reports. The stock price data and RTS market index prices were obtained from Thomson Datastream. Total number of firm years of financial data is 525 whereas the ownership data could only be obtained for 330 firm years during the whole time period. Hence, matching the earnings data with ownership leaves a maximum of 330 observations. We do not include banking and other financial firms due to their different accounting methodologies. 4.1. Earnings Management Measure We rely on earnings management model directly relating income, cash and accruals because it enables us to measure accruals proxy in a time series and cross-sectional way simultaneously and also requires fewer assumptions than other time series and theoretical models. The Jones (1991) model is considered as the milestone (Hermanns, 2006), but there has been some modifications to the original model to increase the predictability and explanatory power of original version e.g. Dechow et al (1995) modified the model by subtracting changes in receivables from changes in revenues in order to control for management’s intentions to use its discretion over credit sales which is the easiest way of manipulation in a non-conservative accounting environment. The Jones model identifies accounting fundamentals as the determinants of non-discretionary accruals. Schipper and Vincent (2003) states that the Jones model is a direct estimation model because it identifies accounting fundamentals as determinants of expected accruals Discretionary accruals reflect the

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 quality of earnings with an inverse relationship, i.e. higher discretionary accruals proxy worse quality of earnings. Consistent with the earlier studies by Healy (1985) and Jones (1991), total accruals (TA) scaled by lagged total assets (At-1) are calculated as (∆CAi ,t − ∆CLi ,t − ∆Cashi ,t + ∆STDi ,t − Depi , t ) , TAC = i,t

Ai ,t −1

(1) where, ∆CAi,t = change in current assets for firm i in year t, ∆CLi,t = change in current liabilities i in year t, ∆Cashi,t = change in cash and cash holdings i in year t, ∆STDi,t = change in debt included in current liabilities i in year t, Depi,t = depreciation expense i in year t, and Ai,t-1 = One period lagged (t-1) Total Assets. According the modified Jones Model, the nondiscretionary accruals proxy is calculated to eliminate the conjectured tendency of manipulation when discretion is exercised over revenues. Dechow et al. (1996) proposed this modification in original Jones (1991) model in order to control for any use of discretion over credit sales. It seems much easier to manage earnings via credit sales rather cash sales. Hence, the estimated non-discretionary accruals are computed as NDAPi ,t = αˆ1 (

1 ) + αˆ 2 (∆REVi ,t − ∆RECi , t ) + αˆ 3 ( PPEi ,t ) . Ai , t −1

(2) We use residual approach to estimate the discretionary accruals from equation (4) where we compute the series of residuals as a proxy for discretionary accruals. The part explained by lagged total assets (1/At-1), change in revenues minus change in current receivables (∆Revt-∆Rect), and property, plant and equipment (PPEt) is considered as nondiscretionary or normal part of current total accruals and residuals (i.e unexplained part of total accruals) represent discretionary accruals. That can be used as a proxy for earnings management (Hermanns, 2006). The equation (3) describes the regression model: TAC i ,t = α 1 A 1 + α 2 (∆REVi ,t − ∆RECi ,t ) + α 3 PPEi ,t + ε i ,t , i , t −1

(3) where change in revenues (∆REVi,t ), change in receivables (∆RECi,t ) and levels of property, plant and equipment (PPEi,t ) are all scaled by lagged total assets. The error term (εi.t ) is discretionary accruals proxy (DAPi,t) and non-discretionary accruals proxy calculated as the difference between firm i's total accruals (TAC) and discretionary accruals (DAP) at year t as below: (4) NDAPi ,t = TAC i ,t − DAPi ,t The cash flow from operations (CFOi,t) is the difference between net income (NIi,t) and total accruals (TAC) for each firm-year.

4.2. Ownership and Earnings Management In the second stage of our analysis, the discretionary accruals are regressed in a univariate model settings with different ownership variables including management’s stake, state, oligarchs, foreign and local ownership etc along with few control variables to ascertain the true picture of deviations from the efficient market hypotheses, and to test if general and small shareholders are expropriated by the insiders (managers) and controlling owners in Russia. We use univariate regression approach in order to form individual assessment of each control groups with both voting rights and cash flow rights settings. In a traditional earning management models, the regression coefficient of parting variable (in our case, ownership types and levels) will have the predicted sign showing the direction of earnings management (negative or positive) whereas the significance at traditional levels detects the earnings management. Hence, both the direction and the significance of the coefficient are important. The problem of misspecification and omitted variables (see e.g. Dechow et al. 1995) is addressed in the literature by adding few control variables, which strengthen the predictive power of the model. The regression equation takes the form of DAi ,t = a + bOW N i ,t (levels ,types ) + dV i ,t + ei ,t , where (V i ,t ) represent the controls added to address the problems of misspecification. Including industry and year dummies. The cross sectional stacked panel data is used where we have different firm years observations for each ownership variable. Following previous research by Warfield et al. (1995) and Gabrielsen et al. (2002), not only actual discretionary accruals but absolute discretionary accruals are also used to detect the differences in the total levels of earnings management or quality of earnings. The higher the absolute level of discretionary accruals, the lower the quality of earnings. Absolute discretionary accruals are also regressed one by one with ownership variables in order to estimate the difference in the use of discretionary accruals by each controlling shareholder. Equation (5) then takes the shape of

A DAi ,t = a + bOW N i ,t (levels ,types ) + dV i ,t + ei ,t .

(6)

4.3. Earnings Informativeness The earnings response coefficient approach is used to estimate the relationship between the accruals and the annual stock returns. We test the earnings response coefficient in corporate governance setting by analyzing the firm performance. We use earnings quality as a measure of firm performance from general shareholder’s point of view. The extent by which reported earnings represent the actual performance of the companies is considered as quality

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 of earnings. Following Guy et al. (1996) we model the market adjusted returns and accruals in different settings. First step is to test the relationship between total accruals and returns in line with the value relevance and performance measure hypothesis as follows CA R i ,t = a + b 1T Ai ,t + ei ,t , (7) where (CARi,t) is the cumulative net-of-market 12 month stock returns at year t for firm i. TAi,t is the total accruals for firm i in year t. Discretionary accruals (DAi,t) under the performance measure and opportunism hypotheses are always perfectly (positive or negative) correlated so we expect discretionary accruals to correlate with stock returns: CARi ,t = α + β1 DAi ,t + ei ,t . (8) The sign of the correlation of discretionary accruals under performance measure hypothesis depends on whether nondiscretionary accruals include an over or under reaction to the economic shock. In order to find any predictive measures for non-discretionary accruals of stock market returns, we test whether nondiscretionary accruals (NDAi,t) contain any over or under reaction to economic shock: CARi ,t = α + β1 DAi ,t + β 2 NDAi ,t + ei ,t . (9) Furthermore, the regression analyses discussed so far include discretionary and nondiscretionary accruals part of total earnings. It is also interesting to test whether operating cash flows predict stock returns. To gain some initial insights into the question, we use the model to add operating cash flows to estimate in a multiple regression as below:

CARi ,t = α + β 1 DAi ,t + β 2 NDAi ,t + β 3 CFOi ,t + ei ,t , (10) where (CFOi,t) is the operating cash flow scaled by one year lagged total assets included in total disclosed earnings for firm i at year t. The main objective of this study is to test the effect of highly concentrated ownership on the informativeness of disclosed earnings. We expect that the quality of earnings should be better in those firms where ownership is more diversified. Alternatively, the performance and quality should be lower in firms with more concentration in ownership. We use pooled cross-sectional regression and firm-specific timeseries regression to test our hypothesis. The multivariate model used for the analysis is as follows: CARi ,t = a + b1 ADAi ,t + b2 ( ADA * Size) i ,t + b3 ( ADA * Growth ) i ,t + b4 ( ADA * Lev) i ,t + b5 ( ADA * VC ) i ,t + b6 ( ADA * StD) i ,t + b7 ( ADA * OlD ) i ,t + b8 ( ADA * FoD ) i ,t + b9 ( ADA * StO) i ,t + b10 ( ADA * OlO ) i ,t + b11 ( ADA * ForO ) i ,t + IND + YRD + ei ,t

(11) where CARi,t is the cumulative market adjusted annual stock return at year t for firm i, ADAi,t is the absolute discretionary accruals. Sizei,t is natural logarithm of total assets at the beginning of year t, Size is included to control for any missing factor that could effect the earnings-return relationship as Atiase (1985) and

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Freeman (1987) has documented that public disclosure and private development of non-earnings information are increasing function of firm size. Growthi,t is the revenue growth at year t because high growth opportunities are associated with future high earnings or persistence. High growth of revenues may lead to higher expected earnings in future and thus a stronger earnings- return relationship (Collins and Kothari, 1989). On the other hand, high growth firms are more risky, which weakens the earnings-return relationship. We control for any empirical effect that revenue growth may have on earnings informativeness. Levi,t is the ratio of total debt to assets. Dhailwal et al. (1991) argue that leverage could be proxy for the riskiness of debt or default risk. The earnings informativeness of highly leveraged firms is lower. On the other hand, Smith and Watts (1992) suggest that leverage represents the investment opportunities of a firm and mature firms usually have high leverage but more information in disclosed earnings. Hence, leverage can also improve the informativeness of earnings. VCi,t is the ratio of voting rights over cash flow rights of the largest controlling owner i.e. the voting right has to be more or equal to 50% in order to have full control of the firm (VC) is inversely related to cash-vote divergence by definition). It represents the gap between ownership and control and if we expect alignment effect to have any significance impact on earnings informativeness, then this coefficient should be positively or negatively related to stock returns. StDi,t, OlDi,t and FoDi,t are the dummy variables if state, oligarchs and foreign corporations are the controlling owner of the firm respectively. StOi,t, OlOi,t and FoOi,t are the total levels of ownership stakes by state, oligarchs and foreign corporations respectively in a firm without any controlling limits. These variables define the difference in slope coefficients for these three major types of owners in Russia. Widely held firms are included as control group to avoid any multicolinearity in the analysis. IND and YRD are included to control for specific industry and year effects. The model is tested in various specifications capturing a particular variable effect if any on the overall coefficients. 5. Results This section describes the results of estimates of the models presented in previous section. First, we discuss the descriptive statistics of all variables used in our study including accounting and ownership variables. Second, the basic results obtained by earnings management and ownership structure is presented and finally we show the results obtained from the earnings informativeness models and possible association of different ownership variables (levels and types of majority shareholders) in the earnings-return relationship.

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 5.1. Descriptive Statistics Table 1 presents the descriptive statistics of ownership variables in our study. Panel A describes the levels of cash flow rights for each type of controlling owner. State owns 41% of ownership stake in all sample firms whereas oligarchs own 57% stakes on average in all listed firms in our sample. The portion of foreign ownership in all firms amounts to almost 40%. These levels of ownership also include cash flow rights of each type with and without control. This is important to understand the effect of the presence of other influential shareholder in the firm when control is held by one of the major shareholders in Russia. For example, if oligarch is the controlling owner in a company, the presence of the state as the second largest owner may have an effect on the discretionary powers of managers and the controller. Panel B of table 1 shows the percentage of control by each type. State has the controlling powers (i.e. more than 50% of voting rights) of almost 55% of the total companies. Oligarchs control 37% of the total companies, whereas foreign corporations have 4% of companies under their control and remaining 4% of the companies are widely held. The distribution of companies with respect to industrial sectors is shown in panel C. Power sector remains the biggest sector in Russia with 28% representation in whole sample. Panel D, presents the distribution of companies with respect to compliance of accounting standards. In our sample period, 53% of the companies comply with Russian accounting standards, which mostly are regional power and ferrous metal companies and remaining 47% issue accounting statements according to international accounting standards (IAS/US GAAP). We have firmspecific time series data as well, so any possible effect of shift from Russian standards to International standards is captured as we use accounting standards compliance dummy in all of our analyses. [Insert Table 1 about here] Figure 1 shows the discretionary accruals across years in whole sample period. Negative (income decreasing) earnings management was more common than positive (income enhancing) management during years 2002 and 2003, whereas on average companies were more involved in positive earnings management during 1999, 2001 and 2004. Figure 1 shows that negative earnings management to avoid taxes took place during tax reforms of 2001-02, whereas lower manipulations took place in 2002 due to lower marginal tax rates (Top statutory tax rate was dropped from 35% in 2001 to 24% in year 2002). [Insert Figure 1 about here] Absolute levels of discretionary accruals (inverse of the quality of earnings) are shown in Figure 2. The levels of discretionary accruals were highest in 2004,

and least in 2002, meaning the disclosed earnings were of better quality in 2002 and worst in 2004. [Insert Figure 2 about here] We then present the descriptive statistics of stock market returns and other accounting variables used in our analysis (equation 11) in Table 2 below. The average cumulative annual gross and market adjusted returns (CAR) across ownership control, industrial sectors and accounting standards compliance are in first two columns of table 2. Widely held companies have higher net-of-market returns but lowest gross returns. Oligarchs controlled companies have 41.7% market adjusted returns as compared to state owned companies that have 29.3% excess returns. Foreign owned companied have negative excess returns, it might be because they are more exposed to international pressures and foreign investors as most of these companies are cross-listed in other markets along-with RTS index which is overwhelmingly dominated by state and oligarchs owned companies who drive the market by controlling the supply and demand forces within Russia. They possess significant amount of liquidity in the market and trade within themselves to affect the market value and stock index. Oligarchs owned companies are the largest companies as they have an average size of more than 34 million US dollars of assets ahead of foreign owned companies with almost 23 million USD of total assets. Oligarchs also have highest leverage indicating a higher riskiness of their equity stake. The revenue growth of almost 36% shows the future profitability and higher consumer base, which is consistent with high returns of oligarchs owned companies. Foreign owned companies have highest market to book ratio representing growth opportunities, high market price can also be representative of more investor confidence. The last two columns of the table 2 represents the profitability of companies where operating and net profit are shown in averages across all ownership types and industrial sectors. [Insert Table 2 about here] 5.2. Test of Ownership and Discretionary Accruals Before making direct prediction about disclosed earnings and stock returns, we perform analysis of directly relating earnings management and ownership structure in order to understand the endogeneity of earnings when ownership is concentrated. Table 3 presents the simple t-test of the levels (absolute values) of discretionary accruals across different ownership, industrial sectors and accounting standards compliance. Difference-in-mean analysis is done to show the direction of earnings management between positive and negative accruals. We divide whole sample into positive and negative discretionary

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 accruals and results show that the levels of discretionary accruals are significant across all ownership types and industrial sectors. Overall the mean of positive accruals is higher than the mean of negative accruals. The difference of mean 0.051 is significant at 5% level. The quality of earnings of state owned companies is quite bad with positive accruals significantly higher than negative accruals. The same results hold in ferrous metal and power sectors. Earnings management in companies complying Russian accounting standards is significantly higher than those complying international standards while reporting. This result is consistent with previous literature on Russia (e.g. Desai et al. 2005). International accounting standards compliance leads to better, timely and transparent disclosure of information. It not only increases quantity of disclosure but quality as well. [Insert Table 3 about here] Table 4 presents the univariate regression of both signed and absolute discretionary accruals with ownership variables (levels and types). The literature on earnings management model directly relating company fundamentals like income, cash and accruals argue that these models possess the problem of omitted variables and hence very low predictive powers because, there are certain unobservable factors which impact earnings-return relationship other than firm characteristics (Jones, 1991, Dechow et al. 1995, Guy et al. 1996). We try to control the problem of omitted variables by introducing some industry, year and accounting standard variables in an earningsownership relationship. Ownership being one of the variables to affect the earnings management practices of companies should also capture some misspecifications. Ownership levels and control types should have an impact on manipulations. We have shown in table 3 that earnings management is persistent across all ownership types and industrial sectors, hence, it makes more important to assess the quality of earnings with respect to different ownership structures. Both entrenchment and alignment effect if present should explain earnings management (discretionary accruals in our case). White-adjusted tstatistics for all the coefficients are reported due to heteroskedasticity. Table 4 shows that the direction of earnings management is consistent with our predictions based on our hypothesis presented in section 2. Long-term motives (value enhancing) of state owned companies and short-term objectives (tax management) seems supported but we do not find any significant relationship with actual discretionary accruals. However, the levels of discretionary accruals are significantly lower in state-owned companies as compared to others. This is consistent with both types and levels of state ownership. [Insert Table 4 about here]

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5.3. Ownership and Earnings Informativeness Results from pooled cross-sectional and firm-specific time-series regressions are similar to those reported below. Table 5 reports the time-series mean of the estimated annual cross-sectional regression statistics. For each model, we report estimated parameters, standard errors and White-adjusted t-statistics for all the coefficients to eliminate heteroskedasticity. We begin with regression on total accruals (panel A). Total accruals are negatively related to returns but this relationship is insignificant at traditional level. Since total accruals include both nondiscretionary and discretionary accruals and performance measure hypothesis expect the negative correlation between two types of accruals. Any over or under reaction of economic shock should be offset by an opposite discretionary accruals. So individual relation with each type of accruals should be measured to make assessment of performance measure hypothesis. Panel B of table 5 shows the regression of returns with discretionary accruals. The coefficient is negative (0.657, t-value: -1.92) and significant representing negative informativeness of discretionary accruals on stock returns. Opportunistic earnings management hypothesis is supported by the results presented in Panel A and B of table 5, where we see that discretion is used over earnings (accruals part) to get private benefits of ownership which include entrenchment, self dealing or other short term goals e.g. tax management. We then add nondiscretionary accruals in the regression and results are presented in panel C, it shows no informativeness (0.804, t-value: 0.68) of non-discretionary accruals predicted by performance measure hypothesis. Positive coefficient of nondiscretionary accruals is as expected by performance measure hypothesis but not significant. Therefore, we support the notation that companies in Russia use discretionary accruals for opportunistic purposes. These results are consistent with entrenchment effect of majority shareholders. We further add cash flow component of total earnings to check if there is any relation of cash flow generated directly from operation affect the stock returns. Panel D of Table 5 shows the coefficient estimates of equation (10). Cash flows are insignificantly but negatively correlated with returns. Note that the explanatory power of all models in table 5 is low. In general, the weak association of returns with discretionary and nondiscretionary accruals and negative association of discretionary accruals are inconsistent with the joint hypothesis that the market reacts mechanically to discretionary accruals and that the model accurately identify discretionary accruals. The results also suggest the inefficiencies in Russian market where discretion is used by majority or controlling owners over earnings in general and accruals in particular to opportunistically create sources of expropriation of rights of minority

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 shareholders. Opportunistic earnings management hypothesis holds. [Insert Table 5 about here] We also test the relative effect of different ownership variables on the earnings-return relationship. Table 6 presents the results obtained by the pooled cross-sectional regression on returns with different firms characteristics and ownership levels and types. Again we report White-adjusted t-statistics for all the coefficients to capture and eliminate heteroskedasticity. The next step is to check whether different ownership structures explain this use of discretionary powers. For this purpose, we use levels of discretionary accruals in each firm year to find the relationship between returns and levels of earning management (use of discretion) with ownership and firm-specific variables. The levels of discretionary earnings management (ADA) are insignificant but it doesn’t contrast to results of simple regression in table 5. Earnings are informative (negatively) but their levels (negative and/or positive) do not explain contemporaneous returns and there relationship also becomes insignificant because of the inclusion of the additional variables. The levels of discretionary accruals of larger firms seem to have lower returns because the Size coefficient is negative but significant in model 3 and 5 where we include control type dummies. Model 1, 2 and 3 show lower informativeness of earnings in high revenue growth firms, which is consistent with the fact that the use of discretion over revenues (especially credit sales) is much easier and high growth firms become more risky thus keeping the levels of accruals constant, an increase in revenue growth decrease contemporaneous market adjusted returns. Leverage is positively related to returns consistent with the view that highly levered firms tend to be mature firms and thus have more credible earnings in spite of any levels of discretion. The results in all models presented in Table 6 support the notation that the presence of creditors in the corporate governance increases the informativeness of disclosed earnings. This result is also consistent with earlier research on other parts of the world 2 . The creditors can be better monitors in countries where legal and investor protection is weak because large creditors put a lighter burden on legal system than the small investors might if they tried to enforce their rights. In order to investigate the effect of separation of cash flow and voting right on earnings informativeness, we use ratio of voting rights over cash flow rights obtained by each controlling shareholder. To be consistent with entrenchment effect we should observe a significantly positive coefficient of VC which is by definition inversely related to cash-vote divergence. We do not find any 2

see Shleifer and Vishny (1997) for a detailed note on the role of large creditors in corporate governance.

significant relationship between cash-vote divergence of controlling shareholder and stock returns. It means that obtaining more cash flow rights than the minimum level needed to effectively control the firm do not produce any addition in the market value of the firm. The result can be considered consistent with alignment effect. The control type dummies are added to check if there is any difference in slope coefficient between CAR and levels of discretionary accruals and the results show that both State and oligarch control is positively related to stock returns at the given level of earning management. It is very interesting that the credibility of earnings disclosed by both control groups increases when either gets effective control. There can be two explanations of this result. Whether investors consider both of them as credible controllers of firms and do not put much attention over the levels of discretionary accruals used as they are beneficial for all. Or the disclosed earnings simply improve the value relevance of earnings conveying private information to the stakeholders and public. When we add levels of cash flow rights by each type of owner when they are not in control, it further clarifies the phenomena. The results in column 4 and 5 of table 6 show that levels of ownership by oligarchs without control negatively affect the stock returns at a given level of earnings management. It clarifies that its control only that increases the value relevance of earnings not the levels of cash flow rights. This result is again consistent with opportunistic earnings management hypothesis that majority owners and controllers of firm are involved in earnings management (both positive and negative), which in turn give them shortterm benefits. Low liquidity of Russian stock exchange, lower dividend payout ratio and significantly lower value of non-voting preferred shares in Russia can also be the results of these short term benefits extraction. The level of foreign ownership also decreases the credibility of earnings and hence reduces the stock returns. [Insert Table 6 about here] 6. Conclusion Using pooled cross-sectional and firm specific timeseries regression we test for earnings management practices of Russian listed firms in different ownership setups. We tested the value relevance of earnings with performance measure and opportunistic earnings management hypotheses. Performance measure hypothesis where firms manage earnings by discretionary accruals to offset the over or under reaction of economic shock present in nondiscretionary earnings is not supported. The use of accrual based accounting in Russia has resulted in lower informativeness of earnings due to use of powers for opportunistic purposes where in a highly concentrated ownership environment the majority shareholders (controllers) enjoy short-term

19

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 benefits of manipulating the accounting numbers. These benefits include, tax management to avoid heavy taxes, entrenchment plans, speculative insider trading before or after disclosure. Accrual accounting is serving the purpose of control group only. We further hypothesized that significant use of discretionary accruals is explained by ownership structure and both control and levels of ownership affect the informativeness of disclosed earnings. The traditional aspect of agency theory where conflicts lie between control (managers) and ownership shifts away to the conflict between majority and minority shareholders in highly concentrated environment of Russia. We found that state-owned companies use lesser discretion to manipulate the earnings than other control groups (oligarchs and foreign corporations). However, the market reaction of accounting numbers is positive with control by either state or oligarch. Leverage increases the informativeness of earnings but size and revenue growth reduce it at given level of discretionary accruals. The levels of ownership stake without control by oligarchs and foreign corporations are negatively related to earnings informativeness. Cross holdings and business groups of Russian economy do not provide ample opportunities for outside investors to trade on public information. This partly explains the lower liquidity and market valuation of Russian companies. The control of major Russian firm is in the hand of state or those big business tycoons. State firm have some long-term objectives of privatization and increasing the value but they still lack property rights enforcement. In the presence of significant benefits attached to control, the non-voting (preferred) shares have very low value in Russia. We propose that in order to improve the quality of corporate governance and earnings quality in Russia, first there should be full isolation between state and private ownership as sometimes they have common objectives and sometimes they combine powers to design the firm’s policy matters. In both cases, minority shareholders suffer so state should first isolate itself from private companies and then make sure that the proper corporate regulations and property rights are enforced. State should more concentrate on its role as a useful monitor than the active participation in the corporate sector.

4.

5.

6.

7.

8.

9. 10.

11.

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15.

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Appendices

.1 .05 0 -.05 -.1

1999

2000

2001

2002

2003

2004

Figure 1. Average discretionary accruals across years

0

.05

.1

.15

.2

.25

Absolute Discretionary Accruals by Years

Absolute Discretionary Accruals

Average Discretionary Accruals

.15

Average Discretionary Accruals by year

1999

2000

2001

2002

2003

2004

Figure 2. Average discretionary accruals across years

21

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 1. Distribution of ownership levels and types of controlling owner in whole sample period Mean

Median

Min

Max

Obs

0.003

0.956

207

Panel A: Level of ownership MOWN

0.262

0.149

COWN

0.499

0.464

0.123

0.97

315

STOWN

0.408

0.313

0.0418

0.83

195

OGOWN

0.570

0.605

0.0793

0.97

147

FOWN

0.400

0.2704

0.0803

0.895

26

State

0.55

1

0

1

182

Oligarch

0.37

0

0

1

123

Foreign

0.04

0

0

1

12

Widely held

0.04

0

0

1

13

Ferrous Metal

0.16

1

54

Panel B: Controlling owner type

Panel C: Industrial Sector’s 0

0

Power

0.28

0

0

1

93

Oil & Gas

0.16

0

0

1

54

Telecom

0.15

0

0

1

51

Others

0.25

0

0

1

78

RSA

0.53

1

0

1

176

ISD

0.47

0

0

1

154

Panel D: Accounting Standards and ADRs

The table presents the distribution of ownership across all listed Russian firms in the sample. Panel A presents the levels of ownership stake 8cash flow rights) by all major types of owners like management (MOWN), the state (STOWN), oligarchs (OGOWN) and foreign corporations (FOWN). The level of cash flow rights by controlling owner is represented by COWN. Panel B shows the types of controlling owners and percentage of companies owned by each type of controlling owner. Panel C describes the distribution of whole sample by major industrial sectors and Panel D shows the percentage of firms complying Russian Accounting standards (RSA) and International Accounting Standards (ISA) by all firms included in the sample.

Table 2. Descriptive Statistics of stock returns and accounting variables used in earnings-return regression Gross Return (%)

CAR (%)

Size (USD million)

Leverage (%)

Revenue Growth

Market To Book

Operating Profit (%)

Net Profit (%)

74.2

33.9

22983.63

10.5

34.0

1.701

11.7

5.8

State

56.7

29.3

16070.78

9.1

35.1

1.475

9.2

3.0

Oligarch

108.8

41.7

34474.87

13.9

35.9

1.891

14.2

8.5

Foreign Widely held

79.7 26.4

-27.0 48.9

22791.37 11216.25

7.5 0.9

32.9 5.4

3.453 1.484

18.3 18.3

12.3 13.2

Ferrous Metal Power

127.6 65.0

45.1 18.9

16450.07 22827.52

5.8 5.1

41.4 6.2

1.722 0.913

16.4 3.9

9.3 -0.7

Oil & Gas

119.0

35.1

62496.4

13.6

28.9

2.831

21.5

13.5

Telecom

36.3

24.2

5232.68

10.5

105.6

1.660

12.5

6.2

Others

64.4

51.5

11944.4

18.1

19.2

1.900

10.8

5.6

RSA

73.7

30.5

15028.93

7.6

14.1

1.685

11.7

4.9

Overall

ISA 74.6 38.5 32074.72 13.9 57.4 1.721 11.8 6.7 The table presents the descriptive statistics of performance indicators. It includes Gross Return (the cumulative annual return on equity), CAR is the market adjusted cumulative annual return; Size is the amount of total assets in USD millions. Leverage is the ration of total debt to total assets in percentage. Revenue growth is the difference in revenue generated in year t by previous year divided by revenues of previous year. Market to Book Ratio is the ratio of market value of equity per share divided by book value of equity. Operating profit and net profits are the percentage over total equity of the firm. The statistics are presented for type of each controlling owner, industrial sectors and accounting standards compliance respectively.

22

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 3. Difference in mean analysis (t-test) of absolute discretionary accruals ADA

Mean

t value

Diff (Pos –Neg)

Min

Max

Obs.

0.0001

1.4738

330

0.0001

1.4738

147

0.0002

0.6962

183

0.6962

182

1.4738

123

0.3754

12

0.6373

13

1.1603

54

0.5076

93

0.4799

54

0.3967

51

1.4738

78

0.7458 1.4738

176 154

Panel A: Discretionary Accruals across whole sample Overall

0.1417

15.79***

Positive DA

0.1700

10.01***

Negative DA

0.119

14.23***

State Oligarch Foreign Widely held

Ferrous Metal Power Oil & Gas Telecom Others

0.0510 (2.85)**

Panel B: Discretionary Accruals across Ownership levels 0.0371 13.77*** 0.0002 (2.10)** 0.0601 0.1671 8.69*** 0.0001 (1.59) 0.0005 0.1591 4.71** 0.0066 (0.01) 0.0589 0.1878 3.99** 0.0106 (0.59) Panel C: Discretionary Accruals across Industrial Sectors 0.1025 0.1763 6.04*** 0.0068 (2.20)** 0.0500 0.1227 9.77*** 0.0002 (2.02)** 0.0096 0.115 7.51*** 0.002 (0.30) -0.0529 0.1245 9.34*** 0.0017 (-1.39) 0.0629 0.1702 6.94*** 0.0001 (1.25) Panel D: Discretionary Accruals across Accounting standards compliance 0.1202

RSA 0.1581 14.33*** ISA 0.1231 8.54*** *, **, *** Significant at 10%, 5% and 1% levels respectively

0.0002 0.0001

0.035 1.96*

Table 4. Univariate Analysis of Ownership and Earnings Management with controls

Signed Discretionary Accruals

Absolute Discretionary Accruals

-0.0344 (-0.48) 0.0267 (0.48) 0.0487 (1.04)

-0.0025 (-0.04) -0.0238 (-0.54) -0.0733** (-2.22)

OGOWN

0.0368 (0.83)

FOWN STATE

MOWN COWN STOWN

OLIG FOR

Controls

No. of Observations

Adjusted R2

Yes

207

6.3/2.2

Yes

330

6.3/2.3

Yes

195

6.4/3.1

0.0447 (1.32)

Yes

147

6.4/2.6

-0.1082 (-1.17)

0.0537 (0.75)

Yes

26

6.6/2.4

0.0197 (0.66)

-0.0445** (-2.01)

Yes

330

6.3/3.0

-0.0002 (-0.01) -0.0876 (-1.59)

0.0322 (1.45) 0.0175 (0.43)

Yes

330

6.2/2.7

Yes

330

6.8/2.2

** Significant at 5% level The coefficient estimates of univariate regression with discretionary and absolute discretionary accruals are shown in table above. The equation of discretionary accruals and ownership type and level used is DA = a + bOW N and regression equation i ,t i ,t (levels ,types ) + dV i ,t + ei ,t of absolute accruals is A DA = a + bOW N . Table shows the coefficients of Management ownership (MOWN), i ,t i ,t (levels ,types ) + dV i ,t + ei ,t Controlling owner’s cash flow rights (COWN), state ownership levels (STOWN) and oligarchs’ level of ownership (OGOWN). Then STATE is the coefficient representing the dummy variable if state is the effective controller of firm. Similarly, OLIG and FOR are the dummy variables for oligarchs and foreign corporations provided they are the ultimate owner of a firm. Robust t-statistics are in parentheses.

23

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 5. Pooled regression of cumulative annual market adjusted returns on accruals and cash flow components of earnings

Model

α

Panel A: Returns on Total Accruals:

Panel B: Returns on Discretionary Accruals: 0.448** 0.151 2.97

Mean St. Error t-value Panel C:

β2

β3

Adj. R2 (%)

F-stat (p-value)

0.3

7.38 (0.007)

0.4

7.32 (0.007)

0.5

3.75 (0.025)

CARi ,t = α + β1TA + ε i ,t

0.437** 0.151 2.90

Mean St. Error t-value

β1

-0523 0.337 -1.55

CARi ,t = α + β 1 DAi ,t + ei ,t -0.657* 0.343 -1.92

CARi ,t = α + β 1 DAi ,t + β 2 NDAi ,t + ei ,t 0.461** 0.160 2.88

Mean St. Error t-value

-0.657* 0.356 -1.85

Panel D: Returns on Accruals and Cash Flows: CARi ,t

0.804 1.183 0.68

= α + β 1 DAi ,t + β 2 NDAi ,t + β 3CFOi ,t + ei ,t

Mean 0.533** -0.661* 0.546 -1.909 2.54 1.3 St. Error 0.239 0.361 1.126 3.194 (0.057) t-value 2.22 -1.83 0.48 -0.60 The regression coefficients of each model for earnings informativeness are presented in table 5. CARi,t is the cumulative market adjusted annual return of form i at year t. TAi,t is the total accruals of firm i for year t, DAi,t is the discretionary accruals of firm i for year t. Similarly NDAi,t and Cashi,t are non-discretionary accruals and cash flows of firm i in year t. respectively. All variables are scaled by lagged total assets. We present the mean value of coefficient, standard errors and corresponding robust t-values. * significant at 10% level of significance. ** significant at 5% level of significance. *** significant at 1% level of significance

Table 6. Pooled regression of returns on absolute discretionary accruals and ownership variables CAR Intercept ADA ADA*Size ADA*Growth ADA*Lev ADA*VC

1

2

3

4

5

0.285 (1.61) 1.454 (1.21) -0.222 (-1.29) -0.606* (-1.87) 1.735*** (8.75)

0.312* (1.71) 1.427 (1.18) -0.299 (-1.47) -0.641** (-2.08) 1.671*** (8.46) 0.406 (0.65)

0.287 (1.55) 1.146 (1.24) -0.492** (-2.43) -1.132* (-1.82) 1.523*** (6.87) -0.221 (-0.29)

0.329* (1.73) 1.633 (1.15) -0.238 (-1.17) -0.396 (-0.57) 1.687*** (8.21) 0.465 (0.64)

0.302 (1.58) 1.398 (1.25) -0.511** (-2.16) -0.530 (-0.78) 1.490*** (6.52) -0.449 (-0.62)

Control Type: ADA*StD ADA*OliD ADA*ForD

2.737** (2.21) 3.171* (1.85) 0.565 (0.46)

5.147** (2.50) 7.386** (2.30) 12.822 (1.11)

Ownership Levels: ADA*StO ADA*OliO ADA*ForO No. of observations 175 169 169 Adjusted R2 1.6 1.8 2.5 F-stat 20.22*** 15.08*** 14.80*** * significant at 10% level of significance ** significant at 5% level of significance. *** significant at 1% level of significance

24

-1.929 (-0.87) -1.247 (-0.65) -4.260** (2.18) 169 2.1 13.23***

-5.247 (-1.53) -6.219* (-1.86) -17.207 (-1.09) 169 3.8 10.40***


CORPORATE GOVERNANCE AND THE DYNAMICS OF OWNERSHIP OF GERMAN FIRMS BETWEEN 1997 AND 2007 Bernhard Schwetzler*, Marco O. Sperling** Abstract La Porta et al. (1999) find that countries with weak corporate governance tend to have higher ownership concentration than countries with legal systems that protect shareholders well. Changes in the quality of corporate governance are often followed by adjustments in ownership structure. On a sample of first layer as well as ultimate ownership (10% and 20% cut-off threshold) data for 11 years between 1997 and 2007 for German firms listed in the DAX, we examine the dynamics of ownership structure. We find that ownership concentration strongly declined. Further, foreign financial institutions became an important investor group with an increase of average stake from 0.4% in 1997 to 9.1% in 2007. We conclude that the quality of corporate governance increased and the Germany capital market became more open during that period. Keywords: corporate governance, ownership concentration, ultimate ownership, Germany *WestLB Chair of Finance at HHL – Leipzig Graduate School of Management and Academic Director of the Center for Corporate Transactions (CCT) **Research Associate at the Center for Corporate Transactions (CCT) at HHL – Leipzig Graduate School of Management

1. Introduction Corporate governance and shareholder protection in Germany is perceived to be weak compared to AngloSaxon countries (La Porta et al. (1999)). During the last 10 years, however, there have been several efforts to improve corporate governance in order to make German firms more attractive for international investors. One interesting aspect of corporate governance is its impact on ownership structure. Demsetz (1983) was among the first to argue that ownership structure is endogenous and adjusts in order to maximize firm value for investors. La Porta et al. (1999) find that countries with weak shareholder protection tend to have higher levels of ownership concentration. There is large body of literature providing empirical evidence for the impact of corporate governance on the value of the firm. In parts factors influencing corporate governance of a firm are given exogenously by the prevailing legal environment. But the quality of a firm’s governance can also be shaped by the management and its owners. Shareholder protection and rights can also be adjusted on firm level e.g. by reducing anti-takeover provisions or allowing proxy voting. Gompers et al. (2003) was among the first to find that well-governed firms perform significantly better compared to their poorly-governed counterparts (for evidence on German firms see Drobetz et al. (2004)). Further, the impact of ownership structure upon firm value is also well documented in the literature: extensive research has been done on the influence of

internal/external ownership and concentrated ownership (e.g. Himmelberg et al. (1999) or Thomsen et al. (2006)) and especially on management ownership upon corporate value (e.g. Mørck et al. (1988), Davies et al. (2005) or Kaserer and Moldenhauer (2007)). The legal environment is argued to have an impact on ownership structure and concentration: laws and regulations implying “weak” governance systems (in terms of legal protection for shareholders) impose higher costs of monitoring and control on shareholders. In order to secure effective control against malicious management and in order to get compensated for the higher monitoring cost by the benefits of closer control of management, a monitoring shareholder has to own a larger stake in the equity of the firm when governance mechanisms are weaker. Thus, in some sense ownership concentration may serve as a substitute for legal protection (see Shleifer and Vishny (1986)). On the one hand this is beneficial for all shareholders due to more efficient monitoring of managers, i.e. mitigating the principal agent conflict between owners. On the other hand it also includes deadweight costs of potential abuse of this power by siphoning benefits out of the company (so called tunneling) at cost of minority shareholders. Furthermore, in the case of concentrated ownership a conflict between controlling and minority shareholders might arise (for a discussion of these effects see Holderness (2003)). On the development of corporate governance in Germany Goergen et al. (2008) summarizes empirical evidence on the convergence in function towards Anglo-Saxon

25

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 model. We want to extent this stream of literature by investigating the development of corporate governance and ownership structure over time. We collected annual first layer as well as ultimate ownership data for firms listed in Germany’s DAX index over a time from 1997 to 2007 and grouped investors in order to find out if composition and concentration of owners changed since it is widely believed that ownership structures are rather sticky. This paper is organized as follows. Section 2 describes reasons why Germany is a special case in terms of corporate governance as well as ownership structure and outlines major changes in corporate law during the last 15 years. The methods of how we constructed our data sets are described in Section 3. Section 4 discusses our results and its implications. Section 5 concludes. 2. Major Development in Corporate Governance in Germany Currently, there is an ongoing debate in Germany about improving domestic corporate governance and in recent years there have been developments to change the legal environment (e.g. Hackethal et al. (2003) or Steger and Hartz (2005)). However, before discussing current changes we want to stress some reasons why German corporate governance is of particular interest for research. In Germany, a prototype of a bank-based economy, even large firms tended to rely heavily on internal funds and credits provided by their relationship bank as a financing (Franks and Mayer (2001)). The capital market is less developed in terms of size and liquidity compared to Anglo-Saxon countries although German and British capital markets looked quite similar in many ways at the beginning of the 19th century. However, in Britain (inside) ownership concentration decreased in favour of free float whereas it was substituted by outside ownership concentration in Germany (Franks et al. (2005)). Moreover, at the end of the 1990s it was not unusual even for the largest firms to have multiple classes of shares outstanding. Thus, significant deviations from the one-share one-vote principle were quite common. Often these deviations were used in order to secure the influence of incumbent owners. Further, German corporate, security, and labor law offer weak shareholder protection (La Porta et al. (1998)) and offers some peculiarities like a two-tier board structure (a supervisory board is controlling the management board) and “co-determination” (Mitbestimmung). “Co-determination” makes representation of employees at the supervisory board mandatory. In most of the cases, employees account for a third to half of the seats at the supervisory board. Another characteristic is the strong influence of German banks and insurance companies. Only until recently there were strong capital links between the relationship banks and its (corporate) costumer. Many

26

German banks and insurances did not only hold debt but also considerable equity stakes in many large German firms. Further, many banks had and to some extent still have representation on the supervisory board of German firms (for the effects of this see Dittmann et al. (2008)). Additionally, German banks and insurances have a keen voting power and influence on the general assembly due to proxy voting. Due to these factors ownership structures of German firms developed differently compared to their Anglo-Saxon counterparts. Until the beginning of this decade, the ownership structure of Germany’s largest firms was tellingly labeled as “Germany, Inc.” since it was characterized by a web of cross holdings and pyramidal ownership (among others La Porta et al. (1999), Faccio and Lang (2002) or for the impact of cross holdings see Adams (1999)). The result was a high degree of insulation of managers from capital market pressure. It was hard for raiders to acquire significant voting power in order to gain control. Furthermore, unsolicited takeover offers and unfriendly takeover attempts were almost unknown in corporate Germany. However, there have been significant changes in the legal and regulatory environment in Germany during the last 15 years. Corporate law has undergone some major changes: most notably the “Law for the Strengthening of Control and Transparency” (KonTraG) increased the power of the supervisory board in controlling management effectively and introduced the possibility for stock-based compensation which was virtually unknown before in corporate German. Public and political awareness on corporate governance issues was further propelled by the report of a “Government Commission on Corporate Governance” and a Corporate Governance Code developed and published by the so called “Cromme Commission” containing governance regulations and meanwhile being voluntarily adopted by most large German firms. It is possible to adapt only parts of the Code. Nevertheless, firms not adopting the standards are required to state this in their annual statement. The Securities Exchange act (WpHG) in 1995 and the creation of a new Federal Authority (BaFin) supervising the stock market activities in 2001 additionally fostered the development of the German equity market. In 2001 the German federal government introduced a tax relief for corporations which allow them to sell equity investments without having to pay taxes on profits. The purpose of it was to encourage corporations to disentangle their cross holdings. The introduction of a German takeover act in 2002, including regulations for mandatory offers and reducing managerial discretion in takeover defense measures further increased the level of shareholder protection. To sum up, even though significant peculiarities of the German corporate and labor law still prevail one might conclude that shareholder protection has materially improved recently.


3. Sample Description and Methodology Our initial sample consists of 30 German firms listed in the DAX over 11 years between 1997 and 2007. We took data from Commerzbank’s “Wer gehört zu wem? – Beteiligungsverhältnisse in Deutschland” in order to construct ownership data using three different definitions: first layer ownership and ultimate ownership using 10% and 20% as cut-off threshold. There are many different definitions of ultimate ownership (e.g. La Porta et al. (1999) for a sample of international data or Köke (2004) for German firms) taking pyramids, cross holdings, and a multitude of voting rights differently into account which sometimes leads to conflicting results. We used the algorithm of Faccio and Lang (2002). However, it was only possible to obtain data for 302 firm years from the above mentioned publication (for the distribution over time see Table 1). To investigate dynamics of ownership structure we grouped owners into ten different investor classes: The group “Individuals/families” which includes individuals, families and groups of individuals may have emotional ties to firms they own equity in. This may be especially important if they are the founders of the firm. For outside (minority) shareholders, concentrated ownership by families or individual may turn out to be a double edged sword: on the one hand it ensures a close alignment of interest between management and owners, if the founder/manager owns a significant equity stake in the firm (for a comparative analysis of family capitalism see Franks et al. (2008)). On the other hand family owners/managers may reap private benefits at cost of minority shareholders (see Maury (2006)). Further, agendas with respect to other stakeholders (e.g. giving job guarantees) of a family managers/owners may be conflicting with minority shareholders who are interested in maximizing the value of their stake. “German financials” are of special interest because the influence of German banks and insurances by block holdings, board membership and proxy voting was considered to be one of the major drawbacks of the “old” German corporate governance. There were considerable cross holdings between German financial firms especially in the early years of our sample. One might assume that

banks and insurances were controlled by their management and not by their owners. Further, the interests of banks and insurances might not necessarily be maximizing their equity stake but their combined debt and equity stake they hold in a firm. All owners of voting rights that are non-financial firms with their origin in German are grouped into “German non-financial firms”. For firms listed in the DAX these owners are important since some of Germany’s recent spin-offs of large firms entered directly into the major index. Another important owner is the “German government”. Due to the privatization of state owned companies the German government turned out to be an important capital market participant owning large stakes in some German firms. As entities owned by the government are perceived to be prone to the political decisionmaking process firms that are controlled or influenced by government authorities deserve particular interest. Two prominent examples in this category are Deutsche Telekom AG as well as Deutsche Post AG. It was impossible to sell the equity at one time to the capital market due to liquidity reasons so the German government remained a block holder for some time after their IPOs. Equity of these firms was mainly bought by small investors. 3 Some firms in Germany are owned by foundations (“German foundations”). Foundations holding equity are sometimes established due to tax considerations since they benefit from peculiarities in the German tax code. “Foreign financials” subsumes all financial firms especially foreign mutual funds that do not have their origin in Germany. All non-financial firms that own voting rights in German firms are grouped into “Foreign non-financial firms”. Likewise German government, foreign government and government sector entities are comprised in the group “Foreign government”. The owner group “Employee” consists of all voting rights held by employees of the firm. The owner group “Not disclosed” comprises all owners who not belong to any of the above mentioned groups. This is especially important for privately owned limited liability firms who are quite common in Germany since we are not able to identify owners of this type of companies.

3

In contrast to that, privatization of former French state owned firms took another path. Since in France small investors were reluctant to buy equity, former state owned firms acquired each others equity leading to an ownership structure characterized by cross holdings likewise the Germany, Inc. (see Harbula (2006)).

27


28


To examine changes in the quality of corporate governance we measure ownership concentration. Since concentrated ownership is a substitute for good corporate governance an increase in the quality of corporate governance should be followed by a decrease of ownership concentration. We measure ownership concentration by calculating the Herfindahl index for the five largest shareholders for each firm and then averaging over all firms for each given year. The index H(x) is the sum over the squared percentages of the equity stakes: n

H( x ) = ∑ (si )

2

i =1

Clearly, the higher the shareholder concentration, the higher is H(x). Moreover, the highly non-linear features of H(x) should be noted: H(x) is 0.25 if there is one owner holding 50% and all other stocks are in free-float and 0.05 if there are five owners holdings a 10% share each. 4. Results and Their Implications for Corporate Governance One of our most important results is the material decrease of German financial institutions as owners when looking at first layer owner data (see Table 2 Panel A). Their stake drops from 12.9% in 1997 to 1.5% in 2007 while foreign financials increase their stake up to 9.1% coming from under 1%. In 2007 they have become the largest group of owners of DAX firms. Furthermore, the importance of individuals and families as owners of DAX firms also declines over time. The average stake of the German government fell to 3.1% coming from 10.1% in 2001. All other owner groups remain more or less constant in their stake of voting rights. When taking a look at ultimate ownership data in Table 2 Panel B it becomes clear that individuals and families are still an important group of owners as they ultimately own 6.9% of voting on average over time and about 4% in 2007. However, on the ultimate level the German government and, for the late years of the sample, foreign investors become more important than individuals. Further, the significance of German financials vanishes completely while foreign financial gained importance. When looking at the ultimate ownership data using a 20% cut-off threshold (Table 2 Panel C), neither German nor foreign financials are of any significance. This might have two rather technical reasons: first, since there were frequent cases of cross holdings among German financial firms, many of their voting rights simply cancel each other out. Although this effect is also present in the ultimate ownership sample using a 10% cut-off threshold, it is more severe when applying the stricter definition. Second, foreign investors are not owners in the sense of this definition because mostly they only

own between 3% and 5% of voting capital each. There is hardly any case in which a single foreign financial firm owns more 20% of voting rights, thus, they drop out. The decrease of entanglement and emergence of foreign investors is show in the anecdotic case of the network of cross and pyramid holdings around Munich Re and Allianz which formed the “heart” of “Germany, Inc.” (see Figure 1). It might be deduced that voting power and control of German financial institutions has been decreasing significantly over time. However, our study only takes a look at equity participation and leaves stakes in debt as well as seats on supervisory board aside. Therefore, the influence of German financial institutions might have decreased less then the numbers would suggest while foreign financial firms have taken their place. This can be taken as evidence that German equity markets are integrating into the global capital markets. Besides changes in composition of owners, it is also remarkable that the overall concentration of ownership sharply decreased over time. In 1997 there were on average about 40% of all voting rights in the hands of block holders. This number dropped to 26% in 2007, i.e. the average ownership concentration decreased by 35% within only 11 years. The effect is stable in the ultimate ownership samples: there is a decline from 30% (19%) to 16% (8%) when looking at ultimate ownership data using a 10% (20%) cut-off threshold. Further, the Herfindahl index of ownership concentration shown in Table 5 also declines over time. The effect is stable for all three ownership definitions. It should be noted that there is a sharp decline after 2001 which might be attributed to the 2002 tax relief act mentioned above which made it possible for firms to sell off equity holdings without being taxed for profits. Further, Table 5 shows that the number of widely held firms increased for the two ultimate ownership definitions. Being widely held on the first layer would mean that the firms have a free float of 100% while it means on ultimate ownership level that the firms do not have a ultimate owner according to the definition. We take this as evidence that the quality of corporate governance increased over time. It seems that investors reduced their controlling share over time since improved rules provided them with better possibilities to control and in the case of low performance punish management. 5. Conclusion We investigate the development of corporate governance and ownership structure in Germany over 11 years between 1997 and 2007. Further, we review the most important changes in the legal framework. We find that the composition of owners changed significantly over the time of the sample. The assumption that ownership is rather sticky over time

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 seems to be rather contestable. The importance of German financial firms as owners sharply declined during the last years of the sample while foreign financials build up a significant average share of voting rights. Since most other groups only declined slightly in their average stake, we suspect that German financial firms were substituted by their international counterparts, especially mutual funds. We take this as evidence that Germany is now more attractive for participants of the international capital markets. The average ownership concentration of Germany’s largest firms dropped over the years. Since ownership concentration is a substitute for effective corporate governance we take this as evidence that the legal changes aiming to improve the quality of Germany’s corporate governance worked well. Further, it seems that investors can efficiently monitor management with an on average smaller stake in voting rights now. This can be taken as evidence that the legal changes helped mitigate agency conflicts between managers and owners. We expect that Germany will become even more open for international investors and that the concentration of owner will further decrease. It would be an interesting task to compare the dynamics of ownership structures between different countries with respect to changes their legal system. References 1.

2.

3.

4.

5.

6.

7.

8.

30

Adams, M. (1999), ‘Cross Holdings in Germany’, Journal of Institutional and Theoretical Economics, 155(1), pp. 80–109. Davies, J. R., Hillier, D., and McColgan, P. (2005), ‘Ownership Structure, Managerial Behaviour and Corporate Value’, Journal of Corporate Finance, 11(4), pp. 645–660. Demsetz, H. (1983), ‘The Structure of Ownership and the Theory of the Firm’, Journal of Law and Economics, 26(2), pp. 375–390. Dittmann, I., Maug, E. and Schneider, C. (2008), ‘Bankers on the Boards of German Firms: What they do, what they are worth, and why they are (still) there’ (February 2008), ECGI - Finance Working Paper No. 196/2008, Available at SSRN: http://ssrn.com/abstract=1093899. Drobetz, W., Schillhofer, A. and Zimmermann, H. (2004), ‘Corporate Governance and Expected Stock Returns: Evidence from Germany’, European Financial Management, 10(2), pp. 267–293. Faccio, M. and Lang, L. H. P. (2002), ‘The Ultimate Ownership of Western European Corporation’, Journal of Financial Economics, 65(3), pp. 365–395. Franks, J. R. and Mayer, C. (2001), ‘Ownership and Control of German Corporations’, The Review of Financial Studies, 14(4), pp. 943–977. Franks, J. R., Mayer, C. and Wagner, H. F. (2005), ‘The Origins of the German Corporation -- Finance, Ownership and Control’ (August 2005), ECGI Finance

9.

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Working Paper No. 110/2005, Available at SSRN: http://ssrn.com/abstract=798347. Franks, J. R., Mayer, C., Volpin, P. F. and Wagner, H. F. (2008), ‘Evolution of Family Capitalism: A Comparative Study of France, Germany, Italy and the UK’ (March 2008), Available at SSRN: http://ssrn.com/abstract=1102475. Goergen, M., Manjon, M. & Renneboog, L. (2008), ‘Is the German system of corporate governance converging towards the Anglo-American model?’, Journal of Management and Governance, 12(1), pp. 37–71. Hacketal, A., Schmidt, R. H. and Tyrell, M. (2003), ‘Corporate Governance in Germany: Transition to a Modern Capital-Market-Based System?’, Journal of Institutional and Theoretical Economics, 159(4), pp. 664–674. Harbula, P. (2007), ‘The Ownership Structure, Governance, and Performance of French Companies’, Journal of Applied Corporate Finance, 19(1), pp. 88– 101. Himmelberg, C. P., Hubbard, R. G. and Palia, D. (1999), ‘Understanding the Determinants of Managerial Ownership and the Link between Ownership and Performance’, Journal of Financial Economics, 53(3), pp. 353–384. Holderness, C. G. (2003), ‘A Survey of Blockholders and Corporate Control’, Economic Policy Review, 9(1), April 2003, pp. 51–63. Kaserer, C. & Moldenhauer, B. (2008), ‘Insider Ownership and Corporate Performance – Evidence from Germany’, Review of Management Science, 2(1), pp. 1–35. Köke, J. (2004), ‘The Market for Corporate Control in a Bank-Based Economy: A Governance Device?’, Journal of Corporate Finance, 10(1), pp. 53–80. La Porta, R., Lopez-De-Silanes, F. and Shleifer, A. (1999), `Corporate Ownership Around the World', Journal of Finance, 54(2), pp. 471–517. La Porta, R., Lopez-De-Silanes, F., Shleifer, A. and Vishny, R. W. (1998), `Law and Finance', Journal of Political Economy, 106(6), pp. 1113–1154. Maury, B. (2006), ‘Family Ownership and Firm Performance: Empirical Evidence from Western European Corporations’, Journal of Corporate Finance, 12(2), pp. 321–341. Mørck, R. ,Shleifer, A. and Vishny, R. W. (1988), ‘Management Ownership and Firm Value: An Empirical Analysis’, Journal of Financial Economics, 20(1), pp. 293–315. Shleifer, A. and Vishny, R. W. (1986), ‘Large Shareholders and Corporate Control’, Journal of Political Economy, 94(3), pp. 461–488. Steger, T. and Hartz, R. (2005), ‘On the Way to “Good” Corporate Governance? A Critical Review of the German Debate’, Corporate Ownership and Control, 3(1), pp. 9–16. Thomsen, S., Pedersen, T. and Kvist, H. K. (2006), ‘Blockholder Ownership: Effects on Firm Value in Market and Control Based Governance Systems’, Journal of Corporate Finance, 12(2), pp. 246–269.


10%

Allianz

10,22%

5%

10%

Allianz 6,8%

5,03% 11,42%

Dresdner Bank

Bay. Hypo- und Wechsel-Bank

Deutsche Bank 25%

11,42%

Dresdner Bank

25%

Deutsche Bank 25%

9,9% 10% CF 9,9% VR

5,03%

10%

10%

5%

Münchener Rück

5,8%

10% CF 9,9% VR

25% 10% CF 9,9% VR

Münchener Rück 6,5% CF 6,75% VR

5,4%

Bayerische Vereinsbank

9,2% 9,9% VR

40%

Bayer. HypoVereinsbank 13,29% VR

10,24% CF 10,83% VR 10,24% CF 10,83% VR

Bayernwerk

8,23% CF 8,53% VR

95,2% CF 100% VR

5,9%

5,9%

VIAG

VIAG

November 1997

November 1999

Allianz

7%

Allianz

3,2%

3,66% 4,6%

9,4%

77,33%

Dresdner Bank 11,62%

20%

Münchener Rück Münchener Rück 9,2%

Commerzbank

Deutsche Bank

10,42% VR

Deutsche Bank

Commerzbank

27,7%

9,2%

Bayer. HypoVereinsbank

62,92%

ERGO Versicherungsgruppe

11,89%

9,5%

92,74%

6,72% 5%

9,97%

3,8%

18,44% CF 18,8% VR



5%

3,43% CF 3,5% VR

E.ON

E.ON

November 2004

November 2002

Allianz

Deutsche Bank

Assicurazioni Generali S.p.A. 8,6%

Alliance Bernstein 5,2%

Münchener Rück

Commerzbank 92,74%


Uni Credito Italiano S.p.A. CF 94% VR 93,9%

The Capital Group Companies, Inc. 5%


5%

E.ON

November 2007

Figure 1 – Development of Allianz–Munich Re net over time Major shareholders within the Allianz–Munich Re net and the disentanglement of these companies over time. Dotted lines mark possession of at least 5% of voting rights while solid lines mark ownership of at least 10% of voting rights. In the case of deviation of one share-one vote, voting rights (VR) and cash flow rights (CF) are stated separately.

31


First layer ownership Year

Ultimate ownership 10% threshold Herfindahl Widely index held

Ultimate ownership 20% threshold Herfindahl Widely index held

Herfindahl index

Widely held

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

0,10394 0,09906 0,09517 0,10460 0,12529 0,07386 0,06686 0,06345 0,04569 0,06082 0,03887

0,00% 0,00% 0,00% 4,00% 0,00% 0,00% 3,45% 3,57% 3,57% 6,67% 0,00%

0,09978 0,09270 0,08143 0,08906 0,13133 0,07192 0,07594 0,06957 0,05261 0,04846 0,05924

14,81% 18,52% 21,43% 16,00% 25,00% 34,48% 31,03% 28,57% 42,86% 33,33% 44,44%

0,08876 0,08586 0,08023 0,07889 0,11682 0,03839 0,06431 0,05636 0,04232 0,03855 0,02148

51,85% 55,56% 64,29% 72,00% 62,50% 75,86% 72,41% 71,43% 78,57% 73,33% 74,07%

total

0,07874

1,99%

0,07820

28,48%

0,06363

68,54%

Table 3 – Development of average ownership concentration over time Table 3 shows the development of ownership concentration proxied by the Herfindahl index of the voting rights of the five largest owners as well as the percentage of widely held firms over time with respect to the three different ownership definitions.

32


IMPLICATIONS OF INSOLVENCY LAWS ON FIRMS’ GOVERNANCE. AN ANALYSIS FROM THE RELATIONSHIPS WITH CREDITORS IN FRANCE Nadine Levratto* Abstract This paper aims at showing that ex post consequences of insolvency law are not the only one visible after a judge states that the amount of equity is not enough to repay all the debts. On the opposite, the judicial system that defines bankruptcy shapes the relationship between a firm and its stakeholders among which lenders play a specific role. Thus, the expectations of failure that are generally considered from a pure statistic point of view have to be enriched by the introduction of legal elements to understand fully the strategic behaviour of lenders and borrowers. Such is the point we want to present here taking the French case. Section 1 reminds that insolvency law is not only a tool implemented and improved to maximise creditors’ wealth but also to protect others stakeholders. Having state this multiplicity of goals, section 2 shows the influence of insolvency laws on bank-borrowers relationships according to the institutional context. Section 3 considers insolvency law as a governance device that structures the need of information and behaviour of creditors in the firm's ordinary life. We conclude reminding that if that law matters in crisis but also as a milestone economic actors refer to determine their preferred situation. Keywords: corporate governance, bankruptcy, insolvency, creditors, France * Research Professor at the National Council of Scientific Research EconomiX-Université deParis Ouest, Nanterre, la Défense Bâtiment K, 200 avenue de la République F-92001 Nanterre Cedex E-mail : [email protected]

Introduction Bankruptcy occurs when a debtor is unable to pay his debts. From thi broad definition, it appears that bankruptcyt is a collective enforcement procedure whereby the debtor’s assets are liquidated and the money raised is used to pay creditors 4 . In many jurisdictions different bankruptcy procedures are available for corporate and individual debtors 5 . In addition to collective enforcement, bankruptcy procedures open to individuals (‘personal bankruptcy law’) serve important social functions of providing 4 Bankruptcy law solves a collective action problem. When a debtor becomes insolvent, creditors have incentives to engage in a ‘run on the bank’, enforcing their individual claims as quickly as possible, even if this results in a reduced overall value being obtained for the debtor’s assets. In response, bankruptcy law provides a mandatory and orderly mechanism for the realisation of the insolvent’s assets (Jackson, 1982). 5 In the US, Chapter 7 and Chapter 11 bankruptcy proceedings are open both to individuals and to corporate debtors. However, many countries have different procedures for individuals and corporations, or distinguish according to whether the debtor is a ‘trader’ (individual or corporate) or a consumer. This is indeed the case in France where personal bankruptcy originally authorized in two regions (Alsace and Moselle) has been applied to the whole country in 2003. Until this date two different regimes applied. The insolvency law included in the "Code de Commerce" for merchants and the "déconfiture" a much more severe system devoted to individuals embedded in the "Code Civil". This split was sealed in the Napoleonic Codes (see Hautcoeur and Levratto, forthcoming).

social insurance against failure, and of punishing or rehabilitating financially distressed individuals (Adler, Polack and Schwartz, 2000). The ‘severity’ of these consequences for the debtor is mitigated in two ways that history refines since their introduction in the beginning of the modern period. First, some assets are exempt from the process. Universally, debtors are entitled to retain living expenses, personal effects and the like 6 . Secondly, many jurisdictions or at least many courts allow a bankrupt debtor to obtain a ‘fresh start’: namely, that after a certain period of time, a bankrupt is permitted to discharge his outstanding credit obligations and emerge from bankruptcy proceedings. Over the world, many jurisdictions do not permit a discharge of debts following insolvency; Japan is still an example of such a situation. For those that do, the length of time which must elapse, and the other conditions which must be fulfilled, vary considerably7. 6 In France, the so-called 'patrimoine de la famille' originally compounded of the dower and nowadays equivalent to the minimum income necessary to leave cannot be seize. In the US, debtors are also allowed to retain an interest in their homes, although the maximum value of this ‘homestead exemption’ varies from state to state. 7 In almost all jurisdictions, a debtor may emerge from bankruptcy by entering into a ‘composition’ with his creditors, whereby he agrees to repay a proportion of the face value of his debts and the

33

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 In addition to the legal consequences of bankruptcy, the circumstance of ‘being bankrupt’ or ‘having been bankrupt’ typically carries with it social stigmatisation (Athreya, 2004). Bankruptcy in most places is viewed as a signal of financial irresponsibility, and, even after a legal ‘fresh start’; individuals who have been bankrupt often find it difficult to obtain credit. Demanding for information concerning the past performances of an entrepreneur banks and other creditors enhance the vicious circle initiated with a first failure. Furthermore, there may be a loss of reputation from other individuals associated with this public signal of failure. These effects will mean that the adverse consequences of bankruptcy for an individual may extend for much longer than the formal legal proceedings. There is evidence to suggest that such social attitudes to bankruptcy vary across countries (Flash Eurobarometer Entrepreneurship Survey, 2007). This paper aims at showing that ex post consequences of insolvency law are not the only one visible. On the opposite, the judicial system that defines bankruptcy shapes the relationship between a firm and its stakeholders among which lenders play a specific role. As providers of financial resources banks are indeed involved in the projects undertook by an entrepreneur without having any control on their management. Moreover, as demonstrated by credit rationing theory, the asymmetry of information worsen by the hands off management system imposed to external investors, often causes a shortage of credit that can entail a decrease in the probability of success of an investment. Thus, the expectations of failure that are generally considered from a pure statistic point of view have to be enriched by the introduction of legal elements to understand fully the strategic behaviour of lenders and borrowers. Such is the point we want to present here taking the French case as an example of the relationship between the functioning of the debt market and the insolvency law. Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny (1998, 1999) have documented relationships among countries’ financial laws and their legal origin. These authors created an index to measure the quality of investor protection in various countries, and then analyzed the index data across countries. The study found correlations between, on the one hand, corporate ownership and investor protection, and on the other, the respective origins of the legal system. In particular, the studies found dramatic differences between legal systems evolved from the French civil law model and the Anglo-American common law model 8 . Countries

whose financial laws derived from French civil law, in general, possessed weaker investor protection and higher transaction costs (Weber, 2005). We take this assessment as the point of departure for our own analysis. We however don't use it to demonstrate the superiority of one system on the other but to examine how any insolvency procedure transforms the economic relationships between debtors and creditors. This change in the economic transactions induces by a rule of law happens of course when the situation concerned by the law takes place. But, as stated by the weberian tradition, actors take into account the rules prior being concerned by their application. Regulation becomes then a background for any economic action. This is particularly important for firms financing since already shaped by expectations on risk, these contracts are also influenced by the judicial consequences of the inability of the borrower to repay his debts. This is what we aim at studying here. First section will remind that insolvency law is not only a tool implemented and improved to maximise creditors’ wealth but also to protect others stakeholders. Having this multiplicity of goals in mind, the second section will show the influence of insolvency laws on bank borrowers relationships according to the institutional context will be enlighten. In the third section we consider insolvency law as a governance device that structures the need of information and behaviour of creditors not only when the firm goes bankrupt but also in its ordinary life. We conclude reminding that if that law matters in crisis but also as a milestone economic actors refer to determine their preferred situation.

rest is treated as discharged. The difference between this and the ‘fresh start’ discussed in the text is, however, that a composition requires the agreement of a majority of the debtor’s creditors. A ‘fresh start’ regime on the other hand entitles the debtor to be discharged against the wishes of creditors. 8 Lamoreux and Rosenthal (2004) paint a different picture: namely, that the broad generalization equating French civil law with higher transaction costs is misguided because it fails to

account for the actual historical development of French civil law. Their findings suggest to the contrary that French law offered more organizational forms and flexible contract options than AngloAmerican law, which was less responsive to the needs of business community. The Anglo-American common law caught up to French civil law in terms of efficient contract law only in the late twentieth Century. For an exhaustive presentation of the bankruptcy code 19th century France, see Hautcoeur & Levratto, 2007

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1. Too much Goals For One Law? When applied to bankruptcy, the approach adopted in Law and Economics, which is essentially positive, presupposes that reforms of the legal system are necessary because the procedures in force are not efficient in most countries. This results in limited use of the rules in place for fear of seeing either the asset value diminish to such an extent that the creditors will only recover a small part of their due, or an exclusion from business life that prompts the entrepreneur to dissimulate his problems. On the contrary, when bankruptcy law is “good”, companies in financial distress and their suppliers do not hesitate to have recourse to proceedings from which they expect quick and efficient results. In addition to these direct advantages, the business climate is said to improve as a result of tidying up bankruptcy law. Two dimensions of the application of what is generally

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 called the LLSV approach are examined in depth here: We depart from the minimisation of the transaction costs involved by bankruptcy systematically and often exclusively targeted by the so-called LLSV point of view (1.1.) to adopt a broader perspective according to insolvency law aims at protecting capitalism what requires coping with the role of the stakeholders (1.2.). 1.1. A quest for the Grail: the Minimisation of Transaction Costs The inclusion of bankruptcy law in an economic perspective centred on the distribution of assets is characteristic of the penetration of the law by the economic policy objectives characteristic of the recent period. By including procedures relating to cessation of payments in the policy agenda to stimulate a sort of growth based on the production of wealth by companies, legislators in most OECD countries gave up a moral and social vision of bankruptcy law. In so doing, they embed it in a private framework guaranteeing company prosperity or turnaround, or in the worst-case scenario, a quick liquidation of the business in such a way as to favour the reuse of production machinery in another framework. The utilitarian approach that prevails here is especially obvious in “Doing Business” which argues in favour of a “modernisation of the law” based exclusively on practical considerations. Thus, one of the two French partners in the survey maintains that the law must be tidied up due to the globalisation of trade, that “the relative efficiency of the law is obviously a factor in economic productivity and [that] in this area, France must do better by pragmatically agreeing to seek greater efficiency...” (Backer,2006, p. 2). Two questions flow from the positive view of bankruptcy law. Both of them are related to the efficiency of the procedures within the scope of a market economy which orients the content of the research carried out. An initial level of analysis asks what means are available in collective proceedings to distribute the risks among all the actors in a market economy in a predictable, fair and transparent way. In addition to this question, the work seeks to identify what incentive mechanisms collective proceedings have acquired to encourage market economy actors to make sound decisions. Helping to resolve these questions will guarantee the introduction of efficient law, i.e. bankruptcy law in which the proceedings fulfil a twofold function: - they give rise to good incentives for debtors and creditors in such a way as to encourage entrepreneurship, - they ensure a good selection of companies by eliminating from the market those that are performing poorly and rescuing the others. Seen in this light, bankruptcy law is essentially designed to keep businesses going and protect the

value of the company in the interest of all the stakeholders. To achieve this objective, collective proceedings must avoid dangerous competition among creditors and enable viable businesses with temporary problems to be filtered out from those with a structurally compromised future. According to LLSV, this aim would be achieved through English common law, which favours private arrangements among debtors and creditors. French law, on the other hand, is held to be inefficient because it is too costly, with low recovery rates of the amounts due to creditors and too favourable to the debtor (Davidenko & Franks, 2005). The changes to be made in procedures for handling cessations of payment thus depend on the level of the country’s score and rank in the World Bank classification. In general, they must help improve the level of at least one of the criteria presented above (the length of time required to process a bankruptcy case, the cost of the bankruptcy itself and the rate of claim recovery). Two types of efficiency will then be attained: - ex ante efficiency consisting in encouraging the actors in a market economy (mainly company directors and shareholders, as well as banks in their decision to grant credit) to make the right decisions in order to avoid situations resulting in shortfalls of short-term liquidity and medium- or long-term insolvency. Here again the means available to collective proceedings must be balanced so as not to appear too disadvantageous and discourage the risk-taking inherent in entrepreneurship and the smooth workings of the market economy. - ex post efficiency consists in liquidating only non-viable companies and maximising, or at least protecting, the value of the company in the interest of all the stakeholders and the economy in general. This first principle explains the intrinsically collective nature of this type of procedure: individual proceedings by creditors to recover their claims would result in piecemeal sale of the company that would prevent it from obtaining the best price for the disposal of its assets. The number of stakeholders (creditors with absolute priority, secured or unsecured creditors, shareholders, government administrations and social organisations, potential buyers, society, etc.) generates a variety of often conflicting interests. Having in mind that financing is the first step in any entrepreneurial project, number of US commentators9, have argued that the proper function of insolvency law can be used as a tool to ease firms financing. In this perspective, the judicial treatment of economic failure is seen in terms of a single objective: to maximize the collective return to creditors. Thus, insolvency law is best seen as a 'collectivized debt 9 See e.g., Jackson (2001); Baird (1986); Jackson & Scott (1989).

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 collection device' and as a response to the 'common pool' problem created when diverse 'co-owners' assert rights against a common pool of assets (Finch, 1997, p. 231). Jackson, moreover, has stated that insolvency law should be seen as a system designed to mirror the agreement one would expect creditors to arrive at where they able to negotiate such an agreement exante from behind a 'veil of ignorance' (Jackson, 2001, p. 17) 10. This 'creditors' bargain' theory is argued to justify the compulsory, collectivist regime of insolvency law on the grounds that were company creditors free to agree forms of enforcement of their claims on insolvency they would agree to collectivist arrangements rather than procedures of individual action or partial collectivism. In agreement with the conclusions of the Law and Economic movement, Jackson sees the collectivist, compulsory system as attractive to creditors in reducing strategic costs, increasing the aggregate pool of assets and as administratively efficient. It follows from the above argument that the protection of non-creditor interests of other victims of corporate decline such as employees, managers and members of the community, is not the role of insolvency law at least for this group of scholars. Many other consider nevertheless that keeping firms in operation must be seen as an independent goal of insolvency law (Armstrong & Cerfontaine, 2000) In the creditor wealth maximization approach all policies and rules are designed to ensure that the return to creditors as a homogenous group is maximized. Insolvency law is thus concerned to maximize the value of a given set of assets, not with the allocation of entitlements to the pool. Accordingly effect should only be given to existing pre-insolvency rights what will soon lead to introduce the difference between secured and unsecured debt deeply studies elsewhere (see for instance Ponoroff & Knippenberg, 1997). Moreover, in order to keep the hierarchy among creditors stable, new rights should not be created once the default is stated by the judge. Variation of existing rights is only justified when those rights interfere with group advantages associated with creditors acting in concert what has been organized by the last version of the French insolvency Act voted in July 2005 (see below). The creditor wealth maximization vision has been subject to severe criticisms. Major concerns have focused, firstly, on insolvency being seen as a debt collection process for the benefit of creditors. This fails to recognize the legitimate interests of all the stakeholders who are not defined as contract creditors. That is indeed the case for managers, suppliers, employees, their dependents and the community at large. To see insolvency as in essence a sale of assets for creditors, moreover, fails both to treat insolvency as a problem of business failure and to place value on assisting firms to stay in business. Thus, it has been 10 See Jackson, ibid, 17.

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argued that to explain why the law might give firms breathing space or re-organize them in order to preserve jobs requires resort to other values in addition to economic ones. The economic approach, as exemplified by Jackson, is, therefore, alleged to demonstrate only that its own economic value is incapable of recognizing non-economic values, such as moral, political, social and personal considerations11. The idea, moreover, that a troubled company constitutes a mere pool of assets can also be criticized. Such a firm can be seen not purely as a lost cause but as an organic enterprise with a degree of residual capability: it results from the potential imbedded in a going concern what differentiates a corporation that can continue as an enterprise from a mere property. Insolvency law, indeed, recognizes that the rehabilitation of the firm is a legitimate factor to take on board in insolvency decision-making. Does it make sense, in any event, to point to a common pool of assets to which creditors have a claim before insolvency? Unless credit is secured, it arguably is extended on the basis that repayments will be made from income and not from a sale of fixed assets. Income, moreover, can be said not normally to be produced by the assets themselves but, in the case of an enterprise, from 'an organizational set-up consisting of owners, management, employees plus a functioning network of relations with the outside world, particularly with customers, suppliers and, under modem conditions, with various government agencies. It is, indeed, insolvency law itself that creates an estate or pool of assets and this undermines any assertion that insolvency processes should maximize the value of a pre-existing pool of assets and should not disturb pre-insolvency entitlements. The idea that insolvency law can be justified in a contractual fashion with reference to a creditors' bargain has also come under heavy fire. The creditors' bargain restricts participation to contract creditors. In this sense the veil of ignorance used by Jackson is transparent since the agreeing parties know their status in insolvency. It is not surprising that in an ex ante position such creditors would agree to maximize the value of assets available for distribution to themselves. Another vision of insolvency law attempts to overcome the restrictions of creditors’ wealth maximization taking into consideration not only the interest brought by the other partners in the firm’s activity but also the capitalist system itself.

11 According to Korobkin ‘Bankruptcy law includes provisions that empower courts to decide bankruptcy-related matters; specify the duties and powers of the representative of an estate and regulate it in matters affecting rights of parties to the bankruptcy case; afford to creditors a mechanism for enforcing their rights against the debtor and the estate; provide, in the case of an individual, for repayment plans or, in the case of a corporation, for plans of reorganization; and discharge the debtor from some kinds of debt.’ (Korobkin, 1991, p. 723).

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 1.2. From Protection of The Rights of Creditors to that of the Business: A Capitalist Evolution Historically, the repayment of debt was considered as a moral act and the inability to comply with this rule implied prohibition from any contractual activity as well as the suspension of all civic rights. By excluding bankrupt owners simultaneously from the market and civil society, the first bankruptcy procedures merged the civic and economic dimensions of society. While the use of the rules in the 19th century conveyed a concern for reinsertion manifested by the trader-judges, the crises of the 20th century were to make the rehabilitation of the bankrupt trader and the protection of the business more systematic. We are going to look at this dimension through two elements: first, the establishment of a hierarchy among creditors so as to eliminate the race to the courts (1.2.1) and secondly, the replacement of exclusion by protection (1.2.2). 1.2.1. The Redistribution of Assets: between Hierarchy and Collective Proceedings Splitting assets among creditors is the core redistributive challenge of bankruptcy. With the passage of time, successive reforms have constantly sought to attenuate the risk of a race to the courts fostered by the principle of “first come, first served”, in force for a long time, for example in German law (Desurvire, 1992). Whereas the judge takes official note of the failure of the business, the ownerentrepreneur or the shareholders are formally and legally expropriated. This removal is required in liquidation and the accompanying disposal of assets. This is the stage in the procedure when conflicts emerge among the various categories of stakeholders, which have been given considerable attention in the literature on bankruptcy. Overall, the law provides that the payment of creditors shall be based on the price of the sale or the proceeds from the liquidation, with the income serving to repay creditors. Here a new level of bankruptcy organisation appears with a view to ordering the actual losses which until then were potential and now become real, and as a result, charged to the balance sheets of the various partners. The amount depends on the rank of the creditor’s claim in the order of repayment: legally or conventionally secured creditors (the State, employees, secured suppliers) are repaid in order of priority according to the rank and extent of their privilege from the proceeds of the sale of the pledged property. In every case, their repayment takes place before that of creditors who relied on the debtor’s ability to pay (unsecured creditors), who are then paid in proportion to the amount of their verified, accepted claims out of the amount remaining after payment of the privileged creditors. These dividends are often low and in many cases unsecured creditors receive nothing.

These differences of status and the resulting variations in payment explain why unsecured creditors, especially banks in the recent period, continually denounce the unfair treatment reserved for them. Hence, it seems timely to study the internal conflicts within the class of creditors to understand the observable differences in the order of priority and the numerous reorganisations they have brought about since the procedure took on a collective character (Goré, 1969). By emphasising the existing tensions between the personal interests of the creditors and those of the mass to which they nevertheless belong, we can shed new light on the conflict between the need for swift liquidation of a business in cessation of payments and the attempts to protect the company and maintain its business which benefit not only ordinary creditors but also third parties either directly (employees, for example) or indirectly (local authorities, etc.). 1.2.2. Company Protection or Liquidation of Assets? The fate of the company is one of the major concerns of the different actors involved in the bankruptcy process. The future of the firm’s productive assets – both tangible and increasingly intangible – is indeed important not only to the owner but also to commercial judge, the court-appointed administrator and the creditors who, from the 19th century onwards, have worried about the loss entailed by the cessation of business. Early on, reports by court-appointed administrators and the minutes of general meeting of creditors expressed this fear linked to the loss of what would later be called ‘goodwill’, by pointing out the damaging effects of interrupting business on the amount of payout to creditors. The latter, grouped together and assumed to play a key role in settling the bankruptcy through general assemblies, soon realised the antagonism that existed between their interests and those of the court-appointed administrator: - the creditors, like the entrepreneur to a certain extent, see their interests preserved by continuing the business which enables receipts to come in instead of having only disbursements to record, - the trustee or the court-appointed administrator often finds it advantageous to keep the proceedings going, for his remuneration depends on the number of steps carried out and because he may have connections with other entrepreneurs with an interest in taking part in the dismemberment of other companies to boost the growth of their own businesses. Here again, in the face of deviations from the doctrine revealed by an interpretive reading, we observe that very early on the commercial courts demonstrated imagination in getting beyond the lack of definitions of the basic concepts of bankruptcy to assess as best they could the complex situations experienced by bankrupt companies (Noël, 2003).

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Often deviating from the legislation condemning most bankrupt owners, the victims of events beyond their control, the actors in the proceedings (magistrates, agents, court-appointed administrators, and creditors) seem to be largely free from the weight and rigidity of an essentially repressive procedure to adopt an economic attitude towards failing companies authorised by their experience and familiarity with the local business network. While this practice would initially result in protection of creditors whose interests were affected by the complexity and length of the proceedings as well as the loss of assets following the shutdown of business operations, it would also be concerned with the interests of the debtor. In this respect, although attenuated by the law of 28 May 1838, the extremely strict provisions introduced by legislators in 1807 were soon be skirted by the judges who often favoured continuing business activity. During the 19th century, the latter would also mean almost systematically recognising the excusable character of the bankruptcy and a tendency to easily obtain the rehabilitation of the bankrupt owner, allowing the latter to begin commercial activity anew. The will of French legislators to promote the survival of companies in financial distress is visible above all in legislation in 1955, 1967, 1985, 1994 and 2005. 12 It also distinguished itself by granting essential authority to the courts and by the prevalence of the rights of debtors over those of creditors. The concern for continuing the business usually means deciding on a receivership procedure, which attributes to the judge the power to set, only in the cases where receivership is not manifestly impossible, an observation period which may last from six to twenty months, during which the management of the company is placed under direct or indirect court control. At the end of the observation period, the court may decide to liquidate the company or impose a receivership plan on the debtor and all the creditors. As the procedure almost always results in liquidation of the firm, the law of 2005 sought to strengthen the means implemented in favour of protection and to do whatever was necessary to give the prevention of company failure precedence over receivership. Here again, we see that the various legal systems for handling bankruptcy have resulted in a sort of convergence tending to favour keeping companies alive, as the value of a “going concern” is 12 These trends were also perceptible abroad. Starting in the 19th century, bankruptcy law in the United States gradually detached itself from English legislation. Throughout the century, economic crises encouraged the adoption of laws favorable to debtors, which allowed the sale of residual property to creditors and sometimes recognized the right to be freed from unpaid debts without the consent of the creditors, which were repealed several years later under pressure from creditors. At the same time, the practice of amicable agreements between creditors and debtors became more widespread, even though it was impeded by the power of any creditor to denounce these agreements by requesting the commencement of bankruptcy proceedings. In Italy, the same demands were expressed by the Prodi law and several other extraordinary laws introduced between the end of the 1960s and the beginning of the 1980s to limit the social effects of industrial crises.

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systematically assumed to be superior to the value of dismembered assets. In this case, it should be recognised that French bankruptcy law, represented today by the company protection law, authorised very early on an explicit distinction between the prevention of problems and their treatment.13 The priority given to the survival of the business is therefore presented as a supplementary objective to the minimisation of transaction costs which consequently cannot constitute the sole criterion for assessing the efficiency of the law governing the end of operations. In any case, the legislators and court actors raised the question at an early date concerning returning the unused assets of companies involved in litigation to the market. Thus, they met capitalism’s need for selfregulation which, more than the simultaneous exclusion from the market and civil society in force in outdated law, requires setting up a system that authorises the cancellation of debts after liquidation of assets and decriminalisation. This dissociation of the economic order from that of civil society makes it possible to close the economic cycle by charging losses to balance sheets, returning part of creditors’ capital so they can reinvest it and giving the debtor a chance to engage in business once again. 2. How Creditors Are Influenced By Insolvency Laws? The multiple goals possibly associated to a single insolvency law open various possibilities as far as creditors' behaviour is concerned. Much of the insolvency process aims at sorting out rights among creditors (Jackson, 1982). In a judicial perspective, bankruptcy helps to constrain creditors from attempting to promote their individual interests every time they are in conflict with the overall interest of the group of claimants (employees, suppliers, financing partners...). Insolvency law can thus be seen as an attempt a compulsory system that rational creditors acting under a 'veil of ignorance' would privately agree to before the bankruptcy occurs. One can pretend the order fixed in the law exert a strong influence on the creditors behaviour especially when the contracts does not result from a social subordination, as it is the case for the contract of employment, but is a genuine mean used by the co contractors to maximise their wealth. Debt contract enters in this category. And the importance of the ex ante distribution of remaining assets on the decision to enter or not in a financial relationship is illustrate by the insistence the banks put to access to the group of privileged creditors all over the history of bankruptcy codes. We propose to shed some light on 13 The use of out-of-court modes of payment by companies in financial distress guaranteeing wide latitude for negotiation with stakeholders appeared as early as the Ancien Régime (Bertholet, 2004) and was quickly denounced due to the high costs they engendered (see Michel, 1900, p. 985 or Balzac, 1948, pp. 147150).

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 this phenomenon referring to the French case and, more precisely, to the last insolvency Act voted in July 2005 (2.1). Then we will show how, given this context, the possible issues of the failure process will determine in turn the respective behaviours of debtor and creditors. 2.1 What about the French Insolvency Law Voted in July 2005? The new French insolvency law took effect on 1st January 2006. The decision to overhaul the law came after figures published by the French ministry of justice showed that 89 per cent of the 44699 insolvency proceedings in 2003 ended up in liquidation. The key aims of the reform were to: • promote voluntary arrangements between the debtor and the creditors; • anticipate debtor difficulties by allowing it to ask the court to commence insolvency proceedings before the traditional insolvency test (cessation des paiements – basically a simple cash flow test, meaning the debtor company is no longer in a position to repay its debts with its available assets) is met; • simplify proceedings; and • reduce the length of proceedings (in 2003, the average length of French insolvency proceedings was about four years). Much emphasis has been put on the fact that the new act voted by the Parliament in august 2005 and applied since January 2006 shows a marked willingness on the part of the legislator to implement a kind of Chapter 11 à la française. However, in addition to implementing US-style insolvency proceedings called sauvegarde, the proposed reform promotes the existing voluntary arrangement procedure (conciliation) and re-defines the purpose of reorganization (redressement judiciaire) and liquidation proceedings (liquidation judiciaire). The legislation also reforms the sanctions applicable to managing directors of insolvent companies. • The anticipation of financial difficulties • The amended voluntary arrangement procedure • The voluntary arrangement procedure is currently available to companies that are still solvent according to the French cessation des paiements test. It is a brief three-month process (renewable for an additional onemonth period) during which the courtappointed mediator (conciliateur) supervises the negotiation of a voluntary arrangement between the debtor and its creditors. Under this new legislation, the voluntary arrangement procedure is also available to companies that have been insolvent for less than 45 days. The process has been extended to four months (renewable for an additional one-month period). As under the previous legislation, the commencement of a

voluntary arrangement procedure does not stay proceedings against the debtor. In order to encourage lenders to finance the debtor company, the legislation provides that lenders who consent to finance the debtor’s company during the conciliation will have priority in the re-payment of these claims. Safeguard proceedings allow companies that face difficulties but are not yet insolvent to anticipate financial difficulties and negotiate a reorganisation plan with their creditors while enjoying a stay of proceedings. This change has primarily affected large companies (in terms of turnover and number of employees). For the purposes of the negotiation of a reorganisation plan the court will appoint two committees of creditors: one composed of credit institutions and the other composed of the debtor’s main trade creditors. The two committees have to vote on the plan. If they reject it, the court may nevertheless approve such reorganisation plan and impose a rescheduling of the creditors’ debts. As with the safeguard proceedings, the new reorganization proceedings enable companies that are already insolvent to be reorganised whilst benefiting from a stay of proceedings. The law provides that a company has to file for reorganization proceedings (redressement judiciaire) within 45 days of the date it becomes insolvent (instead of the previous 15 days), if it has not asked the court to open a voluntary arrangement procedure during that period. As in the safeguard proceedings, the legislation introduces creditor committees for large companies in the reorganization proceedings. Another possibility may however occur. The legislator provided that a company that cannot be reorganised through a reorganisation plan would have to file for liquidation proceedings (liquidation judiciaire) within 45 days of the date it becomes insolvent (instead of the previous 15 days), if it has not asked the court to open a voluntary arrangement procedure during that period. The commencement of liquidation proceedings imposes a stay of proceedings. A simplified and quicker liquidation proceedings for smaller companies has also been introduced in the new Act. In this case, a sale of the debtor’s business (plan de cession) can only be implemented in liquidation proceedings. Generally speaking, the sauvegarde laws permit management to retain control over the company and provide for a more limited charge for the administrator 14 . In fact, the sauvegarde mimics Chapter 11’s exclusivity period by providing a time lag of 30 days prior to the constitution of the creditors’ committees, and a two-month time lag before the debtor must present a plan to the committees (Sauvegarde law, art. 83 (art. L.626-30 of the Commercial Code). But if all goes well, the firm will not be forced into redressement, and will be able 14 Sauvegarde law, at arts. L.621-4 and L.622-1 of the Commercial Code) (“L’adminstration de l’entreprise est assurée par son dirigeant.”).

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 to reach a compromise with its creditors’ committees without too much heavy-handed interference of the administrator. By preserving management’s control, the sauvegarde system grants management a stake in the firm’s future, if management is willing to appease creditors. The goals of preserving going concern value and efficiently distributing assets (as well as preserving employment) are synchronized with the goals of reducing the ex ante agency conflicts. The modifications introduced reveal the will of creditors to be given a priority rank that will allow them to anticipate a higher payout than that granted to ordinary unsecured creditors. The order of payment instituted by article L.622-17-II of the Commercial Code establishes the following ranking among earlier and later claims: 1. The highest privilege of employees, 2. The privilege of court fees prior to the decision to commence collective proceedings, 3. The privilege of conciliation (see article L.61111 of the Commercial Code), 4. Later claims eligible for preferential treatment, 5. In the event of the sale of property subject to a special actual pledge (special privilege, pledge, mortgage) during the observation period or during the execution of a protection or rehabilitation plan, the holders of special pledges will be paid: - before later creditors not entitled to preferential treatment and earlier creditors, - but after later creditors entitled to preferential treatment. 6. Later claims not entitled to preferential treatment and later claims. The law of 26 July 2005 introduced a distinction among the later claims15 and provides that only those creditors whose claims are “useful” to collective proceedings shall benefit from favourable treatment. This modification corresponds to a new privilege in favour of later creditors, consisting of payment priority for later claims defined in articles L.622-17-I and L.641-13-I, in the event of failure to pay these claims by the debtor. This is a privilege insofar as the benefit of payment priority is maintained, even if further collective proceedings are subsequently initiated, regardless of whether they involve receivership or liquidation. This means that the ‘useful’ later claims of the first proceedings will retain their payment priority over the earlier claims of the second. They will, however, be ranked after the new “useful” later claims of the second collective proceedings. This provision, which improved the rank of bank claims, was introduced to give creditors an incentive to take part in company receivership. Does this mean 15 Traditionally, later creditors known as “article 40 creditors” (art. L. 631-32 of the Commercial Code) benefited from favourable treatment insofar as their so-called “later” claims had to be paid at due date by the debtors, as opposed to so-called “earlier” claims that were frozen until the end of the observation period and then settled, if possible, either within the scope of a continuation plan or a sale plan.

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that, even if the outcome of the proceedings is market-oriented, a dividing line can be traced between the liquidated assets that will be put back into the market by the buyers who will attempt to enhance the value of the machines and technologies included in those assets, on the one hand, and the rescue of viable companies that will be able to face the commercial world after restructuring their assets and liabilities, on the other? 2.2. A Presentation of Entrepreneur and Creditors Behaviour Under Insolvency Law Our main theoretical claim here is that bankruptcy is not a clear-cut common knowledge fact, a situation in which a firm is and one that the court can recognize and settle. To enter a bankruptcy procedure is a choice which depends partly from the situation of the firm as known by the actor making the choice, partly from what he expects from the decision to enter the procedure, which depends on bankruptcy law and the behaviours all other actors concerned. This "realist" epistemological choice leads to emphasize the strategic and the information dimensions in the bankruptcy process, as well as the characteristics of the legal system and the economic environment.16. We will simplify the model by supposing that the choice to enter a bankruptcy procedure is either made by the debtor or the creditor, letting aside those cases when the courts take the initiative (less than 10% of all cases during our period). One can consider the start of a legal case as the default situation since both sides must agree on a private settlement (and actually all creditors, as we saw) when a single side can impose the legal procedure. The choice for a debtor lacking liquidity was between borrowing more, filing for bankruptcy and asking his creditors for a private settlement. We suppose that the debtor could not borrow anymore when he faced that choice. Concentrating then on the last two solutions, we can consider that the private settlement was superior for him in terms of reputation (nobody knew of it except the creditors) and in terms of transaction costs; it also did not bring the risk of the death and liquidation of the firm if no concordat could be obtained. Nevertheless, if there was a conflict among the firm's owners (associés) because of asymmetric information among them, it was less likely that a private settlement would be accepted by all of them. It was also probably inferior in terms of the debt reduction that could be obtained at least inasmuch as it maintained the information asymmetry

16 The realistic approach differs profoundly from the idealistic approach of finance theory which leads to such optimal systems such as those proposed for example by Aghion & alii, (1992) or Hart & alii, (1997), which suppose that the value of the firm is independent from who controls it, when in the period under study almost all firms were entirely dependent from their owner-manager, and, correspondingly, the bankruptcy procedure did not provide any instrument allowing for the transfer of control of an existing firm.

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 between the debtor and the creditors. 17 The main difficulty was to obtain the agreement of all creditors, since no single debt could be reduced without the agreement of the creditor concerned (who could always sue for bankruptcy). The choice for the creditor was not entirely symmetric. He also preferred the survival of the firm, but only if the actualized value of the flow of payments it would make was likely to be superior to the present value of its parts. Both a private settlement and a concordat would allow for a survival. The differences between them were the procedure cost and the agency costs. The procedure cost made the creditor prefer a private settlement; the agency cost with the debtor made the creditor prefer the bankruptcy procedure, which would provide him with information on the actual situation of the debtor allowing him to adjust the debt reduction to the exact need of the debtor. Furthermore, a legal procedure protected the creditor against differences in information among creditors and the risk that some creditors may obtain privileged access to the firm's funds, since equality among non legally-privileged creditors was a basic principle of bankruptcy law. In sum, the legal procedure can be seen for the creditor as an option allowing him to ask for the liquidation of the assets (but only under a majority vote procedure) in the case an agreement cannot be reached with the debtor and the other creditors. The value of such an option increases with the probability of such a liquidation, with the uncertainty of the debtor toward the actual situation of the firm and with the risk of a conflict with other creditors; its price is the cost of the bankruptcy procedure. As a conclusion, we can consider that the choice between private settlement and legal procedure resulted mostly from: • The actual situation of the firm (the probability of a legal procedure increasing when the situation of the firm worsens); • the information asymmetry among the firm's owners, between debtor and creditor or among creditors (the probability of a legal procedure increasing with these asymmetries); • the relative costs of the two procedures (the probability of a legal procedure decreasing with its cost); • the cost for the debtor of the start of a legal procedure: reputation cost in particular (the probability of a legal procedure decreasing with that cost); • the difference between the value of the firm as a going concern and the value of its assets

17 We suppose that this information asymmetry would never be suppressed under private agreements given the lack of reliable common-knowledge accounting systems during that period, and the cost of transferring the adequate information in the case of small businesses.

(the probability of a legal procedure decreasing with that difference); • the risk of not agreeing on a concordat for a given situation in the case a legal procedure was chosen (the probability of a legal procedure decreasing with that risk). Furthermore, it is likely that the choice of a legal procedure would be made by the debtor the more frequently the less dangerous it was for him in terms of reputation and risk of future liquidation, when the firm's situation was relatively good and the asymmetry in information with the creditors and among creditors were low as well (so the risk not to obtain a concordat was low). The creditors' initiative of a bankruptcy procedure would appear when the option value would be high enough. Both would be incited to go to the court by a reduction in the procedure cost. Once a bankruptcy procedure started, creditors and debtors could again choose between a concordat and a union, but they had to agree on a concordat for it to be accepted when each of them could impose a union (with the proviso that the creditors' decision was based on majority, not unanimity). The advantages of the concordat are obvious, since it allowed the debtor to keep control and escape the most infamous aspects of the faillite. But the union could free the debtor from all its debts (although it was not legally the case), and provided the creditors with low, but immediate and risk-free dividends. Again, transaction costs and information asymmetries would intervene in the choice. So among bankruptcies, the probability of a concordat being chosen was: • increasing with the actual situation of the firm; • increasing with the difference between the value of the firm as a going concern and the value of its assets; • decreasing with information asymmetries between debtor and creditors; • increasing with the cost in reputation of the union vs. the concordat; • increasing with the relative procedural cost of the union vs;.the concordat. Graph 1 may help understanding our logic: on the x axis, it represents the actual situation of the firm, in terms of assets to liabilities. On the y axis, the loss of creditors (implicit gain of debtors) is represented for various terminations of the conflict, as a distance to the central optimal 100% line. When the situation is relatively good (high assets/liabilities ratio), the most likely is a private settlement. When it deteriorates, a legal procedure is more likely. The curves are indifference curves of a category of agents (debtors or creditors). The difference between both agents’ curves is the deadweight loss of bankruptcy (what the creditors loose without gain for the debtor). When curves intersect (like at points x(p,l)c or x(l,f)d), the agents switch from preferring one solution to the other. Since

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 both must agree, the decision is imposed by the first agent to reach such an intersection starting from the right: e.g. x(p,l)c > x(lp,l)d in the case depicted on the graph, so that creditors will ask for a liquidation proceedings before the debtor. The legal system and the courts practice explain the distance between the indifference curves and the optimal 100% line, and the impact (possibly variable through time) of the legal system and practice.

Because situations vary and there is a menu of procedures, we suggest there is no optimal bankruptcy system, but the creation of new procedures, if they substantially better the menu, can bring substantial welfare gains: in the graph, the creation of the reorganisation proceedings allows for a solution better than either arrangement procedure thanks to private settlement or liquidation procedure in many cases (from x(p,l)c to x(l,f)c).

Liquidation proceedings (for creditors)

Reorganization proceedings (for creditors)

Figure 1. A Simple Representation of the Bankruptcy Choice In the previous sequence illustrated by graph one, information plays a crucial role. It determines the choice of the procedure but also the gap between creditors and debtors hierarchy of preferences. It is thus highly understandable that the legislator put a high emphasis on the production and use of information in the insolvency law. Information disclosure is vital in insolvency as creditors can only know the financial status of the company through information disclosed by the company. Such a concern involves the standards of the information disclosure to achieve a fair and true revelation of the value of the company in concern. While financial reports and the directors’ report have been the ongoing obligation of companies, such reports may be especially important in insolvency. This importance was perceived very early in the history. That is probably why the first French insolvency Act implemented by Colbert in 1663 insisted upon the fact that any bankrupted unable to present correct books felt immediately upon the rule of fraudulent bankruptcy, much more severe than the ordinary one since the death penalty was possible. Still today, directors of a company facing insolvency commit offences if they falsify the company's books or make any material omissions in any statement relating to the company's affairs. The seriousness of such a

42

dissimulation is all the more important that several Acts put transparency and fairness at the core of a safe economic life. Information disclosure is also important for the reason that insiders may acquire their own benefits at the cost of other stakeholders in corporate rescue activities. The law accordingly prescribes the disclosure of transactions during a certain period prior to the file of insolvency. The safeguard proceedings that aim at determining a reorganization plan 18 is characteristic of this will. Once this step finished, the information becomes public. Also, negotiated rescue plans must be approved by courts or court-assigned insolvency practitioners, who are further required to keep records of their acts and dealings in discharging their duties. The basic objective of these arrangements is to let all relevant parties know the facts and compromises reached. In other words, almost every deal in insolvency is under the supervision of either 18

The name of this step in the procedure varies according the country. In the supposed pro-debtors countries, the insolvency procedure begins with a phase of consultation between the entrepreneur and the main creditors from which a reorganization plan may come up. During this dialogue, information is only shared by the participants to the discussion and the difficulties the firm is facing are not communicated to board members. If this procedure is unsuccessful, one enters in the arrangement proceeding that supposes disclosure of information.

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 the court or the insolvency practitioner. Protection to creditors is further enhanced as disclosure rules are enforced on all companies and directors may be sanctioned for the breach of their duties to creditors. The above discussion thus reveals that mandatory information disclosure is a main characteristic of the legal approach to corporate restructuring transactions. Since such information disclosure requirements are initiated by the occurrence of specific events, they are event-driven and thus more specific than the general information disclosure as required when companies are going concerns. 3. Insolvency as a Governance Device In this section we show that giving its influence upon the sharing of remaining assets in case of failure, insolvency laws act as a governance device. This is particularly clear when a purely economic conception of insolvency law is adopted what seems to be more and more the case. We briefly remind the underlying principles (3.1) and then present in a more detailed way how insolvency laws impact the firms normal life (3.2). 3.1. From Principles… As companies face insolvency, significant changes to the existing governance structure occur. Since the worsening performance becomes widely known among stakeholders, they will modify their behaviour accordingly. In the vicinity of insolvency or if insolvency is imperative, shareholders may prefer risky projects in consideration of their own short-term interests at the expense of the interests of creditors, as they know what is at stake is the money of creditors and the utmost loss for them is the fixed amount of share capital, which may be worth nothing in the case of insolvency. Or, shareholders may simply prefer a quick exit from a long troubled distress. Credit allocation Credit conditions information on credit-worthiness

Credit use Efficiency of investments control of business activities

Ex-ante effects

In comparison, creditors, especially secured creditors, may want to realize their collateral as quickly as possible so that they can invest in other businesses. The result of such exits, however, is a decrease of the value of the pool of assets of the company. Employees may also make underinvestment if they realize their jobs have already become unsafe. Morale among employees will thus decline. Alternatively, employees may be inclined to get a decent compensation and start their new life elsewhere rather than remain enmeshed in a distressed company. Directors attracted by the generous severance compensation package will at most not interfere to save the troubled business. Or they may simply continue the business recklessly for the benefits of shareholders or for their own reputation without due consideration of the interests of creditors. Or they may set up coalitions with employees for the reason of job security but at the cost of both shareholders and creditors by failing to achieve a better result through quick liquidation. But firms in distress are not the only one to be concerned by insolvency laws. Indeed, creditors can make expectations of the consequences of their decisions prior to be involved in a run whose the winners are the owners of securitized debts as organized by the law. Such as in the case of disclosure of information, this device was experimented at the very beginning of the modern version of insolvency. Contrarily to the old German or Roman laws who supposed an individual action of isolated creditors, modern law early organised creditors as a class, introducing a clear cut between secured and unsecured debts. The rank of the liabilities determines thus the probability and the amount of repayment. However, the expectations of failure any potential creditor makes financing a project exert an influence upon his will to become a creditor and upon the sort of credit he will provide.

Insolvency Insolvency Law

Asset utilisation Liquidation vs. continuation

Ex-post effects

Figure 2. The influence of insolvency law on firm’s life The rules of Insolvency law influence how many credit contracts altogether are entered upon, under which conditions, and how much money is spent to examine the creditworthiness of the borrowers. In addition, the Insolvency law also influences the concrete use of the money lent, i.e. the business model and the investment strategy of the company, as

well as the costs which the lender is willing to expend on the control of the ongoing business. Finally, Insolvency law also has an influence on which utilization alternative after the occurrence of insolvency is chosen: dissolution and sale of the individual assets of the enterprise, sale of the complete enterprise or of parts of the enterprise to a

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 new owner, i.e. to a new legal personality, or reorganization and continuation of the enterprise through the existing owners the old legal personality. Figure 2 recalls the relevant incentive effects of Insolvency law on different acts: 1. The credits should be priced in such a way that the interest rate reflects the additional risks caused through the additional investment what corresponds to an ‘efficient credit allocation’, 2. The business policy implemented should maximize the expected market value of the firm what supposes the credit is used in an efficient way and 3. After the occurrence of insolvency, the use of assets with the highest expectation value should be chosen in conformity with the rule of ‘efficient asset utilization’. 3.2. … to the Application of Insolvency in the Continuum of Corporate Governance In general, insolvency does not come into being at a sudden event springing out in a favorable period. On the contrary, payments disruption can be expected from signals empirical works try to identify using either zeta score based models or a more qualitative approach. If empirical evidence does not show a clear causal relationship between good governance practices and good corporate performance mainly because it is almost impossible to discriminate among a favourable conjuncture and good practices as causes of success, it is usually the case that corporate insolvency will be a predictable result of bad corporate governance when the company is still a going concern. Moreover, governance arrangement instituted in ordinary life can still persist when companies turn into distress. If so, it is very possible that what fits to a safe company reveals to be completely inappropriate to an endangered firm. For instance, even though creditors are protected collectively in insolvency, the interests of secured creditors over their collateral or security are expressly excluded from the collective distribution scheme. Alternatively, creditors can stipulate in their contracts with the company much stricter initiating terms than the general requirement in insolvency law. This form of credit rationing boring on other than prices terms is however scarcely studied from a theoretical point of views. It is precisely enlighten by surveys implemented by the Central banks. 19 In consequence, creditors may intervene in corporate governance when such terms are satisfied rather than when rescue efforts will be tried in vain. Therefore, pre-insolvency contractual arrangements may well penetrate into the control structure around the invocation of insolvency.

19

For instance, each quarter the French central bank publishes a survey that gives an idea of the kind of credit provided and at what price to the borrowing firms.

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The influence of an undesirable future on the present decision is all the more complex to define since bankruptcy is in no way a natural state. The question of defining the date on which the cessation of payments occurred arose very early for the courts and the authors of manuals and user guides for practitioners. Beyond the control they exercise over the methods of applying the law, commercial judges possess above all the power to discriminate between a temporary situation of insufficient liquidity and a situation of insolvency, the latter being a necessary but not sufficient preliminary condition for bankruptcy. Commercial law manuals are clear on this point: the mission of the courts is to declare cessation of payments; they are also sovereign in their assessment of the circumstances and the facts related to cessation of payments, which leads them in particular to fix the date of cessation of payments (Colfavru, 1863, p. 433). This provision is essential, for the date of commencement of bankruptcy makes it possible to fix the observation period, i.e. the period preceding bankruptcy commencement during which the debtor may have executed more or less fraudulent legal instruments, for which the creditors may request termination. Therefore, the role of insolvency as a monitoring mechanism can be extended to governance practices of healthy companies (Pochet, 2002, p.343). For instance, insolvency is tested according to two criteria, one of which is the ‘cash flow’ insolvency, according to which a company is insolvent if it is ‘unable to pay its debts’ when they are due, while the other is the ‘balance sheet’ insolvency, according to which liabilities of a company exceed its assets. The common point is thus that the solvency status of a company is legally evaluated in financial terms only. In turn, even if we are not sure what best governance practices are, we are definitely certain that bad financial performance meeting these criteria will lead to insolvency. The strong financial orientated criteria at the end of the life of a company thus keep ringing a bell to directors when it is operated as a going concern. Such understandings can, then, help us explain the current disadvantaged position of employees in corporate governance in general (e.g. Deakin & Armour, 2004 and Van Gehuchten, 1987). It is also relevant to the initiatives of entrepreneurs to set up businesses in the first place (see Armour & Cumming, 2005, and Ayotte, 2007). Viewed from this perspective, insolvency law is relevant not only to the demise of a company but also to the birth of a new company. Governance in the normal life and governance around insolvency are thus mutually influenced. As a threat put on incumbent managers, insolvency has a deterrent effect underlined by Hart who warned that ‘A bankruptcy mechanism that is ‘soft’ on management … may have the undesirable property that it reduces management’s incentive to avoid default, thus undermining the bonding or disciplinary role of debt.’ (Hart, 1995, p. 685)

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 In addition to the above disciplinary role of insolvency, the pro-creditor insolvency scheme may also help to increase creditors’ incentives to make investments. In turn, the potential increase of the ratio of debt to equity may indicate an enhanced governance role of creditors in governance in the normal life. However, it is worth noticing that given the priority for secured creditors in case of insolvency, they may just have fewer incentives to care about the corporate governance in general than to be concerned about the disposition of their collateral once their contractual rights are breached (Li, 2008, chap 2). Viewed from this perspective, the procreditor insolvency governance scheme in the US or in France may indirectly discount the governance role of secured creditors in healthy companies. It can specially lead to an inefficient credit allocation given the full priority of the secured creditors (Eger, 2001).

consequences of a failure and the current choice of a financial partner. Besides its conceptual dimension, this question has also an empirical scope. It is of considerable interest for small scale enterprises. In these firms, the debt structure is typically rearranged under courtsupervised reorganization by way of debt forgiveness and debt deferral. Entrepreneurs demand more trade credit during the pre-bankruptcy period to finance their loss-making business, and suppliers are willing to provide this credit in exchange of a higher level in the creditors ranking. References 1.

2.

Conclusion As an ordinary matter of fact, companies are confronted with the claims of a multitude of creditors as a rule. If an enterprise gets into economic difficulties and is permanently not in the position to pay the bills - what is an economic approach of insolvency- the remaining assets must be divided between the competing claims of the creditors. Insolvency law entails, on one hand, a compulsory transfer of the debtor’s property rights to the community of creditors. The point of this is to avoid ex post that the managers and shareholders shift risks to the creditors through their decisions. Before the insolvency occurs, the threat of withdrawal of the property rights should serve as a sanction to deter managers and shareholders from carelessly externalizing risks on the creditors. But the rule of repartition of risk and wealth is far from being the only one goal aimed by an insolvency law. It also protect the firm as a going concern an, determining the order according to which the claims of the creditors are satisfied prevent a run of creditors and, at the same time, bring an additional information used by potential creditors to improve the quality of their expectations. From an economic point of view it is of interest that the procedural and distributional rules of Insolvency law create incentives which refer both to acts before the occurrence of the insolvency -ex anteas well as to acts after its occurrence -ex post. Being aware of the consequences of their current decision in case of non repayment of the borrowers, creditors are able to engage in a contractual arrangement that grants a maximum probability of repayment ex ante and a good position in the list of creditors ex post. The insistence of the bank to escape the risk of unjustified financial support in exchange of a higher engagement in the financing of insolvent firms is at the origin of one of the changes brought to the French insolvency law. It gives an idea of the importance of the relationships between the expected

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CORPORATE GOVERNANCE, BANKRUPTCY LAW AND FIRMS' DEBT FINANCING UNDER UNCERTAINTY Bruno Funchal*, Fernando Caio Galdi**, Paulo C. Coimbra*** Abstract This paper examines the relationship between corporate governance level and the bankruptcy law to such debt variables as firms’ cost of debt and amount of debt under uncertainty (in the Knight´s sense). First we find that the better the corporate governance and the harsher bankruptcy law, the lower the cost of debt. Second, we find that better governance and a harsher bankruptcy laws have a positive effect on debt. As consequence, firms increase their set of investment projects financed by creditors. Finally, uncertainty has a negative effect on terms of debt (higher interest rate and smaller set of financed investment projects) and such effect is stronger for firms with worse corporate governance and for economies with a bankruptcy law that is lenient to debtors. Keywords: Debt, Cost of Debt, Corporate Governance, Bankruptcy, Uncertainty *Full

Professor at FUCAPE Business School. E-mail: [email protected] Capixaba Research Foundation at FUCAPE Business School, Av. Fernando Ferrari, no1358 - Goiabeiras, Vitoria, ES, CEP: 29075-010, Brazil; url: http://www.fucape.br ** Associated Professor at FUCAPE Business School. E-mail: [email protected] *** Assistant Professor at FUCAPE Business School. E-mail: [email protected]

I. Introduction This paper analyzes the impact of firm-level corporate governance arrangements and of an institutional shock – as a change in the bankruptcy law which increases punishment to managers in case of bankruptcy – on firms’ debt financing features under uncertainty (in the Knight sense). Both effects presumably alleviate moral-hazard and consequently reduce firms' cost of debt, which motivates firms to increase their debt position. The literature of accounting on corporate governance and its effects on firms’ financial decisions is mostly empirical. Anderson, Mansi and Reeb (2004) find an inverse relation between the cost of debt and board independence and size. Bushman, Chen, Engel and Smith (2004) show that limited transparency of firms' operations to outside investors increases demands on governance systems to alleviate moral hazard problems. More recently, Kanagaretnam, Lobo and Whalen (2007) show that firms with higher levels of corporate governance have lower information asymmetry around quarterly earnings announcements. On the bankruptcy law design and its effect on financial markets, La Porta et al (1997, 1998) and Djankov et al (2007) point to an important role of the legal protection to creditors in supporting credit market development. Araujo and Funchal (2006) show how this result modifies if the degree of punishment to debtors is the unique determinant of creditors' protection. They found that higher levels of creditors' protection will not provide a

broader credit market, in fact, there is an intermediate level of protection that is optimal for the development of such market. Funchal (2008), using the Brazilian Bankruptcy Reform as an experiment found that the positive relationship between creditors' protection and credit market conditions are valid for countries whose previous situation was bad in protecting creditors’ interests. Our study adds to the previous literature by relating, theoretically, firm-level corporate governance arrangements and an exogenous shock bankruptcy law reform - to the cost of debt and to the amount of debt under uncertainty. Approach this subject under knightian uncertainty is fundamental. Given the increasing volatility in financial markets, and the set of possibilities of scenarios that we cannot preview nowadays, inserting uncertainty brings more reality to the model. It is important to note that, in an environment subject to uncertainty, creditors weights more the worst state of nature when they evaluate the expected value around the prospective projects. We will do this by the use of uniform squeezes, a special class of convex capacity20 (the interest reader should see the appendix for an introduction to the basics of the study of Knightian uncertainty, through the use of capacities). In the present paper we develop a model that connects the governance and the bankruptcy law to such debt variables as the cost of debt and firms' amount of debt. Through a set of propositions we 20

See Appendix

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 show that: first, corporate governance has a negative impact on the cost of debt and a positive impact on the amount of debt; second, a harsher bankruptcy law also has a negative impact on the cost of debt and a positive impact on its amount; the effect of bankruptcy law changes is stronger for firms with better corporate governance standards; and finally, the effect of uncertainty on interest rates charged to debtors is higher for firms with worse corporate governance arrangements and for countries with lenient bankruptcy laws. The remainder of the paper is organized as follows: Section 2 discusses the theoretical model relating corporate governance and the bankruptcy law to the cost of debt and credit availability in an environment that is also affected by the uncertainty; Section 3 concludes and in the Appendix is presented basic statements of Knightian Uncertainty. II. The Model In this section we develop a model that describes how the corporate governance and the bankruptcy law affect debt variables in an environment subject to the uncertainty. To develop our model we assume the following:

e be the effort exerted by the manager. We assume that the effort e is a function of the level of Let

corporate governance of the firm and the degree of punishment imposed by the bankruptcy law: e( L, g ) = aL + bg , where eL > 0 and eg > 0. When we take effort into account, we can assume that the probability of success of the firm increases with the firm's governance level and the punishment of the bankruptcy law. In precise terms, we assume that p (e( L, g )) is differentiable, strictly increasing, and strictly concave in the governance level, g , as well in the level of the punishment of the bankruptcy law, L and it is also true that

p (e( L, g )) < 1 , where g is the maximum level of governance as well L is the maximum level of the punishment of the bankruptcy law. This condition means that is ever possible the insolvency state due to some idiosyncratic shock, even when

g = g and

L=L . The beliefs of the creditors incorporate uncertainty through a distortion in the probability following sense: (1 − φ ) p (e( L, g )) where φ is a parameter that refers to the uncertainty level. So, if there is no uncertainty then the beliefs of the creditors coincides with the probability distribution.

after it borrows; creditors can predict their mean payoffs in the default state with beliefs that includes uncertainty; and creditors and the firm are riskneutral. We make the first assumption because it captures the asymmetric information between the firm and its creditors. The second rests on the view that professional creditors have considerable experience with default but also incorporating an uncertainty parameter and the third is more accurate when applied to firms than to individual persons. The borrowing firm has a project that requires

I , which it must raise externally. The firm promises to repay creditors the sum, F . The project can return a value, v , where the firm is solvent if v ≥ F and insolvent if v < F . Two states are capital,

possible in the future, one if the firm is solvent and the other if it is not. The solvency and insolvency states return to the

v solv v ins , respectively, firm and where vsolv ≥ F > vins . The convex capacity associated to the solvency state can be written as (1 − φ ) p (e( L, g )) where φ is refers to the uncertainty level and p (e( L, g )) is the probability of solvency and similarly, the convex capacity associated to the insolvency state can be written as (1 − φ )(1 − p (e( L, g ))) where (1 − p (e( L, g ))) is the probability of insolvency. This implies that the expected value of the project is E (v) = vins + (1 − φ ) p (e( L, g ))(v solv − vins ) , where φ is the uncertainty aversion measure, the expected return conditional on the solvency state is E solv (v) = φvinsolv + (1 − φ )v solv , and the expected return conditional on the insolvency state is Eins (v ) = vins . Assuming that the credit market is competitive,

F is the largest sum that creditors can demand to fund the project. We take the risk-free interest rate equal to zero, so that a borrowing firm's interest rate is a function of the riskness of its project and the properties of the corporate governance level, the punishment imposed by bankruptcy law and also from the uncertainty. Creditors who lend I should expect to receive

I in return. This expectation can be written as follows: I = vins + (1 − φ ) p (e( L, g ))( F − vins ); F = I (1 + r (φ )) =

Firms Investment We make three important assumptions: creditors are imperfect monitors a firm’s actions related to payoffs

48

I − (1 − (1 − φ ) p(e( L, g )))(vins ) (1 − φ ) p(e( L, g ))

(1)

The firm's interest rate is r (φ ) = ( F / I ) − 1 , which is increasing in

F ; this is the value that the

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 firm is required to repay in the solvency state. u u Denoting by v ins ( vins ∈ (0,1)) the per-unit-of-

investment ( I = 1) counterparts of have

r=

v ins we also

[1 − (1 − φ ) p (e( L, g ))] u 1 − vins . (1 − φ ) p (e( L, g ))

[

]

(2)

(

Equation (2) shows that interest rate could be affected by the level of corporate governance, bankruptcy law and uncertainty. Using this relation, we will present some results that derive from the influence of such variables on interest rate charged to debtors. First, analyzing the impact of uncertainty on interest rate we find that it exerts a positive effect since

∂r (1 − φ ) −2 u = 1 − vins > 0, ∂φ p (e( L, g ))

(

punishment inhibits moral hazard, increasing the managers’ effort and the probability of solvency, fearing the punishment in the states of default. This effect increases the expected return of creditors and consequently a reduction of interest rate. From equation (2), making comparative static with the level of bankruptcy law punishment to debtors we see that: ∂r u = − p ′(e( L, g ))a (1 − φ ) −1 p (e( L, g )) − 2 1 − vins < 0, ∂L

)

(3)

which allow us to provide the following result: Proposition 1: An increase at the uncertainty level at the economy raises the interest rates charged to debtors. The effect of corporate governance level has a significant impact on interest rate too. Intuitively, better corporate governance arrangements induce managers to work harder, with actions aligned with firm’s interests. A higher effort increases the chance of success of firm’s investment projects reducing the chance of creditors’ insolvency and, as consequence, the interest rate charged to debtors. From equation (2), making comparative static with governance level we see that: ∂r u = − p ′(e( L, g ))b(1 − φ ) −1 p(e( L, g )) −2 1 − vins < 0, ∂g

(

)

(4)

and

∂2r u = − p ′(e( L, g ))b(1 − φ ) −2 p (e( L, g )) − 2 1 − vins < 0, ∂g∂φ

(

)

(5)

which implies by (4) that the interest rate is decreasing on the level of corporate governance and by (5) that the effect of uncertainty on interest rates charged for firms is higher for those with worse corporate governance arrangements. Proposition 2: A higher level of corporate governance reduces the interest rate charged to the firm. Proposition 3: The impact of the uncertainty on the interest rate is higher for firms with worse corporate governance levels. Finally, we will analyze the influence of the design of the bankruptcy law on cost of debt. We expect that a bankruptcy laws that provide a harsh

)

(6)

and ∂2r u = − p ′(e( L, g ))a (1 − φ ) − 2 p (e( L, g )) − 2 (1 − vins ) < 0, ∂L∂φ

(7)

which means that by (6), the interest rate is decreasing on the level of punishment of the bankruptcy law and by (7) the effect of uncertainty on interest rate is stronger for countries with a bankruptcy law that is lenient with indebted firms. Proposition 4: A higher punishment of the bankruptcy law reduces the interest rate charged to the firm. Proposition 5: The impact of the uncertainty on the interest rate is higher in an institutional environment with lower punishment provided the bankruptcy law. Thus, it is clear that from (4) and (6) that the interest rate is decreasing on the degree of governance and bankruptcy law punishment and also from (5) and (7) that the impact of the uncertainty on interest rate is stronger for firms with worse corporate governance arrangements and in economies that protect debtors in case of default. Both – better governance and harsher bankruptcy law – limit the agency cost associated with the external finance. Until this point we analyze the effect governance, bankruptcy law design and uncertainty on interest rates. From now on we will discuss the extension of this effect the set of investment projects and as consequence on economic growth. An ex ante objective of the firm is to maximize the project option set that creditors want to finance. Society prefers firms that pursue projects with positive expected returns. A firm should therefore undertake a project that creates value. We denote social welfare as W, such that W = vins + (1 − φ ) p (e( L, g ))(v solv − vins ) − I ≥ 0 and W = Eins (v) + (1 − φ ) p (e( L, g ))( E solv (v) − Eins (v)) − I ≥ 0 .

As social efficiency always requires a minimum conditional expectation value of return, Esolv (v) , we let

W = 0 . Then,

E solv (v) =

I − (1 − (1 − φ ) p (e( L, g ))) Eins (v) , (1 − φ ) p (e( L, g ))

(8)

49


where F = [ I − (1 − (1 − φ ) p (e( L, g ))) Eins (v)] /(1 − φ ) p (e( L, g )) is identical to the right-hand side of Esolv (v) . Note that the uncertainty affects implicitly both equations. Since equation (1) solves for the minimum repayment promise the firm must make to obtain financing and equation (8) solves for the minimum conditional expected return that is socially accepted, the equations show that it is socially efficient for firms to undertake all projects that creditors will finance. Debtors will thus be able to fulfill their promises in solvency states, since equation (1) equals equation (8). Also, we can notice that the level of corporate governance and a harsher bankruptcy law exert an effect on the minimum conditional expected return, in the sense that a higher level of governance and/or legal punishment reduce it (see equations (9) and (10)), which spans the set of financiable projects by the creditors ∂E solv (v) = −( I − vins ) p ′(e( L, g )) −2 b(1 − φ ) −1 p(e( L, g )) −1 < 0, ∂g (9) ∂E solv (v) = −( I − vins ) p ′(e( L, g )) −2 a(1 − φ ) −1 p(e( L, g )) −1 < 0. ∂L

(10)

However, the effect of uncertainty on minimum conditional expected return is positive, meaning that an economy with higher uncertainty increases it, reducing the set of projects potentially financed by the creditors ∂Esolv (v ) = ( I − vins ) p′(e( L, g )) −1 (1 − φ ) − 2 p(e( L, g )) −1 > 0. ∂φ

(11)

Thus far, we have considered the set of projects to be financed. We now examine borrowers' incentives to invest. The interest rate imposes the expected costs on firms, so the firm's expected return, when it borrows, becomes

E ( R B ) = (1 − φ ) p(e( L, g ))(v solv − F ) + (0) ≥ 0; E ( R ) = (1 − φ ) p(e( L, g ))[E solv (v) − F ] ≥ 0. B

Proposition 9: The impact of the uncertainty on the equilibrium level of debt is higher for firms with worse corporate governance level and for economies with a harsher bankruptcy law. In summary, our model shows that better corporate governance and a harsher bankruptcy law reduces the interest rate charged to debtors and expands the set of financed projects. Also, we find that the negative impact of uncertainty on terms of debt (cost and amount) is stronger for firms with worse corporate governance and for countries with lenient bankruptcy law. V. Conclusion

The objective of this paper was to add new empirical findings to the literature on corporate governance. Our paper contributes to prior literature by relating, theoretically, firm-level corporate governance arrangements and bankruptcy law design to the cost of debt and to the amount of debt, under an economic environment which considers uncertainty. First, we found that uncertainty in economic environment increases interest rate and reduces the credit availability. Second, we found that the better the corporate governance arrangement the lower is the cost of debt and the larger is the set of financed projects. Third, we found that the harsher the bankruptcy law design – punishing debtors in case of default – the lower is the cost of debt and the larger is the set of financed projects. Moreover, the negative effect that uncertainty has on credit (interest rate and amount) is stronger for firms with worse corporate governance and in countries with a lenient bankruptcy law. References 1.

2.

(12)

Substituting for F from equation 1 yields

3.

E ( R B ) = (1 − φ ) p(e( L, g )) E solv (v) + (1 − (1 − φ ) p(e( L, g ))) Eins (v) − I ≥ 0,

4.

which is the expression indicating that the project is socially efficient. This equation holds with equality for the minimum conditional expected return, Esolv (v). Therefore, the borrower invests in all projects that creditors will finance. Proposition 6: Higher level of corporate governance increases the equilibrium level of debt. Proposition 7: A harsher bankruptcy law increases the equilibrium level of debt. Proposition 8: Higher uncertainty reduces the equilibrium level of debt.

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5.

6.

7.

Anderson, R.C., Mansi, S.A. & Reeb D. M. (2004). Board characteristics, accounting report integrity, and the cost of debt. Journal of Accounting and Economics, 37: 315-342. Araujo, A. & Funchal B. (2005). Bankruptcy Law in (12)Economia Latin America: Past and Future. Journal The Journal of the Latin America and Caribbean Economic Association, 6(1): 149-216. Bushman, R., Chen, Q., Engel, E. & Smith, A. (2004). Financial accounting information, organizational complexity and corporate governance systems. Journal of Accounting and Economics, 37: 167-201. Demsetz, H. & Lehn, K. (1985). The Structure of Corporate Ownership: causes and consequences. Journal of Political Economy, 93: 1155-1177. Djankov, S., McLiesh, C., Shleifer, A., 2007, Private Credit in 129 Countries, Journal of Financial Economics, 84(2): 299-329. Funchal, B. (2008). The Effects of the 2005 Bankruptcy Reform in Brazil. Economics Letters, 101(1):84-86. Funchal, B., Galdi, F. C. and Lopes, A. B. (2008). Interactions between corporate governance, bankruptcy law and firms' debt financing: The brazilian case. Brazilian Administration Review, 5(3):245-259.

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 8.

Kanagaretnam, K., Lobo, G.J. & Whalen, D.J. (2007). Does good corporate governance reduce information asymmetry around quarterly earnings announcements? Jornal of Accounting and Public Policy, 26: 497-522. 9. La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, Robert W. Vishny.. 1998. “Law and Finance.” Journal of Political Economy, 106(6): 1113–55. 10. La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, Robert W. Vishny. 1997. “Legal Determinants of External Finance", Journal of Finance 52(3): 1131-1150. 11. Leal, R. P. C. & Carvalhal-da-Silva, A. (2005). Corporate Governance and Value in Brazil (and in Chile). Inter-American Development Bank Working Paper.

Appendix: Preliminaries on Knightian Uncertainty The definitions and notations in this section are standard in the literature. Let S = {s1,…, sn} be a non-empty and finite set of states of nature (world) endowed with the algebra of all events denoted by Σ. A set-function v : Σ →ℜ+ with v(∅) = 0 is called a capacity (also called a non-additive probability) on S if it is normalized and monotone, that is: i)

normalized: v(S) = 1; ii) monotone: For all A,B ⊆ S such that A ⊆ B: v(A) ≤ v(B). A capacity is convex if it is normalized and convex: iii) convex: for all A,B ⊆ S: v(A ∪ B) + v(A ∩ B) ≥ v(A) + v(B). It is easy to prove that every convex capacity is a capacity. A convex capacity is a probability measure if it is normalized and additive: iii’) additive: for all A,B ⊆ S such that A∩B = ∅: v(A ∪ B) = v(A) + v(B). It is easy to prove that every probability measure is a convex capacity. If a convex capacity is not a probability measure then there exists at least a pair A,B ⊆ S such that: v(A ∪ B) + v(A ∩ B) > v(A) + v(B). In particular, if B = S\A then v(A) + v(S\A) may be less than 1, implying that not all probability mass is allocated to an event and its complement. The uncertainty aversion measure of a capacity v at event A ⊆ S is defined by φ (v,A) = 1 - v(A) v(S/A). Because it, convex capacities are also know as nonadditive probabilities reflecting uncertainty aversion. In this paper it was considered a special case of convex capacities: the uniform squeeze, where v(A)=(1-∅)p(A) if A≠S and v(A)=1 if A=S. Because it the expected value has that very interesting formula on which the uncertainty appears parametrically represented by the uncertainty aversion measure that we use in our paper.

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РАЗДЕЛ 2 СОВЕТ ДИРЕКТОРОВ SECTION 2 CORPORATE BOARD

BOARD LEADERSHIP STRUCTURE AND FIRM RISK-TAKING BEHAVIOUR Yi Wang*, Trevor Wilmshurst** Abstract In this paper the conceptual frameworks, which make different predictions about the effect of board leadership structure on firm risk-taking behaviour, are examined. From a sample of 243 Australian listed firms, it is found that leadership structure does not have any significant influence on firm risk; higher blockholder ownership or lower dividend payout is related to increased performance variance. This research suffers from some limitations; the archival study of the functional background of board chairman may not reveal the underlying relationship between the board of directors and firm risktaking behaviour. We only test the influence of leadership structure on performance variance; further research could investigate the potential impact of board composition on firm risk-taking propensity. Keywords: Board of directors, leadership structure, firm risk, corporate governance, Australia * School of Accounting & Corporate Governance, University of Tasmania, Private Bag 1314, Launceston, TAS 7248 Phone: +61 3 63243155 Fax: +61 3 63243711 E-mail: [email protected] ** School of Accounting & Corporate Governance, University of Tasmania, Private Bag 1314, Launceston, TAS 7248

1. Introduction

The global movement for corporate governance reforms has gained momentum in the past fifteen years. Panasian et al (2003) observed that much of this trend was influenced by the publication of the Cadbury Report (1992) in the U.K. The Report, sometimes referred to as the Magna Carta of Corporate Governance (Gregory, 2001), comments that the board of directors must retain full and effective monitor over the executive management; given the importance and particular nature of the chairman’s role, it should be in principle separate from that of the chief executive officer (CEO). As noted by Faleye (2007), following the momentum created by the Cadbury Report (1992) it

52

becomes a consensus among shareholder activists, institutional investors and regulators that the CEO should not also serve as chairman. Dahya (2004) found that between 1994 and 2003 regulators and stock exchange in 16 countries issued reports recommending the separation of CEO and chairman duties. Australia had watched closely as big corporate failures such as Enron and WorldCom had prompted the U.S. regulatory authorities to launch significant reforms. In 2003 the Australian Stock Exchange (ASX) released Principles of Good Corporate Governance and Best Practice Recommendations (Guidelines, 2003) which reflects “best international practice”, including the recommendation that the roles


of chairman and CEO should not be exercised by the same individual, and the chairman should be an independent director21. Prior research on board leadership has generally focused on the performance dimension, and has provided divergent perceptions regarding the performance outcome of CEO duality. The purpose of this study is to extend this literature to other leadership structures than CEO duality, and firm risktaking behavior. We attempt to address the following question – does board leadership structure have any effect on firm risk-taking behavior, for a more comprehensive understanding of the consequences of board leadership. The remainder of this paper is organized as follows. In Section 2 a brief introduction to the recent studies in this area is provided; the potential links between board leadership structure and firm risk as suggested by different theories are discussed in Section 3, resulting in three hypotheses. Section 4 describes the research design used to test these hypotheses. The findings of data analysis are reported in Section 5, leading to conclusions in Section 6. 2. Literature Review

As discussed in Finkelstein and D’Aveni (1994), the most important, controversial and inconclusive question in corporate governance research is whether CEO duality, that is, the practice of one person serving both as a firm’s CEO and as board chairman, contributes to or inhibits firm performance. The two views, drawn from agency theory and stewardship theory respectively, would appear to be at odds with each other. Adopting an agency theory perspective it would be argued to split the roles of CEO and board chairman would facilitate more effective monitoring of the CEO, and firms failing to do so may underperform those in which the two positions are split (Rechner and Dalton, 1991). While stewardship theorists argue that the duality of roles establishes a strong and unambiguous leadership, and firms with CEO duality may make better and faster decisions and therefore may out-perform those which split the positions (Donaldson and Davis, 1991). The empirical evidence, primarily from the US initially and more broadly in recent years, has been mixed. Elsayed (2007) argued that prior studies were subject to a number of research limitations including failure to control for significant variables that would be likely to confound the relationship between CEO duality and performance. The performance measures and resulting finding of prior studies are summarised in Table 1. Kim and Buchanan (2008) discovered that the literature had paid little attention to investigating the 21

According to the Guidelines (2003, p.19), “[a]n independent director is independent of management and free of any business or other relationship that could materially interfere with – or could reasonably be perceived to materially interfere with – the exercise of their unfettered and independent judgement”.

implications of CEO duality on strategic management practices such as firm risk-taking behaviour. As a consequence little is known about the contribution to agent opportunism or the promotion of stewardship behaviour in a firm’s strategic management practices when there is duality at the top. Thus, using a sample of 290 large U.S. corporations the authors examined the empirical relationship between CEO duality and firm risktaking propensity. They reported that consistent with the agency theory perspective, CEO duality reduced firm risk as measured by the standard deviation of ROA. However, traditionally emphasized mechanisms of board independence and managerial shareholdings were found to be ineffective in controlling managerial risk-averse preference. Rather it was found that institutional ownership moderated the negative correlation between the duality structure and firm risk. In this study the work of Kim and Buchanan (2008) is extended beyond CEO duality to other board leadership structures. Specifically the applicability of two theories, agency theory and organizational portfolio theory, which make different predictions about the effect of board leadership on firm risk-taking propensity, are tested; the findings may shed light on the impact of the recent changes to the regulatory environment as introduced by the ASX Guidelines (2003). To our best knowledge it presents the first empirical evidence on the risk preferences of leadership structures in the Australian context. 3. Hypotheses

Denis and McConnell (2003) commented that an extensive literature has built up on corporate governance in general, and boards of directors in particular, following the work of Jensen and Meckling (1976), in which the authors applied agency theory to corporations and modeled the agency costs of outside equity. A central assumption of the theory is that managers will pursue their own goals (self interest) rather than seek to maximise shareholder wealth, unless they are kept in check by a vigilant, independent board (Castaldi and Wortmann 1984, Daily et al 2002). Agency theorists have argued that shareholders (the Principal) generally favor actions that maximize returns, even when accompanied by higher risk, because they are able to diversify against risk by selecting specific stocks for their portfolios. Managers (the Agent), on the other hand, cannot readily diversify their employment risks across a range of investments, as a result they tend to be more risk averse than may be in the interests of shareholders, and would prefer low risk strategies (Jensen and Meckling 1976, Fama 1980, Mizruchi 1983, Knoeber 1986, Eisenhardt 1989, Baysinger and Hoskisson 1990, Prentice 1993, Beatty and Zajac 1994, Coles et al 2001, Ellstrand et al 2002, Godfrey et al 2003). In other words, if there is a good business opportunity involving high risk, shareholders would

53


expect managers to seize the opportunity as a means to maximize their investment return, while managers would be more likely to be hesitant to take this option as their rewards from risk-taking, particularly if not successful, could be devastating to them (Kim and Buchanan, 2008). Managers are more concerned about their employment risk and firm survival than wealth maximization for shareholders (Baysinger and Hoskisson, 1990). To test the potential link between board leadership and firm risk the following hypothesis is posed: H 1 : The executive board chairperson will increase firm risk aversion (agency theory). The Guidelines (2003) identifies several personal and professional affiliations that may limit the independence of non-executive directors. These affiliated directors, or “grey” directors as coined by Baysinger and Bulter (1985), appear to sit somewhere between being executive and independent directors. For most their primary employment is not dependent directly on the firm in which they serve as directors but they do have a personal stake in the firm with financial and/or kinship relationships with the firm or its managers (Ellstrand et al, 2002). These affiliations arguably would affect the monitoring role as expected of the board and these directors within agency theory. It could be expected that these affiliated directors could be inclined to support low risk strategies as favoured by management (Johnson et al 1996, Ellstrand et al 2002). To this expectation the following hypothesis is posed: H 2 : The affiliated board chairperson will increase firm risk aversion (agency theory). Heslin and Donaldson (1999) and Donaldson (2000) proposed a new theory of organizational change and success - organizational portfolio theory, which is built on the premise that low performance is required to trigger adaptive organizational changes. It is acknowledged that the theory is at present “… a series of propositions waiting for empirical testing. Only after it has received such empirical confirmation would the policy implications sketched here become valid prescriptions” (Donaldson, 2000, p.395). Contrary to the assumption of agency theory, Heslin and Donaldson (1999) argued that, in general, executive directors would increase risk (lower levels of risk aversion) and independent directors would reduce risk (higher levels of risk aversion). During periods when executives represent a large proportion of the board, the firm is willingness to take greater risk; when peaks from these high risk strategies occur with favourable combinations of other portfolio factors outstanding performance is likely to result. This reinforces confidence in the integrity and competence of a largely non-independent corporate governance structure and bolsters the position of executives on the board. However, when troughs in these high risk strategies occur simultaneously with

54

other performance-depressing portfolio factors 22 , the particularly low performance may trigger the installation of an independent chairman and a higher proportion of independent directors on the board. The resulting risk-averse governance tends to reduce firm performance variance. It is considered that reducing firm risk may be a means of increasing short-term economic value (Brealey and Myers, 1996). Heslin and Donaldson (1999) asserted that risk aversion could prevent the performance crises needed to trigger required structural adaptation; high economic value achieved by lowering risk is thereby prone to inhibiting long-term growth and profitability. It is hypothesised: H 3 : The independent board chairperson will increase firm risk aversion (organizational portfolio theory). 4. Empirical Testing

Sample selection commenced with the top 500 companies listed on the ASX, ranked by market capitalisation. The 2003 list of top 500 companies provided by Huntleys’ Shareholder (2003) was used to source the sample. At December 31, 2003, the top 500 companies represented 95% of the total market capitalisation of the ASX-listed companies (Standard & Poor’s, 2004). As a result this dataset offers good coverage for the population of interest, that is, the Australian public corporation. In conformity with prior studies financial institutions including property trusts and investment funds were removed from the dataset due to a lack of comparable data in the financial institutions section (for example, Muth and Donaldson 1998, Kiel and Nicholson 2003, Cotter and Silverster 2003). The resultant sample consisted of 384 companies. In gathering the information required to complete the testing in this study, in addition to Huntley’s Shareholder (2003) providing information on firm age and lines of business, the Connect 4 database containing the annual reports of the top 500 companies, and the Fin Analysis database containing market information and statistics of Australian firms were used. Due to the non-availability of items of required data from these sources the sample was further reduced to 243 firms.

22

In Heslin and Donaldson (1999) three factors, namely, diversification, divisionalization and divestment that are likely to prevent instances of poor performance and forestall calls for tougher and more independent boards, are identified. They also identified three factors that could contribute to poor performance and lead to a call for the appointment of additional non-executive people as board members or chairpersons - business cycles, competition and debt.


Table 1. Empirical Evidence: Contribution of CEO Duality on Firm Performance

Authors Berg and Smith (1978) Rechner and Dalton (1989) Donaldson and Davis (1991) Rechner and Dalton (1991) Daily and Dalton (1993) Pi and Timme (1993) Boyd (1995) Baliga et al (1996) Brickley et al (1997) Worrell et al (1997) Dalton et al (1998) Coles et al (2001) Dehaene et al (2001) Abdullah (2004) Balatbat et al (2004) Dahya (2004) Peng (2004) Chen et al (2005) Elsayed (2007) Peng et al (2007) Chan and Li (2008)

Country U.S. U.S. U.S. U.S. U.S. U.S. U.S. U.S. U.S. U.S. U.S. U.S. Belgium Malaysia Australia U.K. China Hong Kong Egypt China U.S.

Performance Measures ROE, ROI and shareholder return Shareholder return ROE and shareholder return ROI and Profit margin ROA, ROE and price/earnings ratio ROA and production efficiency ROI, market share and sales growth ROE and shareholder return ROI and shareholder return Shareholder return Market and accounting measures Economic value added ROA ROA, ROE, EPS and profit margin Operating return ROA ROE and sales growth market-to-book ratio ROA and Tobin’s q ROE and sales growth Tobin’s q

Results Insignificant Insignificant Positive Negative Insignificant Negative Contingent23 Insignificant Positive Negative Insignificant Positive Positive Insignificant Positive Insignificant Positive Negative Contingent24 Positive Negative

23

Boyd (1995) concluded that CEO duality might be advantageous under conditions of resource scarcity and environmental dynamism, i.e., unpredictability of changes. 24 Elsayed (2007) found that the impact of CEO duality varied across industries, and CEO duality attracted a positive coefficient only when firm performance was low.

55


Following the approach adopted by prior studies on the relationship between CEO duality and firm performance (for example, Daily and Dalton 1993, Dehaene et al 2001, Chan and Li 2008) the leadership structure of sample companies is examined at one point in time, i.e., mid-2003. Three binary variables for board leadership - executive chairman (CMEXE), independent chairman (CMIND) and affiliated chairman (CMAFF) - are developed to assess whether the chairman is an affiliated director, executive director or an independent director. If the chairman is an outside director and the sources of information only divide board members into executives and non-executives, the chairman will be classified as an affiliated or independent director, using the definition of independence adopted by the ASX Corporate Governance Council as the benchmark25. The details of directors are available in the director’s report, corporate governance statement and related party note to the financial statements. If a close analysis of this information was not able to provide an objective basis for determining director independence, the company was excluded from the analysis. The measurement of firm risk has been discussed by a number of researchers (Baird and Thomas 1990, Beatty and Zajac 1994). Baird and Thomas (1990) discussed the way risk has been conceptualized by different disciplines. They considered management, finance, marketing and psychology, and concluded that researchers in the field of strategic management typically defined risk as the unpredictability of business outcome variables, for example, the variability of accounting or shareholder return. Kim and Buchanan (2008) employed income stream variance as the measure, i.e., the standard deviation of ROA. They argued that this would reflect managerial risk-taking behaviour. In the finance literature risk is viewed as a systematic risk or unsystematic risk (for example, Ross et al 2005, Reilly and Brown 2006). Schellenger et al (1989) argued that the board was able to influence both the systematic and unsystematic risk. Other researchers have also found that the board of directors is able to raise or reduce the level of risk faced by the firm (Hill and Snell 1988, Lorsch and MacIver 1989, Baysinger et al 1991, Davis and Thompson 1994, Heslin and Donaldson 1999, Donaldson 2000). In this study the measure of risk adopted will be the standard deviation of shareholder return. In order to reduce the influence of short-term fluctuations three-year averages of data were used; the averages were across the 2003-2006 financial years. To locate the specific effect of leadership structure on firm risk aversion this study considered empirical models identified in prior research that had

looked at board composition and structure (for example, Bhagat and Black 2000, Coles et al 2001, Singh and Davidson III 2003, Randoy and Jenssen 2004, Krivogorsky 2006). Several covariates are introduced into this analysis to control for potentially confounding influences, including board size, prior performance, blockholder ownership, diversification, dividend payout, firm age and size, leverage and managerial shareholdings. Consistent with the risk measure, dividend payout, leverage and firm size are calculated for the period of 2003-2006. Like the measures for board leadership, data on board size, firm age, blockholder ownership, diversification and managerial shareholdings are collected for the 2003 financial year; prior performance is measure by the average shareholder return for the years 2000-2003. A summary of the research variables adopted in this study are shown on Table 2. Ordinary least squares (OLS) regressions are developed for the research variables as described in Table 2, in which firm risk serves as the dependent variable; the independent variables consist of leadership structure, firm age, blockholder and managerial shareholdings, dividend payout, leverage, firm size, diversification, prior performance and board size. Moreover, sensitivity tests on the regressions without firm size control are performed to assess the robustness of findings. An algebraic statement of the models is presented below: Yi = α + β 1 ( Leadership) i + β 2 ( AGE ) i + β 3 ( BLOCK ) i + β 4 ( DIVR ) i + β 5 ( EQED ) i + β 6 (GEAR ) i + β 7 ( LogMCAP ) i + β 8 ( SEGMT ) i + β 9 ( SHRET ) i + β 10 ( SIZE ) i + µ i

th

Where, for the i company Y = RISK = Constant of the equation α = Coefficient of the β variable Leadership = CMAFF, CMEXE or CMIND µ = Error term 5.

Results

An overview of descriptive characteristics is provided in Table 3 showing firm characteristics for the sample in 200326. Among the 243 chairpersons of the boards of directors 47 (19.34%) were executive directors, 114 (46.91%) were independent directors and 82 (33.74%) were affiliated directors.

25

There is a list of the persons who should not be considered independent in Box 2.1 of the Guidelines (2003); however, it is unclear how long an independent director could serve on the same board. This research follows the U.K. Higgs Report (2003) which nominates ten years in relation to the director tenure consideration.

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26

The descriptive statistics of other research variables are available from the Authors.

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 2. Description of Research Variables Measure Board Leadership Affiliated chairman Executive chairman

Abbreviation CMAFF CMEXE

Independent chairman

CMIND

Firm Risk Firm risk Control Firm age Blockholder ownership Dividend payout Managerial ownership Leverage Firm size Diversification Prior performance Board size

Definition Binary variable to assess whether or not the chairman is an affiliated director Binary variable to assess whether or not the chairman is an executive director Binary variable to assess whether or not the chairman is an independent director

RISK

Standard deviation of shareholder return

AGE BLOCK DIVR EQED GEAR LogMCAP SEGMT SHRET SIZE

Number of years listed on the ASX The percentage of common stocks held by the top 20 shareholders Ratio of dividend payments to profit after interest and tax Percentage of equity including options held by executive directors Ratio of short-term and long-term debt to book value of equity Natural logarithms of market value of common stocks (in $million) Number of industrial and geographical segments Realised return of returns incorporating capital gains and dividend payments Number of directors on the board

Table 3. Descriptive Statistics

N: 243 Variable AGE BLOCK EQED SEGMT SIZE

Mean 16.90 65.10% 11.84% 4.46 6.33

Median 11.00 67.09% 2.21% 4.00 6.00

Maximum 132.00 99.86% 80.99% 11.00 15.00

Minimum 3.00 13.60% 0 1.00 3.00

Std. Dev 17.81 0.18 0.18 2.23 2.05

Skewness 2.90 -0.42 1.70 0.84 1.02

Kurtosis 15.39 2.74 4.89 3.19 4.53

Table 4. OLS Regressions: Board Leadership Structure and Firm Risk

N: 243 Coefficient t-Statistic Intercept CMAFF

0.904 1.615 0.112 0.472

CMEXE

RISK 0.969 1.715

-0.210 -0.710

CMIND AGE BLOCK DIVR EQED GEAR LogMCAP SEGMT SHRET SIZE

R2 Std Error (Regression) F-Statistic Probability (F-Statistic) Durbin-Watson

* Significance at the 5% level

0.898 1.554

0.003 0.491 1.624 2.604** -0.577 -2.390* -1.342 -2.012* 0.039 0.728 -0.101 -1.129 -0.031 -0.532 -0.067 -0.916 -0.044 -0.620

0.003 0.513 1.649 2.670** -0.594 -2.448* -1.245 -1.803 0.040 0.753 -0.105 -1.175 -0.028 -0.485 -0.064 -0.879 -0.044 -0.626

0.019 0.089 0.003 0.497 1.669 2.687** -0.576 -2.383* -1.410 -2.166* 0.035 0.672 -0.105 -1.173 -0.030 -0.521 -0.064 -0.882 -0.039 -0.551

0.088 1.656 2.229 0.017 1.998

0.089 1.655 2.260 0.015 1.994

0.087 1.657 2.206 0.018 1.987

** Significance at the 1% level

57

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 5. Sensitivity Tests: Board Leadership Structure and Firm Risk

N: 243 Coefficient t-Statistic Intercept CMAFF

0.695 1.315 0.134 0.563

CMEXE

RISK 0.752 1.407

-0.209 -0.703

CMIND AGE BLOCK DIVR EQED GEAR SEGMT SHRET SIZE



0.002 0.286 1.582 2.540** -0.629 -2.657** -1.135 -1.769 0.031 0.596 -0.048 -0.851 -0.068 -0.930 -0.085 -1.390

0.002 0.300 1.614 2.614** -0.648 -2.721** -1.045 -1.560 0.032 0.603 -0.046 -0.815 -0.065 -0.888 -0.086 -1.406

-0.0002 -0.0009 0.002 0.282 1.628 2.623** -0.629 -2.647** -1.212 -1.927 0.027 0.524 -0.048 -0.856 -0.065 -0.896 -0.081 -1.330

0.083 1.657 2.332 0.016 2.004

0.083 1.657 2.354 0.015 1.998

0.081 1.658 2.294 0.017 1.992


The Table reveals that the sample contains a wide range of firms. The number of years the company had been listed on the stock exchange ranges from a low of 3 to a high of 132, with an average of almost 17 years. Block ownership varies from a minimum of 13.60% to almost 100% while managerial ownership varies from none to 81% with a mean of 65.10% and 11.84% respectively. The number of business segments ranges from 1 to 11, and number of directors on the board ranges from 3 to 15, with an average of just over 4 and 6, respectively. The contribution of board leadership and other variables to performance variance is reported in Table 4. According to the Table there is no statistically significant relationship between the presence of executive, independent or affiliated chairperson, and the risk measure. Table 5 displays the results for sensitivity tests without firm size control, in which no significant influence of leadership structure on firm risk-taking behaviour could be identified. With respect to the control variables used in the analysis, some consistent patterns emerge from Table 4 and 5.Some of these patterns coincide with the evidence as reported in

58

0.695 1.260

Kim and Buchanan (2008) - blockholder ownership has a positive impact on risk. Coles et al (2001) suggested that blockholders had the capacity to monitor their investments and, by virtue of the magnitude of their investments, could affect managerial behaviour. The threat that blockholders might sell large blocks of shares if the firm fails to provide an acceptable return, or is not responsive to governance concerns that investors view as critical, is a significant issue for managers. There is empirical evidence for the impact of institutional investors and other blockholders on managerial behaviour (Barclay and Holderness 1991, Van Nuys 1993, Brickley et al 1994, Shome and Singh 1995, Bethel 1998, Allen and Phillips 2000). The results show that poor dividend payout may be related to increased performance variance. However, contrary to the findings in Kim and Buchanan (2008), it appears that higher managerial shareholdings would reduce firm risk-taking propensity (see Table 4), although the effect of managerial ownership becomes insignificant in the additional tests without firm size control (see Table 5); we leave this issue for future investigation.

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 6. Conclusions

This study focuses on an area often overlooked in the literature, namely, the relationship between the board of directors and firm risk-taking behaviour. The results do not support the three hypotheses which have been developed from agency theory and organizational portfolio model. It could be concluded that, in the Australian market, board leadership structure does not have any significant influence on firm risk. The data analysis suggests that higher blockholder ownership increases performance variance; the evidence supports the proposition that blockholders could affect management practices. Moreover, it is found that poor dividend payout leads to increased risk. There are some limitations for this study. First, the archival investigation of the functional background of chairman may not reveal the underlying relationship between the board of directors and performance risk. Second, the sample tested is restricted to companies listed on the ASX; therefore the conclusions should not be extrapolated to all Australian firms. Finally, we only test the influence of leadership structure on performance variance; further research is required to investigate the potential impact of board composition as measure by, for example, the proportion of affiliated, executive or independent directors on the board, on firm risk. References Abdullah, S. (2004), “Board Composition, CEO Duality and Performance among Malaysian Listed Companies”, Corporate Governance: The International Journal of Effective Board Performance, Vol. 4 No. 4, pp. 47-61. 2. Allen, J. W. and Phillips, G. M. (2000), “Corporate Equity Ownership, Strategic Alliance, and Product Market Relationships”, Journal of Finance, Vol. 55. 3. Aspect Huntley (2003), Huntleys’ Shareholder, Wrightbooks, Milton, Queensland. 4. ASX Corporate Governance Council (2003), Principles of Good Corporate Governance and Best Practice Recommendations (Guidelines). 5. ASX Corporate Governance Council (2007), Corporate Governance Principles and Recommendations (Guidelines). 6. Baird, I. S. and Thomas, H. (1990), “What is Risk anyway?” in Bettis, R. A. and Thomas, H., Risk, Strategy and management, JAI Press, Greenwich, Connecticut, pp. 21-52. 7. Balatbat, M. C. A., Taylor, S. L. and Walter, T. S. (2004), “Corporate Governance, Insider Ownership and Operating Performance of Australian Initial Public Offerings”, Accounting and Finance, Vol. 44 No. 3. 8. Baliga, B., Moyer, N. and Rao, R. (1996), “CEO duality and Firm Performance: What’s the Fuss”, Strategic Management Journal, Vol. 17, pp. 41-53. 9. Barclay, M. and Holderness, C. (1991), “Control of Corporations by Active Block Investors”, Journal of Applied Corporate Finance, Vol. 4, pp. 68-77. 10. Baysinger, B. D. and Butler, H. N. (1985), “Corporate Governance and the Board of Directors: Performance

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 29. Dalton, D., Daily, C., Ellstrand, A. and Johnson, J. (1998), “Meta-Analytical Reviews of Board Composition, Leadership Structure, and Financial Performance”, Strategic Management Journal, Vol. 19, pp. 269-290. 30. Davis, G. F. and Thompson, T. A. (1994), “A Social Movement Perspective on Corporate Control”, Administrative Science Quarterly, Vol. 39. 31. Dehaene, A., Vuyst, V. D. and Ooghe, H. (2001), “Corporate Performance and Board Structure in Belgian Companies”, Long Range Planning, Vol. 34, pp. 383-398. 32. Denis, D. K. and McConnell, J. J. (2003), “International Corporate Governance”, Journal of Financial and Quantitative Analysis, Vol. 38 No. 1. 33. Department for Trade and Industry (2003), Higgs Review on the Role and Effectiveness of Non-Executive Directors (Higgs Report). 34. Donaldson, L. (2000), “Organizational Portfolio Theory: Performance-Driven Organizational Change”, Contemporary Economic Policy, Vol. 18 No. 4, pp. 386-396. 35. Donaldson, L. and Davis, J. H. (1991), “Stewardship Theory and Agency Theory: CEO Governance and Shareholder Returns”, Australian Journal of Management, Vol. 16, pp. 49-64. 36. Eisenhardt, K. (1989), “Agency Theory: An Assessment and Review”, Academy of Management Review, Vol. 14, pp. 57-74. 37. Ellstrand, A. E., Tihanyi, L. and Johnson, J. L. (2002), “Board Structure and International Political Risk”, Academy of Management Journal, Vol. 45. 38. Elsayed, K. (2007), “Does CEO Duality Really Affect Corporate Performance?” Corporate Governance: An International Review, Vol. 16 No. 6, pp. 1203-1214. 39. Faleye, O. (2007), “Does One Hat Fit All?” The Case of Corporate Leadership Structure, Working paper, Northeastern University, Boston. 40. Fama, E. F. (1980), “Agency Problem and the Theory of Firm”, Journal of Political Economy, Vol. 88 No. 2, pp. 288-307. 41. Finkelstein, S. and D’Aveni, R. A. (1994), “CEO Duality as a Double-Edged Sword: How Boards of Directors Balance Entrenchment Avoidance and Unity of Command”, Academy of Management Journal, Vol. 37, pp. 1079-1108. 42. Godfrey, J., Hodgson, A. and Holmes, S. (2003), Accounting Theory, Wiley, Milton, Queensland. 43. Heslin, P. A. and Donaldson, L. (1999), “An Organizational Portfolio Theory of Board Composition”, Corporate Governance: An International Review, Vol. 7 No. 1, pp. 81-88. 44. Hill, C. W. L. and Snell, S. A. (1988), “External Control, Corporate Strategy, and Firm Performance in Research-Intensive Industries”, Strategic Management Journal, Vol. 9 No. 6, pp. 577-590. 45. Jensen, M. C. and Meckling, W. H. (1976), “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure”, Journal of Financial Economics, Vol. 2, pp. 305-360. 46. Johnson, J. L., Daily, C. M. and Ellstrand, A. E. (1996), “Boards of Directors: A Review and Research Agenda”, Journal of Management, Vol. 22. 47. Kiel, G. C. and Nicholson, G. J. (2003), “Board Composition and Corporate Performance: How the Australian Experience Informs Contrasting Theories of Corporate Governance”, Corporate Governance: An International Review, Vol. 11 No. 3, pp. 189-205.

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48. Kim, K. H. and Buchanan, R. (2008), “CEO Duality Leadership and Firm Risk-Taking Propensity”, Journal of Applied Business Research, Vol. 24 No. 1. 49. Knoeber, C. R. (1986), “Golden Parachutes, Shark Repellents and Hostile Tender Offers”, American Economic Review, Vol. 76, pp. 155-167. 50. Krivogorsky, V. (2006), “Ownership, Board Structure, and Performance in Continental Europe”, International Journal of Accounting, Vol. 41, pp. 176-197. 51. Lorsch, J. W. and Maclver, E. (1989), Pawns or Potentates: The Reality of America’s Corporate Boards, Harvard Business School Press, Boston. 52. Mizruchi, M. S. (1983), “Who Controls Whom? An Examination of the Relation between Management and Boards of Directors in Large American Corporations”, Academy of management Review, Vol. 8, pp. 426-435. 53. Muth, M. M. and Donaldson, L. (1998), “Stewardship Theory and Board Structure: A Contingency Approach”, Corporate Governance: An International Review, Vol. 6 No. 1, pp. 5-28. 54. Peng, M. W. (2004), “Outside Directors and Firm Performance during Institutional Transactions”, Strategic Management Journal, Vol. 25, pp. 453-471. 55. Pi, L. and Timme, A. (1993), “Corporate Control and Bank Efficiency”, Journal of Banking and Finance, Vol. 17, pp. 515-530. 56. Prentice, D. D. (1993), “Some Aspects of Corporate Governance Debate”, in Prentice, D. D. and Holland, P. R. J., Contemporary Issues in Corporate Governance, Oxford University Press, Oxford. 57. Randoy, T. and Jenssen, J. I. (2004), “Board Independence and Product Market Competition in Swedish Firms”, Corporate Governance: An International Review, Vol. 12 No. 3, pp. 281-289. 58. Rechner, P. L. and Dalton, D. R. (1989), “The Impact of CEO as Board Chairperson on Corporate Performance: Evidence vs. Rhetoric”, Academy of Management Executive, Vol. 3, pp. 141-143. 59. Rechner, P. L. and Dalton, D. R. (1991), “CEO Duality and Organizational Performance: A Longitudinal Analysis”, Strategic Management Journal, Vol. 12, pp. 155-160. 60. Ross, S. A., Westerfield, R. W. and Jaffe, J. (2005), Corporate Finance, McGraw-Hill, Irwin. 61. Schellenger, M. H., Wood, D. D. and Tashakori, A. (1989), “Board of Directors Composition, Shareholder Wealth, and Dividend Policy”, Journal of Management, Vol. 15, pp. 457-467. 62. Shome, D. and Singh, S. (1995), “Firm Value and External Blockholdings”, Financial Management, Vol. 24, pp. 3-14. 63. Singh, M. and Davidson III, W. N. (2003), “Agency Costs, Ownership Structure and Corporate Governance Mechanisms”, Journal of Banking & Finance, Vol. 27, pp. 793-816. 64. Standard & Poor’s (2004), Understanding Indices, [created May 2004; cited October 2007], available from http://www2.standardandpoors.com/spf/pdf/ index/A5_CMYK_UIndices.pdf. 65. Van Nuys, K. (1993), “Corporate Governance through the Proxy Process: Evidence from the 1989 Honeywell Proxy Solicitation”, Journal of Financial Economics, Vol. 34, pp. 101-132. 66. Worrell, D., Nemec, C. and Davidson, W. (1997), “One Hat too Many: Key Executive Plurality and Shareholder Wealth”, Strategic Management Journal, Vol. 18, pp. 499-507.


BOARD LEADERSHIP: ANTECEDENTS AND PERFORMANCE OUTCOMES Yi Wang*, Bob Clift** Abstract In this paper several theories, which make different predictions about the effect of board leadership structure on firm performance, are tested. The results indicate that, for Australian listed companies, there is no strong relationship between leadership structure and subsequent performance. It is reported that companies with higher blockholder ownership or lower managerial shareholdings tend to have an affiliated chairman; firm with higher managerial shareholdings tend to have an executive chairman. The evidence suggests that there is no one optimal leadership structure; each structure, which could be an outcome of a rational choice process influenced by other governance characteristics of individual firms, may have associated costs and benefits. Keywords: Board of directors, leadership structure, firm performance, corporate governance, Australia * School of Accounting & Corporate Governance, University of Tasmania, Private Bag 1314, Launceston, TAS 7248 Phone: +61 3 63243155 Fax: +61 3 63243711 E-mail: [email protected] ** School of Accounting & Corporate Governance, University of Tasmania, Private Bag 86, Hobart, TAS 7001

1. Introduction

The most important, controversial and inconclusive questions in corporate governance research and practice, as argued by Finkelstein and D’Aveni (1994), may be whether CEO duality – the practice of one person serving both as a firm’s chief executive officer (CEO) and board chairman, contribute to or inhibit firm performance. Two views, drawn from agency theory and stewardship theory, are at odds with each other. Agency theory suggests that splitting the CEO and board chairman positions facilitates more effective monitoring of the CEO, and that firms failing to do so may under-perform those which split the two top positions (Rechner and Dalton, 1991). In contrast, stewardship theory argues that CEO duality establishes a strong and unambiguous leadership, and that firms with CEO duality may make better and faster decisions and therefore may out-perform those which split the positions (Donaldson and Davis, 1991). The literature survey indicates that the empirical evidence around this topic has been most developed in the U.S., which, as shown in Table 1, is mixed. Some authors, for example Elsayed (2007), have noted that many of the prior studies could be challenged on their methodological premise, for example, failure to control for significant variables that might confound the relationship between CEO duality and performance.

In spite of the inconclusive evidence, the consensus among shareholder activists, institutional investors and regulators appears to be that the CEO should not also serve as board chairman (Faleye, 2007). According to Dahya (2004), between 1994 and 2003 regulators and stock exchanges in at least 16 countries had issued reports recommending the separation of CEO and chairman duties. In 2003, the Australian Stock Exchange (ASX) Corporate Governance Council released Principles of Good Corporate Governance and Best Practice Recommendations (Guidelines) which reflect “best international practice” by highlighting the importance of independent directors 27 . The stock exchange requires that a majority of each listed company’s directors should qualify as independent directors; the roles of chairman and CEO should not be exercised by the same individual, and the chairman should be an independent director. It is found in the literature survey that the academics in this field have paid little attention to investigating the performance implications of other board leadership structures than CEO duality; we seek to fill this gap by providing robust evidence regarding 27

According to the Guidelines (2003, p.19), “[a]n independent director is independent of management and free of any business or other relationship that could materially interfere with – or could reasonably be perceived to materially interfere with – the exercise of their unfettered and independent judgement”.

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the relationship between different leadership structure and performance. Specifically, we test the applicability of several theories which make different predictions about the effect of board leadership on firm performance, and shed some light on the impact of the recently altered regulatory environment with respect to corporate governance mechanisms. The features of this paper include the use of alternative performance measures and controls for other corporate governance mechanisms, alongside other covariates. We also extend the empirical work to the explanatory factors for different structures, which, to date, are largely unexplored. 2. Hypotheses

Denis and McConnell (2003) observed that the publication of Jensen and Meckling (1976), in which the authors applied agency theory to corporations and modeled the agency costs of outside equity, had produced voluminous works on corporate governance in general, and boards of directors in particular, around the world. A central assumption of the theory is that managers may pursue their own goals rather than seek to maximise shareholder wealth, unless their discretion is kept in check by a vigilant, independent board (Castaldi and Wortmann, 1984; Daily, McDougall, Covin and Dalton, 2002). By emphasising the potential for divergence of interests between investors and managers, agency theorists predict that where the board of directors is more independent of management, company performance would be higher (Fama, 1980; Scott, 1983). Developed as an alternative to agency theory, stewardship theory highlights a range of non-financial motives for managerial behaviours, such as the need for achievement, intrinsic satisfaction of successful performance, and respect for authority and work ethics (Donaldson and Davis, 1989, 1991, 1994; Fox and Hamilton, 1994; Davis, Schoorman and Donaldson, 1997). Having control empowers managers to maximize corporate profits; the detailed operational knowledge, expertise and commitment to the firm by executive directors, would make firms with a management-dominated board more profitable. Therefore, the potential link between board leadership structure and firm performance as expected by agency theory and stewardship theory could be illustrated as follows: H1: There is a positive effect of independent chairman on firm financial performance (agency theory); and H2: There is positive effect of executive chairman on firm financial performance (stewardship theory).

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From the 1980s, two theories founded on the organizational literature have been increasingly used by academics in investigating corporate governance issues, i.e., resource-based theory and resourcedependence theory. The resource-based approach generally argues that a firm's internal environment, in terms of its resources and capabilities, is critical for creating sustainable competitive advantage (Prahalad and Hamel, 1990; Teece, Pisano and Shuen, 1997). Being aware of, improving, and protecting the unique resources of the firm would reinforce its strengths and rearrange its weaknesses, and improve its competitive position and, thereby, performance. However, firms are generally characterized by a lack of internal resources, and in-house knowledge may in many cases be scarce or non-existent (Storey, 1994). It has in this respect been considered important to have a board with outside members in order to overcome this internal lack of resources and complement the management with experience, knowledge and skills (Castaldi and Wortmann, 1984). Outside directors, especially affiliated directors, may be considered as a bundle of strategic resources to be used by and within the firm as they can provide advice and counsel to the management in areas where in-firm knowledge is limited or lacking. They are viewed as a valuable source of competitive advantage through their professional and personal qualifications. From a different point of view, resourcedependence theory proposes that the long-term survival and success of a firm is dependent on its abilities to link the firm with its external environment (Pfeffer, 1972; Pfeffer and Salancik, 1978). A basic argument in this theory is that firms must constantly interact with their external environments either to purchase resources, or to distribute their finished products. Firms should seek to gain control over their environments to create more stable flows of resources and lessen the effects of environmental uncertainties. Outside directors, as boundary spanners, could form links with the external environment, which may be useful for the managers in the achievement of the various goals of the organization (Pfeffer and Salancik, 1978; Zahra and Pearce, 1989; Pearce and Zahra, 1992; Borch and Huse, 1993). Specifically, outside directors may help firms initiate and maintain control over critical relationships, assets and contacts in the external environment. The firm may also co-opt representatives from important organizations as board members in order to achieve organizational goals and manage environmental contingencies. Directors who are prestigious in their professions and communities can be a source of timely information for executives. They become involved in supporting the organization by influencing their other constituencies on behalf of the focal organization (Pfeffer, 1972; Pfeffer and Salancik, 1978).

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 1. Empirical Evidence: Contribution of CEO Duality on Firm Performance Performance Measures

Authors Berg and Smith (1978)

Country U.S.

Rechner and Dalton (1989)

U.S.

Shareholder return

Insignificant

Donaldson and Davis (1991)

U.S.

ROE and shareholder return

Positive

ROE, ROI and shareholder return

Results Insignificant

Rechner and Dalton (1991)

U.S.

ROI and Profit margin

Negative

Daily and Dalton (1993)

U.S.

ROA, ROE and price/earnings ratio

Insignificant

Pi and Timme (1993)

U.S.

ROA and production efficiency

Negative

Boyd (1995)

U.S.

ROI, market share and sales growth

Contingent*

Baliga, Moyer and Rao (1996)

U.S.

ROE and shareholder return

Insignificant

Brickley, Coles and Jarrell (1997)

U.S.

ROI and shareholder return

Positive

Worrell, Nemec and Davidson (1997)

U.S.

Shareholder return

Negative

Dalton, Daily, Ellstrand and Johnson (1998)

U.S.

Market and accounting measures

Insignificant

Coles, McWilliams and Sen (2001)

U.S.

Economic value added

Positive

Dehaene, Vuyst and Ooghe (2001)

Belgium Malaysia

ROA

Positive

ROA, ROE, EPS and profit margin

Insignificant

Balatbat, Taylor and Walter (2004) Dahya (2004)

Australia

Operating return

Positive

U.K.

ROA

Insignificant

Peng (2004)

China

ROE and sales growth

Positive

Abdullah (2004)

Chen, Cheung, Stouraitis and Wong (2005)

Hong Kong

market-to-book ratio

Negative

Elsayed (2007)

Egypt

ROA and Tobin’s q

Contingent**

Peng, Zhang and Li (2007)

China

ROE and sales growth

Positive

Chan and Li (2008)

U.S.

Tobin’s q

Negative

* Boyd (1995) concluded that CEO duality might be advantageous under conditions of resource scarcity and environmental dynamism, i.e., unpredictability of changes. ** Elsayed (2007) found that the impact of CEO duality varied across industries, and CEO duality attracted a positive coefficient only when firm performance was low.

Outside directors comprise independent directors and affiliated directors, or “grey directors” as termed by Baysinger and Bulter (1985). It appears that resource-based theory and resource-dependence theory are more interested in affiliated directors and their experience, knowledge and linkages with other organizations (Pfeffer and Salancik, 1978; Castaldi and Wortmann, 1984; Zahra, 1990). Consequently, with respect to the relationship between leadership structure and performance, the following hypothesis could be developed: H3: There is a positive effect of affiliated chairman on firm financial performance (resource-based theory and resourcedependence theory). 3. Empirical Tests

The initial dataset comprises the top 500 companies listed on the ASX, ranked by market capitalisation. Each year the ASX collects information on these companies to calculate its All Ordinaries Index, the primary indicator of the Australian equity market. At December 31, 2003, the top 500 companies represent 95% of the total market capitalisation of the ASXlisted companies (Standard & Poor’s, 2004). Thus, this dataset offers a reasonable coverage for the population of interest - Australian public corporations. There are 503 firms in the 2003 list of top 500 companies provided by Huntleys’ Shareholder

(2003). In line with previous studies, financial institutions are eliminated from the list due to lack of comparable data (Muth and Donaldson, 1998; Kiel and Nicholson, 2003; Cotter and Silverster, 2003), resulting in a sample of 384 firms. The sources of data include Connect 4 database containing the annual reports on the top 500 companies, Fin Analysis database giving market information and statistics of Australian firms, and Huntleys’ Shareholder (2003) providing some information on firm age and lines of business. The sample is further reduced to 243 firms due to missing data. 3.1.

Research Variables

Following the approach supported by most prior research in the area of board composition and structure, the leadership structures of the sample companies are examined at one point in time, i.e., mid-2003; three binary variables for board leadership, i.e., CMAFF, CMEXE and CMIND, are developed to assess whether the chairman is an affiliated director, executive director or independent director. If the chairman is an outside director and the sources of information only divide board members into executives and non-executives, it would be necessary to classify the chairman as an affiliated or independent director, using the definition of independence proposed by the ASX Corporate

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Governance Council as a benchmark28. The details of directors are available in the director’s report, corporate governance statement and related party note to the financial statements; if a close analysis of the information could not provide an objective basis for determining director independence, the company is excluded from the analysis. Chakravarthy (1986) observed that there was no consensus concerning the selection of an appropriate set of measures to account for corporate financial performance; according to Daily and Dalton (1992), it is unlikely that any one performance indicator could sufficiently capture this performance dimension. It is common for several indices to be used because organizations legitimately seek to accomplish a variety of objectives, ranging from profitability to effective asset utilization and high stockholder returns (Hofer, 1983). Some authors note that there are two broad groups of performance measures – “accounting measures drawn from the accounting systems used by firms to track their internal affairs and financial market measures relating to the share prices and dividend streams observed in the operation of financial markets” (Devinney, Richard, Yip and Johnson, 2005, p.15). Accounting measures are historical and therefore experience a backward- and inward- looking focus; developed as a reporting mechanism, they represent the impact of many factors, including the successes of advice given from the board to the management; they are the traditional mainstay of corporate performance factors (Kiel and Nicholson, 2003). However, accounting measures are “distortable”; this distortion arises from such sources as accounting procedures and policies, government policies towards specific activities, human error and purposeful deception (Devinney et al, 2005). Nevertheless, ROA and ROE are included in this study as performance measures; as noted by Muth and Donaldson (1998), ROA and ROE had been extensively used in the research on board composition and structure. Market-based measures are forward-looking indicators that reflect current plans and strategies, and represent the discounted value of future cash flows (Fisher and McGowan, 1983). Related to the value placed on the firm by the market, they are not susceptible to the impact of accounting policy changes or mere timing effects; they are objective in the sense that they exist outside of the influence of individuals (Devinney et al, 2005). Examples of market measures frequently employed by academics include shareholder return and Tobin’s q. Shareholder return is used in this research given that there is strong market efficiency in Australia (e.g., Ball, Brown, Finn and Officer, 1989; Kasa, 1992). 28

There is a list of the persons who should not be considered independent in Box 2.1 of the Guidelines (2003); however, it is unclear how long an independent director could serve on the same board. This research follows the U.K. Higgs Report (2003) which nominates ten years in relation to director tenure consideration.

64

Shrader, Taylor and Dalton (1984), in examining the literature on the empirical relationship between strategic planning and organizational performance, found that most studies had chosen 3- or 5-year periods as their time frames, as suggested to be appropriate for a given strategic planning intervention to take effect. To reduce the influence of short-term fluctuations, the prior performance or subsequent performance figures tested in this study are the threeyear averages over 2000-2003 or 2003-2006, respectively. Bathala and Rao (1995), Coles, McWilliams and Sen (2001) and Elsayed (2007) suggested that the conflicting evidence on the existence or non-existence of an impact of the board of directors on financial performance might be attributed to the omission of other variables that affect performance. To identify the specific effect of board leadership on performance, a number of covariates are introduced into the analysis to control for confounding influence. According to Bathala and Rao (1995), while the agency literature recognizes the importance of board of directors in monitoring of management decisions, this is only one of the mechanisms used to control agency conflicts. The literature identifies a few other devices which ensure that managers’ interests are aligned with those of shareholders, such as managerial ownership, dividend payout and leverage. Jensen and Meckling (1976) asserted that increasing managerial ownership could mitigate agency conflicts; the higher the proportion of equity owned by managers, the greater the alignment between managers and shareholder interests. The evidence supporting this view could be found in Morck, Shleifer and Vishny (1988), Kim, Lee and Francis (1988), McConell and Servaes (1990) and Hudson, Jahera and Lloyd (1992). Regarding leverage and dividend payout, Jensen (1986) argued that the payment of dividends and the contractual obligations associated with debt reduced the amount of discretionary funds available to management, thereby reducing their incentive to engage in non-optimal activities. Similarly, Grossman and Hart (1980) suggested that increased debt would cause managers to become more efficient in order to lessen the probability of bankruptcy, and loss of control and reputation. The regular payment of dividends would force firms to go to the capital markets for investment funding; scrutiny of firms accessing the markets would act as a deterrent to opportunistic behaviours by managers (Easterbrook, 1984). Harris and Raviv (1991) confirmed that the empirical evidence was broadly consistent with the proposition that debt could mitigate agency conflicts. Drawing on the empirical models identified in prior research the analysis includes several other controls, which capture the firm characteristics likely to be associated with performance or board structure, including board size, diversification, blockholder ownership, firm age and firm size. Consistent with the performance figures, dividend payout, firm size and


leverage are calculated as the three-year averages for 2000-2003 or 2003-2006. Like the measures of board independence, data on board size, blockholder and

executive director shareholdings, diversification and firm age are collected for the 2003 financial year.

Table 2. Description of Research Variables Measure Board Leadership Affiliated chairman Executive chairman Independent chairman Firm Performance ROA ROE Shareholder return Control Firm age Blockholder ownership Dividend payout Managerial ownership Leverage Firm size Diversification Board size

Abbreviation

Definition

CMAFF CMEXE CMIND

Binary variable to assess whether or not the chairman is an affiliated director Binary variable to assess whether or not the chairman is an executive director Binary variable to assess whether or not the chairman is an independent director

ROA ROE SHRET1, 2*

Ratio of EBIT to book value of total assets Ratio of profit after interest and tax to book value of equity Realised rate of return incorporating capital gains and dividend payments

AGE BLOCK DIVR1, 2 EQED GEAR1, 2 LogMCAP1, 2 SEGMT SIZE

Number of years listed on the ASX The percentage of common stocks held by the top 20 shareholders Ratio of dividend payments to profit after interest and tax Percentage of equity including options held by executive directors Ratio of short-term and long-term debt to book value of equity Natural logarithms of market value of common stocks (in $million) Number of industrial and geographical segments Number of directors on the board

*SHRET, DIVR, GEAR and LogMCAP are coded 1 for 2000-2003, and 2 for 2003-2006.

3.2.

β

Data Analysis

Ordinary least squares (OLS) and logit regressions are constructed for the research variables. In the models to test the influence of board leadership on performance, firm performance serves as the dependent variable; the independent variables consist of leadership structure, firm age, blockholder and managerial shareholdings, dividend payout, leverage, firm size, diversification and board size. An algebraic statement of the models is as follows: Yi = α + β1 ( Leadership) i + β 2 ( AGE) i + β 3 ( BLOCK) i + β 4 ( DIVR2) i + β 5 ( EQED) i + β 6 (GEAR2) i + β 7 ( LogMCAP2) i + β 8 ( SEGMT) i + β 9 ( SIZE) i + µ i th

Where, for the i company Y = ROA, ROE or SHRET2 α = Constant of the equation β = Coefficient of the variable Leadership = CMAFF, CMEXE or CMIND = Error term µ In the regressions to investigate the explanatory factors for leadership structure, the independent variables include firm age, blockholder and managerial shareholdings, dividend payout, leverage, firm size, diversification, prior performance and board size.

=

Coefficient

of

the

variable

µ

= Error term In addition, sensitivity tests on the above regressions without firm size control are performed to assess the robustness of findings. 4. Results

Table 3 gives a description of firm characteristics for the sample in 200329. Among the 243 chairs of boards of directors, 82 (33.74%) are affiliated directors, and 47 (19.34%) are executive directors; 114 (46.91%) are independent directors. Casual observation of the Table reveals that the sample contains a wide range of firms. The number of years the company has been listed on the stock exchange ranges from a low of 3 to a high of 132, with an average close to 17. The percentage of equity held by blockholders or executive directors varies between 0% and 99.86%, with a mean of 65.10% or 11.84% respectively. The number of business segments ranges from 1 to 11, and number of directors on the board ranges from 3 to 15, with an average of just over 4 and 6, respectively.

Yi = α + β1 ( AGE ) i + β 2 ( BLOCK ) i + β 3 ( DIVR1) i + β 4 ( EQED ) i + β 5 (GEAR1) i + β 6 ( LogMCAP1) i + β 7 ( SEGMT ) i + β 8 ( SHRET 1) i + β 9 ( SIZE ) i + µ i th

Where, for the i company Y = CMAFF, CMEXE or CMIND α = Constant of the equation

29

The descriptive statistics of other research variables are available from the Authors.

65

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 4.1. Regressions: Board Leadership and Firm Performance

The contribution of affiliated chairman and other variables to firm performance is reported in Table 4; according to the table, there is no statistically significant relationship between the existence of affiliated chairman and subsequent ROA, ROE and shareholder return. The regression results in relation to independent chairman are provided in Table 6, which indicates that there is no significant relationship between executive chairman and subsequent performance. Regarding the control variables used in the analysis, some consistent patterns emerge from the above tables; it is found that higher blockholder ownership or lower managerial shareholdings enhances performance as measured by shareholder return. For the effect of blockholder ownership on performance, it is presumed in Coles et al (2001) that blockholders have the capacity to monitor their investments and, by virtue of the magnitude of their investments, can affect managerial behaviour; the threat that blockholders will sell large blocks of shares if the firm fails to provide an acceptable return, or is not responsive to governance concerns that investors view as critical, is a significant issue for managers. There is empirical evidence that institutional investors and other blockholders do impact managerial behaviour and therefore firm performance (e.g., Barclay and Holderness, 1991; Van Nuys, 1993; Brickley, Lease and Smith, 1994; Shome and Singh, 1995; Bethel, Liebeskind and Opler, 1998; Allen and Phillips, 2000). Although the impact of executive ownership on firm performance has been frequently tested, the resulting evidence is mixed (Sundaramurthy, Rhoades and Rechner, 2005). Jensen and Meckling (1976) proposed that increasing managerial ownership could mitigate agency conflicts; the studies supporting their view include Morck et al (1988), Kim et al (1988) and Hudson et al (1992). Tsetsekos and DeFusco (1990) and Sundaramurthy, Rhoades and Rechner (2005) failed to locate any relationship between managerial shareholdings and performance; there are a number of papers, for example, McConnell and Servaes (1990) and Brailsford, Oliver and Pua (2002), identifying a non-linear relationship. It is not surprising to find that dividend payments of sample firms reflect the accounting measures of ROA and ROE, which indicate that, in Australia, dividend payout is based on the historic performance. However, the results show that ROE is negatively related to leverage over the 2003-2006 financial years. According to Modigliani and Miller (1958), capital structure is irrelevant in determining firm value; the firm’s value is determined by its real assets, not by the securities it issues. Jensen and Meckling (1976), however, argued that leverage could affect managers’ choice of operating activities and that these

66

activities could in turn affect performance. As concluded by some authors, the research that attempts to solve the leverage-performance puzzle continues to report contradictory findings (Barton and Gordon, 1987; Harris and Raviv, 1991; Ghosh, 1992; Robinson and Mcdougall, 2001; O’Brien, 2003). The findings of this study coincide with Alaganar (2004) in which the author documented an inverse relationship between leverage and ROE for the top ASX 100 companies from 1994 to 2003; he reported that this relationship was becoming more dramatic through time. One possible explanation is that newly acquired debt may be deployed on projects that have a negative impact on profitability; the earnings generated by investments funded by new debt are not adequate to offset the additional interest expense. This may have been fuelled by the prevailing low interest rate environment where firms were inclined to undertake such projects (Alaganar, 2004). There may be another possibility - more profitable companies may tend to reduce gearing; we leave this issue for future investigation. 4.2. Regressions: Determinants of Board Leadership

Table 7 provides regression estimates in relation to the explanatory factors for board leadership. It is reported that companies with higher blockholder ownership or with lower managerial shareholdings have a higher chance that the chairman is an affiliated director; companies with higher managerial shareholdings have a higher chance that the chairman is a current executive. However, no significant association is located between the presence of independent chairman and other variables tested in the regression.

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 3. Descriptive Statistics

Sample Period: Included Observations: Variable AGE BLOCK EQED SEGMT SIZE

2003 243

Mean 16.90 65.10% 11.84% 4.46 6.33

Median 11.00 67.09% 2.21% 4.00 6.00

Maximum 132.00 99.86% 80.99% 11.00 15.00

Minimum 3.00 13.60% 0 1.00 3.00

Std. Dev 17.81 0.18 0.18 2.23 2.05

Skewness 2.90 -0.42 1.70 0.84 1.02

Kurtosis 15.39 2.74 4.89 3.19 4.53

Table 4. OLS Regressions: Affiliated Chairman and Firm Performance Sample Period: 2003-2006 Included Observations: 243 Coefficient t-Statistic Intercept CMAFF AGE BLOCK DIVR2

ROA

ROE

SHERT2

-0.371

-0.039

-0.089

-1.963

-0.076

-0.269

0.071

0.224

0.053

0.887

1.025

0.377

0.0008

-0.003

0.002

0.381

-0.491

0.470

-0.030

-0.909

1.050

-0.140

-1.581

2.824** -0.247

0.199

0.499

2.452*

2.261*

-1.732

-0.313

0.154

-0.941

-1.389

0.252

-2.380*

-0.017

-0.694

0.004

-0.950

-14.205**

0.117

LogMCAP2

0.056

0.133

0.050

1.841

1.609

0.946

SEGMT

-0.002

0.098

-0.029

-0.125

1.839

-0.853

-0.005

-0.080

-0.041

-0.222

-1.220

-0.961

R2

0.096

0.491

0.073

Std Error (Regression)

0.562

1.528

0.988

F-Statistic

2.748

25.006

2.050

Probability (F-Statistic)

0.005

0

0.035

Durbin-Watson

2.048

2.033

2.021

EQED GEAR2

SIZE



67

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 5. OLS Regressions: Executive Chairman and Firm Performance Sample Period: 2003-2006 Included Observations: 243 Coefficient t-Statistic Intercept CMEXE AGE BLOCK DIVR2 EQED GEAR2 LogMCAP2 SEGMT SIZE



ROA -0.346 -1.810 -0.070 -0.694 0.0009 0.409 -0.009 -0.042 0.193 2.364* -0.301 -1.287 -0.018 -0.975 0.054 1.772 -0.002 -0.078 -0.004 -0.165

ROE -0.014 -0.028 -0.028 -0.102 -0.003 -0.476 -0.830 -1.454 0.498 2.237* 0.037 0.058 -0.700 -14.289** 0.126 1.529 0.099 1.845 -0.071 -1.086

SHERT2 -0.050 -0.148 -0.127 -0.717 0.002 0.494 1.060 2.880** -0.258 -1.799 -0.873 -2.128* 0.005 0.156 0.049 0.916 -0.028 -0.809 -0.042 -0.985

0.095 0.562 2.710 0.005 2.044

0.489 1.531 24.779 0 2.026

0.075 0.987 2.095 0.031 2.018


Table 6. OLS Regressions: Independent Chairman and Firm Performance Sample Period: 2003-2006 Included Observations: 243 Coefficient t-Statistic Intercept CMIND AGE BLOCK DIVR2 EQED GEAR2 LogMCAP2 SEGMT SIZE



68

ROA

ROE

SHERT2

-0.351 -1.801 -0.022 -0.302 0.0008 0.382 -0.010 -0.050 0.201 2.469* -0.361 -1.639 -0.019 -1.055 0.054 1.792 -0.002 -0.132 -0.003 -0.113

0.088 0.167 -0.172 -0.860 -0.003 -0.504 -0.879 -1.533 0.515 2.324* -0.016 -0.027 -0.700 -14.398** 0.131 1.592 0.096 1.801 -0.074 -1.132

-0.100 -0.293 0.023 0.179 0.002 0.480 1.076 2.905** -0.249 -1.738 -0.970 -2.511* 0.002 0.068 0.048 0.902 -0.029 -0.841 -0.038 -0.905

0.093 0.563 2.662 0.006 2.040

0.491 1.529 24.938 0 2.038

0.073 0.988 2.037 0.036 2.011



Sample Period: Included Observations:

Table 7. Logit Regressions: Determinants of Board Leadership 2000-2003 243

Coefficient t-Statistic Intercept AGE BLOCK DIVR1 EQED GEAR1

LogMCAP1 SEGMT SHERT1

CMAFF

CMEXE

CMIND

-2.192

-0.380

0.844

-2.810**

-0.401

1.199

0.001

0.003

-0.003

0.174

0.254

-0.351

1.739

-0.789

-1.130

2.079*

-0.737

-1.487

-0.069

-0.628

0.293

-0.216

-1.227

0.958

-3.446

4.545

-0.784

-3.261**

4.672**

-0.982

-0.143

0.040

0.135

-1.245

0.262

1.045

-0.079

-0.016

0.076

-0.577

-0.088

0.592

-0.004

0.097

-0.052

-0.053

0.965

-0.694

0.073

0.005

-0.140

0.741

0.048

-0.906

0.190

-0.230

-0.068

1.953

-1.688

-0.758

0.080

0.155

0.029

Std Error (Dependent Variable)

0.474

0.396

0.500

LR-Statistic

24.931

36.998

9.626

Probability (LR-Statistic)

0.003

0.00003

0.382

SIZE

McFadden

R2



5. Conclusions

The results do not support the three hypotheses which have been developed from agency theory, stewardship theory, and resource-based and resource-dependence models. Based on the analysis, it could be concluded that, for Australian public corporations, there does not appear to be a strong relationship between board leadership structure and performance. Regarding the determinants of leadership structure, it is found that firms with higher blockholder ownership or lower managerial shareholdings tend to have an affiliated chairman, and firm with higher managerial shareholdings tend to have an executive chairman. Additional tests without firm size control yield findings consistent with those as reported in Tables 4-730. The absence of a leadership structure-financial performance link indicates that there is no one optimal leadership structure; each structure may have associated costs and benefits. Moreover, the above findings suggest that observed leadership structure is more likely an outcome of a rational choice process influenced by other governance characteristics of

individual firms, such as blockholder and managerial ownership. It could be argued that some types of affiliated, executive or independent chairman may be valuable, while others may not; the argument, however, would lead to the conclusion that to push for a certain leadership structure, such as the one endorsed by the ASX Guidelines (2003), may be fruitless, unless the chairman has some particular attributes, which are currently unclear. Therefore, for policy-makers, practitioners and scholars, it is recommended that whether “best international practice” would enhance corporate performance should be empirically tested in the national context. Consequently a concern that may be raised about our analysis is whether the evidence from Australian firms can be generalized to other countries that have adopted similar codes of best governance practice; we expect future studies by others will explore this question.

30

The results of robustness tests without firm size control are available from the Authors.

69

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THE BOARDS FUNCTIONAL EMPHASIS - A CONTINGENCY APPROACH Sven-Olof Collin* Abstract The understanding of the board of a corporation and its behavior is limited, despite the board’s societal importance. We present a contingency approach to the board’s functional emphasis, considering a fourth function in addition to monitoring, decision making, and service or resource provision. The additional function is conflict resolution (or principal identification). The approach contrasts with mainstream research by assuming that the firm is a nexus of investments, avoiding the empirical assumption that the shareholder is the sole principal. We derive propositions that are not restricted to any empirical category of a corporation, and address praxis implications for managing functional disharmony. Keywords: The Board, Functional Emphasis, Conflict Resolution Function, Functional disharmony *School of Business and Engineering, Halmstad University, Box 823, SE-301 18 Halmstad, Sweden Tel: + 46 35 16 78 59, Fax: +46 35 167564 E-mail: [email protected] The project is financed by The Bank of Sweden Tercentenary Foundation. An earlier version was presented at the Academy of Management Conference, Atlanta. Georgia, August 11-16, 2006. The paper has benefited from comments by Elin Smith and Timurs Umans, Kristianstad University. David Harrison at Proper English AB contributed with language editing.

Introduction

The board of the corporation is a very frequently occurring phenomenon, considering all the corporations on the globe. It is a very popular research object as well. Yet, one has to admit that the knowledge about boards is rather rhapsodic and scant. Several reviewers of board research have made similar observations (Daily, Dalton and Cannella Jr, 2003; Dalton, Daily, Ellstrand and Johnson, 1998; Huse, 1998; Pettigrew, 1992; Zald, 1969). This might have been surprising, given the board’s widespread presence and importance in society today. But it is perhaps not that surprising when one considers that one reason for the low level of knowledge about boards is the hardship of getting high quality data of the phenomena in question (Pettigrew, 1992). Access to boards through direct observation or documents is often limited, obliging board researchers to collect data through surveys and official documents, thus reducing the possibility of studying actual board behavior (Forbes and Milliken, 1999). As Pfeffer (1997) has argued concerning the structural perspective of demographics, lack of high quality data cannot be the overriding excuse since the possibility of “black-boxing” the board’s processes and focusing on the structural conditions are available as an alternative research strategy. Or, from a more

pessimistic view on the capacity of science to deal with the complexities of the board: “…the processes themselves are sometimes most effectively described by novelists” (Zald, 1969:110). Another reason for the limited knowledge could be that of bad theory, either due to a theory of low abstraction, i.e., no theory in any serious sense, or a theory of bad conception. The dominant theory of today is agency theory. It is the aim of the present paper to show that agency theory is a credible and adequate theory for board research. The theory, though, has to be revisited with regard to some of its specific conceptions. One is the empirically grounded conception of the corporation as usually being a Fortune 500 corporation, i.e., a huge corporation located in one single country (Lubatkin, Lane, Collin and Very, 2005). The other conception is more ideologically based, that is, the unproblematic interpretation of shareholders as the principals in the theory. Since there is nothing inherent in agency theory that dooms it to empirical, exotic restrictions or to promoting the ideology of shareholder primacy, an ordinary agency theory can be used to explain board behavior. One issue of importance concerning boards is the issue of the functions of the board. In mainstream research the functions are pretty obvious, being stated as monitoring, decision making, and service or resource provision (Johnson, Daily and Ellstrand,

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1996, Pfeffer, 1997). In this paper we add a fourth function of great importance, that of conflict resolution. We claim that the principal of the corporation cannot be assumed ex ante, but has to be identified through the power battle going on among those groups or individuals that would like to be regarded and to have the capacity to act as the legitimate principals. The board is conceptualized as the arena where this struggle is being settled and the principals are defined. Thus, the board has to manage conflict and exercise the function of identifying the proper principal. The four functions of the board are however not always present. Certain boards at certain times will stress one function at the expense of another. As with all organizations, every activity consumes resources and even boards have to economize. Again, similar to all organizations, even boards have structural limitations that hinder them from fully realizing certain functions. Therefore it can hardly be assumed that all four identified functions can be expected to be present at every board in the world, with the same emphasis on each function. Thus, we expect to find differences between boards in their functional emphasis. If there is a variation in functional emphasis, a rather obvious question is whether there could be any systematic order in functional emphasis. Are there certain conditions that make a board more prone to emphasize one function instead of another? This paper will try to convince the reader that there are factors that influence the functional emphasis of the board, and its overriding aim is to present a contingency approach to the board’s functional emphasis. The theoretical contribution of the paper is modest. We offer a set of factors that we try to argue as being influential on a board’s functional emphasis. But our ambition is much further-reaching: It is to open the eyes of corporate governance researchers in general and board researchers in particular, and allow them to sincerely ask the question, Who is the principal of the corporation? It would enable them to deal with all corporations, not only the large, listed corporations, and to consider all parties that have incentives to be part of the board and the struggle for control going on there. The “fourth function”— identifying the principal and regulating the principal’s influence—is the instrument introduced in this paper as the essential eye-opener. With the objective of drawing some conclusions about the board’s functional emphasis, the paper begins by defining the concept of a board, clearly pinpointing that the assumption of one version of agency theory, that shareholders are the principals of the corporation, is too narrow-minded. We continue by systemizing and defining the functions of the board, introducing the concept of conflict resolution, or principal identification. The ground being laid, the paper then tries to fulfill its theoretical aim by deriving a set of factors that influence the functional emphasis of the board. The paper ends with a

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discussion of the resulting set of hypotheses from the contingency approach, and the implications for theory and empirical research. In concluding, we suggest a new concept, that of functional harmony, which could explain part of the empirical difficulty in finding the reasons for board efficiency. Exploring The Agency Theory Views of The Board

The board is an instrument for the shareholders to govern the corporation. This statement seems apparent—even natural today. It is supported by both academic texts and the popular press. Stated as a matter of fact, treated in an unproblematic way, as if it were as obvious as the existence of the sun, a textbook of corporate governance states that “…the shareholders have limited liability and limited involvement in the company’s affairs. That involvement includes, at least in theory, the right to elect directors and the fiduciary obligation of directors and management to protect their interests” (Monks and Minow, 1995:8). The newly formulated and implemented code of corporate governance in Sweden declares the role of the board of directors as follows: “The board, based on what is in the best interest of the company and its shareholders, is to set objectives for the company’s business operations and make sure that the company has an appropriate strategy, organization and operational management for achieving these objectives” (SOU 2004:46, 2004:30f). The board of directors as an obedient instrument in the hands of the shareholders is, however, neither a good description of the legal point of view, nor a valid empirical description of the board. To state that the shareholders are the one and only principals of the corporation is more of an ideological statement than a theoretical statement or empirical fact. This conception disregards the fact that boards exist in organizational forms without shareholders, and that even in corporations with shareholders, the shareholder is not by logic the only principal. The ideological dependency view of the board of directors stands in contrast to the legal view of the board, which emphasizes the independence of the board. Scanning the world of organizational forms, we realize that a board of directors exists in organizations that are recognized as juridical persons, i.e., those organizations that are corporations, including joint stock companies, co-operative firms, and associations. Typically those that are regarded as the major principals of the organization through being termed as owners, such as shareholders in the joint stock company, or members in the co-operative or association, enjoy limited liability for the business of the corporation. The corporation is a juridical subject in its own right, which implies that the firm cannot be reduced to an extension of the owner, as is the case in the single proprietorship or the partnership. But since someone has to govern the firm, there is an institution


equipped with the rights to govern the firm. This institution is the board of directors. In the legal sphere, the board appears to be a mechanism for dealing with the independence of the corporation. The Swedish legislation of joint stock companies supports the view of independence. It states that the board of directors is responsible for the corporation’s organization and the management of the corporation’s businesses (Aktiebolagslag 1975:1385, Ch 8, 3§). It is important to note that the legislation does not state the direction of the responsibility, whether it is accountable to the shareholders, to another group in society, to the state, or to society as a whole. The omission of shareholders is not an exotic peculiarity of Swedish legislation. It can be found in the United States, presumably the most shareholderoriented economic system in the world, where the view of the board is that it monitors for the benefit of the corporation (Blair and Stout, 2001; Johnson, Daily and Ellstrand, 1996; Kostant, 1999). One conclusion that can be made is that the board, being an institution given the right to influence the corporation, and therefore a powerful institution, is an obvious target for political considerations. The implication for research is that ideas of the board are subject to strong ideological pressure, making the selection of a perspective on the board a delicate matter since it can imply a political position (cf. Myrdal, 1990). In the academic literature of the board one can find two major streams, those assuming the independence view, represented by the stewardship view (Davis, Schoorman, and Donaldson, 1997), and those that assume the shareholder dependency view, typically adhering to the less abstract agency theory (Jensen and Meckling, 1976), where the shareholder is made the principal of the firm, without any consideration or theoretical argument (e.g., Baysinger and Hoskisson, 1990). In this view, the board is mainly a monitoring device for the shareholders. In between these two perspectives is the semiindependent view, represented by the more abstract agency theory, adopting the view of the corporation as a nexus of contracts where “…ownership of the firm is an irrelevant concept” (Fama, 1980:290), and where dependency is created by transaction-specific investments (Williamson, 1985). In this view, the board is a mediator between the firm and those that are residual claimants in a broad sense, i.e., those that have made firm-specific investments (Blair and Stout, 2001). We adopt the more abstract view of agency theory, which is that ownership does not define the principal of the corporation, that the board is responsible for the governance of the corporation, and that the board is the mediator between the residual claimants, termed the principals, and the agents. Since we do not make an empirical determination of the principal, such as being the shareholder, we have to define the principal before trying to distinguish the different functions of the board.

The principal, we assume, consists of those participants in the firm that are affected by the success of the firm, i.e., those that make firm-specific investments or have open contracts, implying that part of the claim on the organization or the whole claim is residual. The corporation is, according to agency theory, a nexus of contracts, but first and foremost, it is a nexus of investments, encouraging and protecting investments (Rajan and Zingales, 1998). This definition makes it possible to broaden the conception of the principal from shareholders to the variety of stakeholders (Aguilera, and Jackson, 2003; Blair and Stout, 2001), for example, to identify as principals the workers who make firm-specific investments and members of an association who rely on the association for specific service(s). The agents are those that operate the firm on a daily basis. The agent is working on behalf of the principals in the sense that the success of the firm influences part or all of the principals’ investments and claims. We avoid considering the principal as equal to a stakeholder. A stakeholder is a party that is affected by the firm, or at least, considered to be affected by the firm, and therefore has incentives to influence the firm. A principal of a firm is not only affected by the firm, but makes investments in the operations through having access to the firm’s resources (Rajan and Zingales, 1998) and takes part in the value-creating activities of the firm, ultimately through receiving part of the cash flow or the products or services produced. By this distinction we can separate political influence from economic influence. For example, we identify as a stakeholder the individual who is fighting for a firm’s responsibility to only buy products from firms not using child labor. The stakeholder is making an investment, but not for the realization of the corporate goal and adding to the value of the firm, thus not taking part of the firm’s cash flow or any other value created by the firm, but for the realization of a political goal. Thus, while the principal is a stakeholder of the corporation, a stakeholder does not have to be a principal of the corporation. The promotion of a stakeholder to the category of principal is made through the individual making investments in the firm, taking part in the value-creating process of the firm, and being directly influenced by the outcome of the firm’s operations. To make the conceptual hierarchy very clear, a shareholder belongs to the set of principals that belongs to the set of stakeholders, but a stakeholder is not by definition a principal, and a principal is not by definition a shareholder. Additionally, a small note about delegation originating from the property rights view of the corporation has to be made. The board being viewed as a mediator implies that the board performs functions on behalf of the principals. It does not imply, however, that something is delegated from the principal to the board. To claim that the principal has some property rights that are delegated to the board is an ancient conception of property rights, inherited

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from the old view of the single owner of a property, based on the view of natural rights (Collin, 1995). In the cases we are discussing here, there are no private property rights that can be delegated. This is indeed indicated by the legal view, where the rights of the board cannot be transferred to the owners, be it to them individually or to them in the collective of the shareholder meeting. Thus, to recapitulate, the aim of the paper is explore the functions of the board. If assuming the less abstract and more ideologically penetrated agency theory where the shareholder is taken for granted as the sole principal, the functional emphasis would be on monitoring, and the aim would be fulfilled with ease. The view taken here, however, accords with the more abstract view of the board, where we assume that the board exists in many organizational forms, not only in a joint stock company where the empirical fact is that the shareholder is the dominant principal. On the contrary, we assume that the board is a device for the governance of the corporation, and populated by individuals who are, or who represent, principals of the corporation, who have made investments in the corporation and who depend on the corporation for its own well-being. By taking a more abstract view of the corporation and the board, we are able to perceive a more complex pattern of functions. Thus, we now turn to explicate the functions of the board of the corporation. The Functions of The Board

The board has been assigned different functions by researchers. The functions can be systemized conceptually through an agency theory lens, assuming that a board has a directed responsibility, which is to mediate between the principals of the organization and the operationally active agents. Figure 1 illustrates the conception. -------------------------------Insert Figure 1 about there -------------------------------The conception contains four functions: (1) Monitoring: The board monitors, on behalf of the principal, the agent and the agent’s actions; (2) Decision making: On behalf of the principal, the board makes decisions influencing the direction of the corporation which it is the responsibility of the agent to implement; (3) Resource provision: The board supplies the agent and the organization with resources, such as links to networks, financial expertise; (4) Conflict resolution: The board identifies the legitimate principals and their legitimate goals concerning the corporation through processing the different goals of the different principals. We now turn to the detailed description of the four functions. The literature tends to focus on two functions of the board: monitoring and resource provision (Daily, Dalton and Cannella Jr, 2003; Carpenter and Westphal, 2001; Forbes and Milliken, 1999: Hillman

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and Dalziel, 2003; Johnson, Daily and Ellstrand, 1996). The monitoring function consists of supervising the performance of the firm and the actions of the top management team (Baysinger and Hoskisson, 1990). It includes activities such as creating control systems, auditing, and rewarding, hiring, or firing the chief executive officer (CEO) (Morck, Shleifer and Vishny, 1989). It is mainly a function directed towards the past and as a prerequisite is in a need of an interpretation of the relevant goals of the corporation. The resource provision function consists of the supply of resources that can be created through the members of the board and their network relationships. The resources consist of the individual competence of the directors, the joint competence created through the interplay between the directors, the relationships and information every individual director brings to the board through being nodes of networks, and finally, the status of the individual board member that contributes to the reputation of the corporation (Certo, 2003; O´Donoghue, 2004; Zald, 1969) and legitimizes the corporation (Huse, 1998). The resource provision function is directed towards daily business and strategy considerations, mainly as an input for the CEO to use. The third function is decision making and consists of decisions that deal with the strategy process of the firm (Judge and Zeithaml, 1992). It covers the whole strategic process, from the initiation of strategy formation, through the actual decision about the strategy, to strategy implementation through making decisions about investments and budgets. It is forwardly directed and implies explicit restrictions on the CEO’s freedom of action. As with the monitoring function, an input into this function is the interpretation of the goals of the corporation. The goal formation of the corporation is, however, not a process that has received marked attention in the literature of boards. The fourth function is the one that deals with this important input of the other functions, namely the identification of the relevant principals and the interpretation of their goals. The activities of the function are coalition formations and voting, that is, trying to manage or deal with the conflicts between those parties that are the principals of the firm (Zald, 1969). Since the major activities of the fourth function deal with management of conflicts, the function has been termed conflict resolution, though it could also very well be termed the function of principal identification. This ignorance of the conflict resolution function could be caused by the agency theory’s occupation with the conflict between the principal and the agent, thus neglecting the formation of the principal, thereby disregarding the possibility of diversity of interest within the group of principals. It can very well be the case that in a well-financed private corporation, with one single dominant owner who dominates the board through selecting the directors, the conflict resolution function will probably not be a dominant function.


But in a large, listed corporation, with dispersed ownership structure, with a variety of owners with different preferences (Aguilera and Jackson, 2003; Baysinger, Kosnik and Turk, 1991), the identification of the relevant goals of the corporation is probably an issue on the agenda of the board. And in small corporations, organized as democratic associations where members populate the board through democratic elections, i.e., one member–one vote, coalitions are formed in order to realize the separate interests of different member categories. The function of conflict resolution is close to the balancing view of the board, stating that the board could fulfill the function of being an agent balancing the interests of various groups (Daily, Dalton and Cannella, 2003; Kostant, 1999). The idea of balancing is, however, the return of the Berle and Means hope regarding the large corporations: “It is conceivable … that the ‘control’ of the great corporations should develop into a purely neutral technocracy, balancing a variety of claims by various groups in the community …” (Berle and Means, 1947:356). While being close to the conflict resolution function, it differs in the important contrast of conflict against balance. There is neither a theoretical reason, nor any empirical indication that the board will turn into a neutral technocracy. The idea of conflict resolution is closer to Cyert and March’s (1965) conception of an organization consisting of participants that form coalitions and through the goal process bargaining about the organization’s relevant goals. This view is echoed in Mintzberg’s (1983) arena view of the board, i.e., the board is an arena for fights, struggles, and power manifestations, where different groups and individuals are striving for power to manifest their view of the corporation and its goals as the objectives of the corporation. Thus, through inspecting the three commonly identified functions of the board, the functions of monitoring, decision making, and resource provision, we find that at least the two first functions need an interpretation of the legitimate goals in order to be efficient. Goal identification and the preceding identification of the legitimate principals therefore become a fourth function of the board. This function of identification of the principals is intimately related to the basic conception of the principal put forward earlier. The relevant principals cannot be defined a priori, but will arise from those that have made firmspecific investments or have open contracts. A Contingency Approach to Functional Emphasis

A board can fulfill four functions: monitoring, resource provision, decision making, and conflict resolution. All functions cannot be expected to be performed every second the board is active. In an association where all the members have managed to reach a consensus about the aims, strategy, and means of implementation, the function of conflict resolution

can be put aside for the moment, and the board can spend more time and energy to help the management of the association, i.e., the board will put an emphasis on the resource provision function. Thus, it can be assumed that the functional emphasis of the board may change, implying that a theory should have an approach dealing with the contingencies of board functions. A contingency approach towards the functions of the board implies an identification of those factors that can influence the functional emphasis of the board. With scant empirical studies, relying mainly on attitude data (e.g. Cornforth, 2001; Jonnergård and Kärreman, 2004; Pearce and Zahra, 1991) and theories mainly limited to a few factors—and in the worst cases, having a constrained conception of the principal, as explained previously—we have to rely on the systematic order illustrated in Figure 1, i.e., in a simple sense, a typology. This order brings into focus: (1) The principal, through an analysis of the functional emphasis that can be influenced by the legal organizational form, which ultimately defines the principal; (2) The board, where it is assumed that the composition of the board will influence the functional emphasis; (3) The agent, in which the characteristics of the CEO, especially length of tenure can be expected to influence board functional emphasis; (4) The organization that the agent is managing, especially the influence of strategy and structure on functional emphasis; and (5) The environment, which creates most of the uncertainty facing the organization, and thereby influences the functional emphasis of the board. This contingency view of functional emphasis contrasts with a more normative version of agency theory. For example, Baysinger and Hoskisson (1990) claim: “Decision management is naturally the responsibility of senior management, whereas decision control becomes the responsibility of the board of directors” (p.76). The distribution of functions is in this view governed by nature. With a contingency view of functional emphasis, the researcher’s eye is less concerned with nature than with social forces, such as organizational structure. As we shall restate later, we would expect a board governing a functionally organized firm to engage in decision management. In this paper we try to avoid deriving propositions that are restricted to any empirical category of a corporation. A theory of the board has no legitimate reason to be based on implicit conceptions of the corporation as being one of those belonging to the “Fortune 500” corporations (e.g., Morck, Shleifer and Vishny, 1989; Pearce and Zahra, 1991; Westphal and Zajac, 1995, 1997; and Zajac and Westphal, 1996). A theory limiting itself to these corporations should be properly labeled as theories of BBB, i.e., Big Business Boards. Although being hard to fully implement, we claim that the goal of a corporate board theory should be one that includes all corporate boards. This implies that the theory has to

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include considerations of corporate boards engaged, for instance, in the hospital industry (Pfeffer, 1973), or in the leisure industry — in which there exist riding school associations with 50 horses and 900 members (Collin and Smith, 2007). Empirical restrictions in theoretical reasoning are legitimate, but not if they are unreflected and implicit. Here the abstract level should be the appropriate one, i.e., focusing on the board of the corporation. Thus, the propositions we shall put forward in this paper, if not made specific to any organizational form, such as the joint stock company or the association, are intended to cover all boards of any corporation. The different functions are not influenced by one single logic, which would simplify our derivation and make it less eclectic in appearance. Indeed, to have a set of logics is an indication of a less developed theory, but this is the status of knowledge today. The different logics influencing the functional emphasis and creating relationships with the contingency factors will shortly be introduced, and will be further developed in the analysis of the different contingency factors. Monitoring is considered to be the supervision of the performance of the corporation and of the managers’ actions on behalf of the principal. Principal engagement will de-emphasize monitoring since the principal directs the managers through a certain number of interventions, thereby influencing performance. In contrast, a passive or absent principal will induce the board to focus on monitoring in order to ensure performance. Similarly, a board comprising many directors with focused industry competence will tend to be more operationally engaged in the corporation, which will de-emphasize monitoring. Directors with less industry experience will, on the contrary, focus on monitoring. Monitoring could also be a way to stress the autonomy of the organizational units, where the simple supervision of performance, without any operational initiative from the board, will leave the units with free hands to be entrepreneurial. The decision-making function, as indicated in Figure 1, is the principal influencing the agent’s action through the board, thus representing a reverse relationship to monitoring. In many cases, a greater emphasis on decision making reduces both the capacity for and the interest in monitoring. In the extreme case, a present and active principal does not need monitoring since the principal’s engagement and involvement almost converts the principal into an agent. What can be added with regard to decision making, which is not apparent in the monitoring function, is the existence of routines. If, due to long and stable development of the organization, strong and well-respected routines about the conduct of business have evolved, then it is the routines that make the decisions, not the board, thus deemphasizing decision making. The resource provision function is the board supplying the agent and the organization with various resources. It therefore varies in emphasis according to

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the needs of the organization. A small, poor organization will try to extract more resources from the board than the wealthy organization. But the resource provision could also be an effect of the power distribution in the corporation since a strong CEO can reduce the board’s role to that of a simple advisor, whereas strong principals populate the board according to their power interest, reducing the board’s capacity to offer resources. Thus, in this case, the resource provision function is contrary to the conflict resolution emphasis. The conflict resolution function is the identification of the legitimate principals and their goals. Obviously, with an increasing number of strong principals, the function will be more important. But even the composition of the board by directors with different competencies will influence the function since it has been found that a high variety of functional experience will induce conflicts. Since the function is about identifying the principal, in cases of highly ambiguous principals, the function will be emphasized, in contrast to the case where there is one obvious, strong principal. But even if the conflict resolution function is focused on the relationship between the principal and the board, one cannot ignore the board’s relationship with other stakeholders that have the capacity of a principal, especially the government and the mass media. The board has to deal with these often conflicting demands through actions such as lobbying. Even the organization can influence the conflict resolution function, pushing conflicts in the organization to the level of the board when there are strong tensions among interdependent organizational units. Having set out these basic views on how functional emphasis can be influenced, we now turn to an analysis of the contingency factors and the derivations of propositions. The Principal

The legitimate principal and the principals’ rights and obligations are institutionally determined, and of these the legal organizational form is decisive. The distribution of property rights creates differences in an organization’s incentive structure and power structure. The members of a not-for-profit association with a democratic power structure have different power and incentive to engage in the governance of the association than has the single shareholder in a public corporation with a highly dispersed ownership structure. These differences are reflected at the board, creating rather different functional emphases. Thus, a theory of board behavior needs to consider the distribution of power and incentives in organizations. We will consider three different types of legal organizational forms: the democratic association, the private corporation, and the public corporation. They differ in the sense that the democratic association and the public corporation have dispersed principals, while the private corporation has but a few, easily


detected principals. The difference between the democratic association and the public corporation is that the members of the association all have one vote, they do not invest in the corporation, and their interest in the association is as a consumer of the association’s services. The public corporation has shareholders that are presumably only interested in the profit, and whose voting power is distributed according to the shareholders’ investments. We start by considering the democratic not-forprofit association, where every member has one vote at the general meeting; they make no capital investments, but are consumers of the association’s services. The members of the association have presumably divergent interests in the services provided, and will therefore have incentives to elect and to be represented by a member that shares the same service interest. Since it is a democratic organization, such interest has the opportunity to be represented at the board. Thus, the composition of the board will reflect the different groupings among the members of the association (Pfeffer, 1973, cf. Forbes and Milliken, 1999). This will make the board first and foremost an arena where the dominant groups are identified and the conflicts among the members and their different interests are mediated and managed. The major functional emphasis of an association’s board will therefore be conflict resolution. The members of the board have strong interest in the products and services of the association, since the members are the consumers of these products. This feature of an association will make the board members prone to engage in the decision making of the organization, even to try to influence the implementation of decisions. A similar attitude has been found in Australian not-for-profit organizations (Steane and Christie, 2001). Thus, a second emphasis will be on decision making. The members of the board cannot be assumed to be capable of providing resources for the firm and the top management since they are elected by virtue of being representatives of the members and not because of their competence; thus there will be low emphasis on resource provision. Finally, the monitoring activities will be conducted through the members’ consumption of the products and services, not through the board, thereby making the board less prone to engage in monitoring. This leads to our first proposition regarding the board of an association: Proposition 1: A democratic, not-for-profit association board tends to de-emphasize monitoring, emphasize decision making, de-emphasize resource provision, and emphasize conflict resolution. The private corporation is owned and governed by one single owner or only a few owners. Although the board could be a mediator of the will of the owners, it could very well be the case that the owner(s) influence(s) the corporation in a direct way, through direct interaction with the CEO or the

organization. Thereby, the board will be circumvented in its capacity to make decisions and thus relieved of its decision-making function. An owner, strong in engagement and competence of the corporation, will not be inclined to use the board as a monitoring device. Instead, a strong owner, with a large capacity to govern the corporation, will use the board only as a device for systematic and frequent advice, i.e., the board will be the owners’ consigliere. Since the private corporation has discernable principals, the conflict resolution function is dormant. Thus, the board in a private corporation can be reduced to being but a supportive group of people. If, however, the board would orient itself towards more engagement in the monitoring and decision-making functions, it would probably experience turnover, since the owner would reduce the board’s ambitions. Thus, we make the following proposition regarding the board of the private corporation: Proposition 2: A private corporation board tends to de-emphasize monitoring, de-emphasize decision making, emphasize resource provision, and deemphasize conflict resolution. The public corporation, with an abundance of shareholders, i.e., with a dispersed ownership structure, where the shareholders enjoy limited liability and are hoping for capital rent to be paid as pension payments, will have a board that delivers profit to the shareholders. The board will therefore be occupied with monitoring performance, assuring the distribution of value to the shareholders. These corporations are heavily dependent upon the market for corporate directors since no principal is strong enough to collect votes. Not much, however, is known about this market (cf. Zajac and Westphal, 1996). It consists presumably of former CEOs who have retired from active duty, but with an understanding of a CEO’s need of autonomy, thus avoiding engagement in operational business decision making. They bring, however, their former network to the board and provide assistance through networking resource capabilities, i.e., resource provision. Finally, the persons in the market for director positions have but their competence to offer, and their market value is dependent on their reputation. They sell a certain way of acting and an attitude towards directorship and enterprise. To act in a stable and coherent way will create a credible commitment, and will reduce uncertainty about behavior. This will make the director a trustworthy mediator between different stakeholders. The board can therefore credibly engage in mediating conflicts. It can also be assumed that the level of conflict will be high in public corporations due to its abundance of shareholders and its public character, which induce stronger stakeholder engagement and increase the corporation’s political visibility (Watts and Zimmerman, 1986). Thus, we make the following proposition:

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Proposition 3: A public corporation’s board tends to emphasize monitoring, de-emphasize decision making, emphasize resource provision, and emphasize conflict resolution. The Board

Turning attention to the board, we realize that the composition of the board will influence the functional emphasis because of the individual directors and the group process they create. Board composition and its influence on different corporate factors, such as strategy (Goodstein and Boeker, 1991), resource acquisition (Hillman, Canella Jr and Paetzold, 2000; Ingley and van der Walt, 2003), and performance (Hillman and Dalziel, 2003; Muth and Donaldson, 1998), has been a popular research focus. One distinction among directors that has been made is between insiders, who are those employed by the corporation, and outsiders. The aim is to find those directors who are independent of the corporation and its top managers, and thus able to act on behalf of the principal. Westphal and Zajac (1995; 1997) and Zajac and Westphal (1996), using almost similar data sets— the Forbes and Fortune 500 list of the largest US corporations from years 1982, 1986, and 1987—have found that dependence can exist even if there is no employment contract between the director and the firm. This is indeed obvious for European researchers on board composition, mainly because Europe has many networks of corporate owners, sometimes even organized in socially, though not legally recognized constellations of corporations termed business groups (Collin, 1998). They use interlocking directors to a large extent, creating a second class of dependent directors, those dependent on the dominant owner. Thus, we assert that it can be useful in board research to distinguish between directors dependent on the corporation and the top management because of employment contract, directors who have strong liaisons with the dominant constellation of principals, and directors who are solely dependent on the market for corporate directors. Applying these distinctions, we find three typical boards: those dominated by insiders, those dominated by principal directors, and those dominated by independent directors. Insider-dominated boards have been found to turn the board into an arena for decision making (Judge and Zeithaml, 1992) and conflict resolution (Boeker and Goodstein, 1993), and to promote entrepreneurial activities (Zahra, Neubaum and Huse, 2000). When dominated by insiders or directors dependent on the top management team (TMT), the board is nothing but a place for the TMT and its allies to meet. There they formulate the strategy of the firm and decide upon the implementation of the strategy (Muth and Donaldson, 1998). Since they experience pressure from many stakeholders, they tend to use the other seats for conflict resolution, thus co-opting the main stakeholders (Hung, 1998). Since they are the managers who should be evaluated, they tend to be

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easy on the monitoring task (Baysinger and Hoskisson, 1990; Carpenter and Westphal, 2001). As for resource provision, they can use the competences of the firm, or acquire them through the use of the corporate funds and thus de-emphasize this function of the board. The proposition relating to insiderdominated boards would therefore be: Proposition 4: An insider-dominated board tends to de-emphasize monitoring, emphasize decision making, de-emphasize resource provision, and emphasize conflict resolution. Principal-dominated boards can be expected to behave as an extension of the principal. A principal is engaged in implementing the strategy, thus emphasizing decision making, especially about organizational structure. The principal will first and foremost use the board as an arena for collecting information and gaining resources. The corporation can be used for these matters, but sometimes legislation makes it harder to use the corporate resources and nevertheless, the board is closer to the principal. Monitoring will be performed through personal means, of which intense interaction with the CEO is the most important. Thus, the dominating principal does not need a board to conduct monitoring activities, implying that the monitoring function of the board is de-emphasized. Due to the strong hierarchical character of this type of board, the principal being clear and obvious and any power struggle being impossible to create, conflict resolution will not be regarded as important. The proposition relating to principal-dominated boards would thus be:

Proposition 5: A principal-dominated board tends to de-emphasize monitoring, emphasize decision making, emphasize resource provision and deemphasize conflict resolution. A board dominated by independent directors exists presumably in corporations with a highly dispersed ownership structure. The literature of boards tends to hypothesize that these boards are the most effective boards (Dalton, Daily, Ellstrand and Johnson, 1998), but empirical research tends to reject the hypothesis (Dulewicz and Herbert, 2004: Johnson, Daily and Ellstrand, 1996; Muth and Donaldson, 1998). Independence of a director can be defined in various ways. It can be defined as a director having no present or previous employment contract with the firm, having no business relationship (including ownership) with the firm, and having no social ties with the insiders of the firm (e.g., Anderson & Reeb, 2004; Luan and Tang, 2007; McCabe and Nowak, 2008). The conception used here is that independent directors lack any social or contractual relationship with the firm or its owners (Clifford and Evans, 1997), and they compete on the market for corporate directors. Since they are independent, they are probably not from the same industry as the


corporation, thus lacking industry competence, which make them less prone to engage in operational decisions. The low emphasis on decision making is amplified by the information asymmetry between the independent director and the management of the firm (Nowak and McCabe, 2003). The overall knowledge about business makes the independent director more prone to emphasize monitoring, especially financial control (Baysinger and Hoskisson, 1990). Their independence makes it highly probable that the directors are from a diverse background and diverse experience, which makes it possible for them to bring a wide set of network connections to the board (Carpenter and Westphal, 2001; Dalton, Daily, Ellstrand and Johnson, 1998), thus emphasizing the resource provision function. On the other hand, not representing any important stakeholder will reduce their interest and capacity to engage in conflict resolution. The proposition of independent-directordominated boards would thus be: Proposition 6: An independent-director-dominated board tends to emphasize monitoring, de-emphasize decision making, emphasize resource provision, and de-emphasize conflict resolution. A characteristic of the board that will influence its capacity to fulfill the different functions is the size of the board. With increasing size of the board, the probability of competencies that can be used as a resource for the firm will increase (Daily, McDougall, Covin and Dalton, 2002), as will the stakeholder representation (Pfeffer, 1973), thus increasing the emphasis on resource provision and conflict resolution. On the other hand, with increasing size, the information flow will be harder to coordinate and the board’s capacity to reach conclusions of monitoring (Carpenter and Westphal, 2001) or decisions (Pfeffer, 1973) will decrease. Thus, the following proposition is suggested: Proposition 7: With increase in board size, the board tends to de-emphasize monitoring, de-emphasize decision making, emphasize resource provision, and emphasize conflict resolution. The Agent

The CEO or the top manager of the organization is an important counterpart and fellow player with the board. The identity and characteristics of the top manger will therefore influence the functions of the board. One important CEO characteristic that will influence his or her way of acting and behavior is the CEO’s tenure. Shen (2003) argues that a board will put more emphasis on control and less emphasis on leadership development as tenure of the CEO increases. Translated to our categories, it implies that with increasing tenure of the CEO, the board will put more emphasis on monitoring. With increasing experience, the board does not have to back up the

inexperienced CEO with decision making, thus deemphasizing the decision making function. At the beginning there could be a need to protect the CEO from all facets of the business, which will induce the board to assume conflict resolution functions. With growing tenure, this function can be left to the CEO. Finally, with increasing tenure of the CEO, the board will devolve more into a device for information and advice to the CEO. Thus, the following proposition is suggested: Proposition 8: With increase in CEO tenure, the board tends to emphasize monitoring, de-emphasize decision making, emphasize resource provision, and de-emphasize conflict resolution. Organizational Strategy

The strategy of an organization will influence the demands put on the board and its functional duties. The strategy of a firm is not solely a subject for rational decision making, since strategies can emerge by action (Mintzberg and Waters, 1985). Therefore the strategy of the firm can govern the board, though especially normative authors claim that strategy initiation and decision is the hallmark of the board’s activities (Fama and Jensen, 1983). In this paper we make the less controversial statement that the board has the possibility of influencing the strategy of the firm. To what extent it will do so depends on many factors, some of which are discussed in this paper. Strategy can be conceptualized in many different ways. We choose the mainstream corporate strategy conception of diversification, as stated by Rumelt (1974) and others. It distinguish between (a) simple business, where the firm is engaged in one business, oriented towards the same market and using the same resources; (b) related business, where the number of businesses are high, but the businesses are related through important resources, such as market knowledge or technology; and (c) unrelated business, where the number of businesses are high, and they have very few relationships between each other—in the most extreme version, the businesses only have the owner, i.e., the corporation, in common. In simple business firms it is hard to find reasons for the board to engage in any function with any emphasis. The simple nature of the business simplifies the monitoring activities; in fact, it could be argued that the principal could prefer a single business strategy because it does not consume as much of the costs connected with monitoring, i.e., the strategy has low agency costs. Decision making will probably be directed towards market dominance and volume of production, eventually with a low cost strategy that could increase the level of conflict with the employees. Resource provision is probably of no concern due to the low complexity of the business. Thus we expect low levels on every functional orientation. It should be noted here, however, that very often the simple business firms tend to be small

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firms with a strong and identifiable principal, thus resembling the functional emphasis as derived in the factors of firm size and principal director dominated board. But the issue here is not to create propositions for an empirical firm, but for a simple business strategy firm ceteris paribus, i.e., without any consideration of firm size or principal identity. Thus, we propose: Proposition 9: A board governing a firm with simple business strategy tends to de-emphasize monitoring, de-emphasize decision making, de-emphasize resource provision, and de-emphasize conflict resolution The related strategy, on the other hand, creates tensions within the firm, due to all the dependencies between the different units. Therefore, there will be a high level of conflict within the organization, which the board has to manage. In order to deal with the interdependencies among the units, the operational decision making and monitoring will be given higher priority than with a simple strategy. Perhaps this is especially emphasized in the monitoring function due to the hardship of evaluating organizational entities with many interdependencies. The resource provision will be emphasized since the complexity is larger than in the simple business, but not to the same extent as in the unrelated business, that makes every possible resource contribution by the directors subject to simple coincidence. In between is the related strategy where the focus on a few resources that create competitive advantage will make it possible for directors to be used as advisors. Thus, we make the following proposition:

Proposition 10: A board governing a firm with related business strategy tends to slightly emphasize monitoring and decision making, and strongly emphasize resource provision and conflict resolution. The unrelated strategy turns the board into a portfolio manager. The board has a strong emphasis on evaluating the business units and making decisions about the optimal composition of units. Thus, there is an emphasis on monitoring and even on decision making, but in this case, not intervening in the units, only in the set of units. Due to the diverse set of businesses, the board cannot bring any competence to the firm, except how to evaluate units and how to compose the portfolio. Resource provision will therefore be low. Finally, unrelated businesses have the intention of reducing the variance of cash flows, but another effect of the diversification is that the stakeholder interest will also become reduced, diluting their influence because of the highly diverse set of industries the corporation is engaged in (Judge and Zeithaml, 1992). Should the level of conflict increase and become troublesome, the corporation would have always the alternative to change the composition of the portfolio, i.e., to sell off the unit

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that induced the conflicts. In other cases, increasing the number of units has been connected with an increase in conflict resolution emphasis. This, as argued, is not the case in the unrelated strategy, because of the low specificity of each unit. The conflict resolution function will therefore be reduced. Thus, we offer the following proposition: Proposition 11: A board governing a firm with unrelated business strategy tends to highly emphasize monitoring and decision making, and de-emphasize resource provision and conflict resolution. Another facet of corporate strategy is the age of the firm. Corporations have life-phases in which different demands are put on the organizational parts (Zald, 1969). There is a huge difference in managing a newly created business, directed towards a market of uncertain demands, compared to the business of a 600-year-old corporation, where strong routines have been developed how to deal with different situations and disturbances. Routines, knowledge and competence are developed during the lifetime of the corporation. At the beginning of the firm’s life they have to be built, which puts a demand on the board to contribute with resources and experience transformed to decisions (Goodstein and Boeker, 1991). As time passes, the board can withdraw from active duty and watch the development of the firm, thus emphasize the monitoring function (Lynall, Golden, and Hillman, 2003) and de-emphasizing the decisionmaking function (Judge and Zeithaml, 1992). With increasingly stable routines, the corporation creates a stable impression among stakeholders, especially the principals, who realize the high costs involved in changing these routines. Thus, we expect that the conflict resolution function will be de-emphasized when the corporation is aging. Consequently, the proposition of the aging organization’s board would be: Proposition 12: An aging organization’s board tends to emphasize monitoring, de-emphasize decision making, de-emphasize resource provision, and deemphasize conflict resolution. Last, but not the least is the size of the corporation, partly a factor determined by market conditions and partly determined in the strategy process. With growing size, the corporation increases its level of division of labor, which makes the board less of an operating agent within the firm, and turns it into an institutionalized arena (Judge and Zeithaml, 1992). It has been found that the board tends to be more influential in small firms, more active and less constrained by the organizational structure (Daily, McDougall, Covin and Dalton, 2002). Thus, the decision making capacity will be high in a small firm, compared to the large firm. On the other hand, being engaged in the operations makes the monitoring activities of less concern in the small firm. A small


firm, with low levels of division of labor and presumably a weaker cash flow, will tend to use the directors on the board as a cheap method of gaining advice, inspiration, and other resources, thus emphasizing the resource provision function. Finally, being small implies a small number of stakeholders and discernable principals, thus de-emphasizing conflict resolution. We can thus put forward the proposition of how the firm’s size influences functional emphasis: Proposition 13: With growing size of the firm, the organization’s board tends to emphasize monitoring, de-emphasize decision making, de-emphasize resource provision, and emphasize conflict resolution. Organizational Structure

The organizational structure influences the functions of the board in two concerted ways. The structure makes it possible for the board to perform the functions, and the structure put demands on the board. Thus, we claim that the board is part of the organizational division of labor (cf. Campbell, and Kracaw, 1985), and that the organizational structure will influence the functional emphasis of the board. The demands on the board originate from the organizational structure’s capacity to deal with different operations. It has been claimed (Chandler, 1984; Williamson, 1975) that the functional form (Fform) of organization has a tendency to force decisions up the ladder, putting a strong load of tactical decision making on the TMT. This tendency will therefore continue to the board, forcing strategic issues on the board, thus emphasizing the decisionmaking capacity of the board, at the expense of its monitoring capacity. The strong focus on decision making will give directors incentives to engage in resource acquisition, in order to improve the operations of the firm, in which the board is heavily engaged, thus emphasizing the function of resource provision. This inward-looking tendency of the Fform, being occupied with operations within the firm will, on the other hand, make the board less prone to deal with stakeholder considerations, thus reducing its focus on conflict resolution. We therefore propose the following: Proposition 14: In an F-form organized firm, the board will tend to de-emphasize monitoring, emphasize decision making, emphasize resource provision, and de-emphasize conflict resolution. The multidivisional form (M-form), in contrast, has a strong capacity to encapsulate decisions within the different divisions, and to focus strategic issues on the level of the TMT. The board will then be left with the rather simple financial control mode of monitoring. It can offer but scant environmental scanning, especially when the divisions differ highly due to diversification, thus reducing the importance of resource provision.

On the other hand, containing many divisions within the corporation, a problem of communication with the principals could evolve, due to the complexity created by the organizational structure. The communication activity could therefore put a slight emphasis on conflict resolution. Thus, the following proposition is suggested: Proposition 15: In an M-form organized firm, the board will tend to emphasize monitoring, deemphasize decision making, de-emphasize resource provision, and emphasize conflict resolution. One characteristic of an organizational structure that can be expected to influence the functional emphasis of the board is structural complexity, i.e., the quantity and quality of interrelationships among different structural entities. An organization with increasing numbers of interrelationships with qualitative characteristics that are hard to observe in a simple, abstract fashion will be harder to manage. The causal relationships are difficult to identify and ambiguous, which makes it hard to intervene since the outcome will be unpredictable. Due to causal ambiguity in highly complex organizations, management has to be highly decentralized. This characteristic therefore withdraws the board’s possibility of conducting decision making (Zald, 1969), leaving the board with the function of monitoring (Carpenter and Westphal, 2001), presumably entirely focused on rather simple output controls, such as financial control. In this manner, it resembles the M-form board functions. There are, however, huge and important differences between complex organizations and Mform organized firms. It should be noticed that in the M-form organized firm, the delegation is made because of the need to reduce the tactical decision making at the TMT-level, but the delegation in the complex organization is a prerequisite for the functioning of the entire organization. The complex organization needs to acquire information and to attain competencies in an unpredictable way. The board can assist the organization through connecting the organization with the directors’ networks. Thus, a complex organization’s board will perform the function of resource provision (Carpenter and Westphal, 2001). Finally, a complex organization will not only have to communicate the complexity to the principals, but have probably complex relationships in terms of dependencies with stakeholders in the environment. Thus, the management of stakeholder relationships will be an important issue for the board. Consequently, we advance the proposition for the complex organization’s board: Proposition 16: A complex organization’s board tends to emphasize monitoring, de-emphasize decision making, emphasize resource provision, and emphasize conflict resolution.

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Environmental Uncertainty

Environmental uncertainty, such as technology change, market risk, and political risk, face a corporation to different degrees, and will influence the board and its emphasis on different functions. In general, an increase in the pace of change will put pressure on the organization to be prepared to act and react very fast. A board, which typically has infrequent meetings (compared to the employees, who meet regularly in the coffee-rooms or elsewhere in the organization) will not have the opportunity to react fast. Lack of speed will reduce the board’s capacity to engage fully in decision making. Concerning the monitoring function, the board is in a conflictual situation. On one hand, not being engaged in decision making makes the board prone to secure the corporation through monitoring. On the other hand, in an environment characterized by high speed of change, the managers have to be open to fast new actions, thus stressing the entrepreneurial capacity. But too much emphasis on monitoring will have the risk of alienating the CEOs (Randøy and Jenssen, 2004), thereby reducing their capacity and interest in entrepreneurial action. The formula appears to have no solution. But if adding the notion that a highly dynamic environment present opportunities of monopoly rents, i.e., no sharp, on-the-edge competition, the board cannot rest with the simple monitoring of competitive capacity, but has to engage in more advanced monitoring, fully realizing that it will go with the risk of reducing entrepreneurial spirit. Thus, there is an emphasis on monitoring and a deemphasis on decision making. A firm facing high environmental change is, however, in need of diverse information, even information flow that cannot be predicted beforehand. The firm will profit from a board’s capacity to offer channels to a diverse set of resources contained in the environment (Carpenter and Westphal, 2001). Thus, the directors will perform the function of resource provision. Finally, if the environment is in flux, a stable set of stakeholders will be hard to identify, which will emphasize the function of conflict resolution, since part of the function is the labor of identifying the legitimate principal. Thus, the following proposition is suggested: Proposition 17: With environmental uncertainty increasing, the board tends to emphasize monitoring, de-emphasize decision making, emphasize resource provision, and emphasize conflict resolution. The general tendency cannot be assumed to be applicable to every aspect of environmental uncertainty. We have to qualify our general prediction by focusing on one exemption, the political risk. Political risk consists of changes in the institutional and legal set-up of the firm. According to positive accounting theory (Watts and Zimmerman, 1986) certain firms can attract the attention of politicians,

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such as large firms or firms that are of special national interest. In order to avoid the attention, and thus induce politicians to create changes in laws or regulations, politically sensitive firms will have boards that do not settle by monitoring, but engage in decision making concerning those aspects of the firm that can draw attention to the firm. Indirectly it has been showed that in regulated industries, where the political risk can be assumed to be high, boards tend to be composed of insiders (Hillman, Canella Jr. and Paetzold, 2000), who put an emphasis on the decision making functions of the board. The board facing high political risk will therefore resemble much of the insider-board emphasis. The conflict resolution function will probably be even more exaggerated since a high political risk implies that there are many actors surrounding the corporation that are stakeholders or make claims of being principals. Thus, we make an exemption from the general tendencies created by environmental uncertainty when it concerns political risk: Proposition 18: With an increase in political risk, the board tends to de-emphasize monitoring, emphasize decision making, de-emphasize resource provision, and emphasize conflict resolution. Summarising and Discussing The Contingency Approach of Board Functional Emphasis

The deduction of the different propositions indicates that a board differs in functional emphasis due to many influential factors. Table 1 summarizes the propositions. -------------------------------Insert Table 1 about here -------------------------------Inspecting the columns of the two traditional functions in Table 1, monitoring and resource provision, and counting the occurrence of functional emphasis and de-emphasis, it can be found that both functions show a rather equal distribution. Of course, this algebraic operation appears to be rather arbitrary since the distribution is dependent on the factors chosen. Inspecting the column of the decision-making function shows that de-emphasis of the function is slightly more frequent. This result seems intuitively correct and attuned with the popular belief that decision making is not the most prominent function of a board. The fourth function added in this paper, the conflict resolution function, did receive a slight higher occurrence on emphasis than de-emphasis, which indicates that it is a viable function. Overall, the distribution of functional emphasis varies between 6 for the decision making function to 10 for conflict resolution and resource provision. This low variance overall we interpret as an indication of the relevance of all four functions.


A second analysis of the collected propositions in Table 1 can be performed through correlating the set of signs for different factors. There appears to be a negative relationship between monitoring and decision making, which is in accordance with our assumptions. A very slight but similar negative relationship could exist between resource provision and decision making. This could be interpreted as a sign of a board being engaged in either directing the corporation through decisions, or influencing it through resource provision. Conflict resolution does not appear to be related to the other functions. One reason could be that monitoring, decision making, and resource provision are all related to the agent and the organization, as expressed in Figure 1, but the conflict resolution function is mainly directed towards the principals and in some cases towards the other stakeholders. The conflict resolution function has been added in this paper, based on a view of the board as being oriented not only towards the corporation, but also being directed towards the principal and representing an instrument of identifying and managing the principals. The intermediary role of the board is thereby stressed, which is a more complex role than the one given in agency theories where the board is an obedient servant of clearly identifiable principals. Thus, the main contribution is the more complex view of the board. The derivation of the set of hypotheses have been made with the intention not to implicitly assume a specific empirical subject, but to offer a theory that is more abstract and less bound to an empirical category. Even if this is hard to accomplish, since all derivations have to partly rely on existing knowledge, which has had the tendency to be less abstract, a theory of the board must have this abstract intention. Whether the intention has been implemented can be judged by theoretical criticism, but in the end the best way of judging a theory or a set of hypotheses is to confront them with empirical material and let the empirical validity be the judge. The ultimate test would be a data set of archival data and data from a survey covering both attitudes and actions that could be used in an application of the four models, including all the independent factors and including each one of the four dependent variables, monitoring, decision making, resource provision and conflict resolution. Such a design, however, runs into the same difficulties as a majority of board research, that it is hard to get information from the board. This difficulty, however, has been overcome by some researchers, which introduces the next problem, that of operationalizing. It is mainly the dependent variables that constitute the problem. To measure monitoring activities can at the surface appear to be rather simple. Some questions about the frequency of budget evaluations, monthly reports on sales, and other main variables could be indicators of monitoring. But the production of these numbers does not in itself represent monitoring, since monitoring

has to include the production of the numbers, the interpretation of the numbers, the decision how to act, and the very action itself. This complexity of the monitoring function indicates the empirical difficulty. After that problem, the measuring of emphasis is introduced. Is emphasis an absolute value or a relative value? Is it the distribution of activities in a board, i.e., a relative value, or is it the distribution between the boards? The underlying idea in this paper is that boards are economic entities that have to economize on resources. If that were not the case, then every board would engage in most of the functions at full power. But facing the economics of the board, the board has to focus on different activities, thereby stressing certain functions at the expense of the other functions. Thus, emphasis has mainly to be a relative value. Considering the difficulty in the operationalization of the dependent variables, a rational step has to be the use of the case study technique as expressed by Yin (2003), in order to find the relevant empirical dimensions of the different functions and the relevant scales to measure. Finally, the idea that the functions vary due to contingency factors has a theoretical implication with interesting praxis implications. The concept that can be introduced is functional harmony. We have claimed the view that the board is positioned in between the principals and the agent and the organization, thus experiencing many diverse influences. The set of hypotheses in the paper is a representation of these influences, showing that the board is subject to many factors simultaneously, and every factor will stimulate an emphasis or a deemphasis of the different functions. If the factors stimulate the same direction of functional emphasis, for example insider-dominated boards have the same set of predictions about functional emphasis as does the association, then an insider-dominated board of an association will experience functional harmony. On the other hand, as the association’s CEO tenure increases, the board experiences opposite influence on each function. The board of an association with a CEO with very long tenure will therefore experience functional disharmony. Functional harmony could presumably influence the efficiency of a board due to its effect on focus and unproductive conflicts. With growing functional disharmony, the board would tend to lose focus and become confused in orientation. Functional disharmony would presumably foster conflict since different board members and subgroups of the board will be representatives of different functional emphasis. The conflicts caused by functional disharmony cannot be assumed to be productive. Conflicts of a productive nature, those that promote innovation, are substantive conflicts (Pelled, 1996) that are caused by different views on the same topic. Functional disharmony could be assumed to produce emphasis on different topics, dependent on which functional emphasis is being emphasized or de-

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emphasized. The loss of focus and the conflicts will make the board an arena of many fights and long discussions, but without being able to produce any outcome other than long board meetings. If this reasoning carries some truth, the devotion towards investigating the efficiency of a board dependent on its number of independent directors, could be refocused and the mixed results found could partly be explained by ignorance of functional harmony. In a functionally disharmonized board much of the resources, such as the directors’ time, will be consumed, yet produce nothing more than an image of an introverted and paralyzed board. Hence, the contingency approach of a board’s functional emphasis could have praxis implications. As in the foregoing example, the association and its longtenured CEO can be helped in their understanding of their presumably conflictual relationship between the board and the CEO, and the loss of legitimacy an inefficient board presumably experiences. Understanding the forces directing the functional emphasis will not reduce their influence, but perhaps their impact on the board’s activities through the board’s conscious management of functional emphasis. Every board will presumably experience some level of functional disharmony. The overriding responsibility of the chair of the board would therefore be to manage the functional emphasis of the board. To a certain extent it is given by the factors we have found influence the functional emphasis. In the case they are deterministic, the chair has to subordinate the board and the organization and adapt to the factors. For example, if the CEO tenure factor is deterministic, then one method of reducing functional disharmony would be to recruit a new CEO. In the case where the influence of the factors can be managed, the chair can manage the board’s functional emphasis through the agenda and the process in the boardroom.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

13.

Conclusions

The understanding of the board and its behavior is restricted, in spite of the board’s tremendous societal importance. We have claimed that the conception of the board can be more accurate if it (1) reduces the ideological interpretation of a board’s responsibilities, which can be achieved through regarding the firm as a nexus of investments; (2) acknowledges the fourth function of the board, conflict resolution or principal identification; and (3) considers the whole range of boards existing worldwide, thus making the theory of the board less empirically bound. In this paper we have indicated one implication of this change in conception by producing a rudimentary contingency approach to a board’s functional emphasis.

14.

15.

16.

17.

References 1.

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 60. Watts, R. L. and Zimmerman, J. L. (1986) Positive Accounting Theory. Englewood Cliffs, New Jersey: Prentice-Hall. 61. Westphal, J. D. and Zajac, J. (1995) Who shall govern? CEO/board power, demographic similarity, and new director selection, Administrative Science Quarterly, 40, 60-83. 62. Westphal, J. D. and Zajac, J. (1997) Defections from the inner circle: Social exchange, reciprocity, and the diffusion of board independent in U.S. corporations, Administrative Science Quarterly, 42, 161-183 63. Williamson, O.E. (1985) Economic institutions of capitalism. New York: Free Press.

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Appendices Principal Conflict resolution Monitor

Board of Directors Decision

Resource

provision

Agent

Figure 1. An agency theory conception of four board functions Table 1. Summary of propositions about the board’s functional emphasis Monitoring The Principal P.1 Not-for-profit democratic association P.2 Private corporation P.3 Public corporation The Board P.4 Insider-dominated P.5 Principal-dominated P.6 Independent-dominated P.7 Board size The Agent P.8 Tenure Corporate strategy P.9 Simple business P.10 Related businesses P.11 Unrelated businesses P.12 Age of the corporation P.13 Size of the corporation Corporate structure P.14 Functional form P.15 Multidivisional form P.16 Complexity Environment P. 17 Market and technology uncertainty P. 18 Political risk

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Resource Provision

Conflict Resolution

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NON-GOVERNMENTAL ORGANISATIONS (NGOS) BOARDS AND CORPORATE GOVERNANCE: THE GHANAIAN EXPERIENCE Samuel Nana Yaw Simpson* Abstract This paper seeks to examine the Boards of NGOs in line with best corporate governance practices using evidence from Ghana. Data collected were analysed using a comparative case approach which involved a comparison of the Boards of the four (4) main categories of NGOs in Ghana to ascertain whether they exhibit differences or similarities. NGOs in Ghana exhibited some weaknesses ranging board appointment to other board characteristics which depart from international best practices. Besides, there are no reference guides for NGO Board or codes on governance for NGOs in Ghana like in other countries. Therefore, there is the need to develop codes/by-laws or reference guidelines for NGOs, supported by an enabling environment to realise the full potential of NGOs. Keywords: NGOs, Boards, Corporate governance, Ghana *

Department of Accounting, University of Ghana Business School, P.O.Box LG 78, Legon ,Accra, Ghana Tel:+233244749596 Email: [email protected]

1. Introduction

The concept of corporate governance has made boards of organizations popular and critical. Together with management they pursue objectives that are in the interests of the organization and its stakeholders, facilitate effective monitoring and encourage an organization to use its resources more efficiently (e.g. OECD, 1999, 2004; IFAC 2001). Quoted in the Institute of Chartered Secretaries and Administrators (ICSA), New Zealand Publication (February, 2000), Pound argues that corporate governance cannot work without the informed involvement of three critical groups, especially board of directors, thus reiterating the key role of board in achieving good corporate governance. Indeed, the issues of corporate governance vis-àvis boards have been a growing area of research ranging from the private sector to the public sector. Beginning from the private sector which traditionally focused on the corporation-shareholder relationship, specifically large and listed firms, studies have been extended to small and medium-scale enterprises (Abor and Biekpe, 2007; Eisenberg et al, 1998; Bennet and Robson, 2004) and the public sector (see Hicks, 2003; Halligan, 2006; Nicoll, 2006; Edwards and Clough, 2005; Hepworth, 2004). In recent years, there has been a resurgence of interest in questions of accountability and governance among non-governmental organisations considering the very important roles they play in an economy (see Moore and Stewart, 1998; Karajkov, 2006; McGann and Johnstone, 2006; Kurkure, 2006). Paul (1999) explains that NGOs have developed to emphasize

humanitarian issues, developmental aid and sustainable development to the extent that, they are seen as "indispensable partners" of governments and the international community. Consequently, in virtually every part of the world, these NGOs are having a major impact on governments, corporations, official international organizations like the United Nations and the World Bank, and most importantly the lives of people and the environment. For Karajkov (2006), NGOs are well positioned to do things that nobody else can do effectively. Apart from providing essential social services, many are engaged in development projects and provision of technical assistance to help improve the lives of the poor. What’s more, they participate in the design, consultations, operation and evaluation of projects especially in developing countries (Ofusu- Appiah 2008). In recent years, NGOs in the developed countries have come into the light with respect to mobilizing, defending their work, and thinking of self-regulation, creating standards of proper conduct, and essentially reforming the sector (Karajkov, 2006). However in developing countries like Ghana, NGOs are lagging behind especially in the area of governance and accountability 31 .Furthermore, although NGOs have proven their effectiveness in holding large institutions and governments accountable and exposing them to public scrutiny, very little has been done in their 31

www.generallawconsult.com/docs/ILO_NEWSLETTER_TRUST_ BILL.pdf (April 25, 2008)

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governance and accountability (see Karajkov, 2006; McGann and Johnstone, 2006). In view of the above, one wonders the type board or governing body arrangements NGOs operate. Therefore, this paper seeks to examine the Board of NGOs in Ghana in line with the concept of Corporate Governance to improve their operations and activities. In a period of intense scrutiny both at the public and private sector, it is only logical that NGOs should be closely examined. Moreover, this paper is timely considering the controversies surrounding the recently proposed Trust Bill in Ghana to govern inter alia the operation of NGOs and Charitable Trusts as well as provide more accountability through institutionalized governance mechanisms, oversight and sanctions for non- compliance (see Atuguba, 2007; and others32). The rest of the paper is organized as follows: the next section briefly discusses the nature of the NGO sector, section 3 looks at the theoretical perspective of Board and corporate governance. The research methodology applied is described in section 4 whilst results of the findings are discussed in section 5. The final section considers the conclusions and recommendations made.

The phrase “non-governmental organization” from literature became popular with the establishment of the United Nations Organization (UNO) in 1945. They date back to at least the mid-nineteenth century (Davies, 2006; 2007). Today, the term NGO describes a wide variety of organizations variously known as “private voluntary organizations,” “civil society organizations,” and “non profit organizations.” According to McGann and Johnstone (2006), they have become a powerful force due to the dramatic proliferation in their numbers and the growth in public and private grants and contracts flowing to them. In the field of international relations, scholars now speak of NGOs as non state actors (a category that can also include transnational corporations). They are now emerging influence in the international policy arena where previously only states played a significant role. For instance, the technical NGOs have been consulted on relevant issues by the World Bank and other UN agencies before policies are implemented and treaties drafted (Ofusu-Appiah, 2008). From the above, it is clear that there is no single definition of an NGO as the term carries different connotations in different circumstances. Therefore, they are often defined by the law or code that governs their activities in a particular country. The World Bank 33 defines NGOs as "private organizations that

pursue activities to relieve suffering, promote the interests of the poor, protect the environment, provide basic social services or undertake community development". Moreover, NGO is defined as an independent voluntary association of people acting together on a continuous basis, for some common purpose, other than achieving government office, making money or illegal activities (UNESCO Encyclopedia). Sometimes, NGOs are defined using the generally accepted characteristics that exclude particular types of bodies from consideration. For instance, an NGO should not be constituted as a political party; it must be non-profit-making and not be a criminal group (UNESCO Encyclopedia). According to Kurkure, (2006), some of the characteristics are that, they are independent of any direct control of the government; are not constituted by any political party; must not have profit making as a goal; must not conduct any illegal activities; but be devoted to managing resources & implementing projects with the objective of addressing social problems. Besides, some consider NGOs in the light of their operations 34 , size, thematic scope and geographical location (NGO Café, Mercieca, 2007). In Ghana, they include a wide variety of indigenous grassroot organizations, community-based organizations, religious organizations, local unions, women’s associations, and village associations. They are generally classified as follows: traditional associations, community-based organizations (CBO), religious or church-related and charitable institutions, voluntary organizations (VOLU), and private voluntary organizations (PVO). Moreover, they are seen as local grassroots organizations without external affiliations; national organizations without external affiliations; international organizations operating locally; and national affiliates of international organizations (Atingdui, 1995). For the purpose of identification and supervision, the Department of Social Welfare under the Ministry of Manpower, Labour & Employment, recognizes four (4) main categories, in Ghana, namely: • Indigenous, i.e. community organization without external affiliation, • National indigenous, i.e. national organisations without external affiliation, • National affiliates of international organizations with indigenous leadership, and • International organizations operating locally. Like other organizations, NGOs are founded for public benefit and operates to accomplish a welldefined, articulated mission. They programme effectively and efficiently work toward achieving that mission. To achieve these, NGOs are governed by

32 Meeting of CSO/NGO representatives with Mr. James Shaw Hamilton, head of programmes, charity commission, UK, 18TH April, 2007 33 World Bank, Working with NGOs A Practical Guide to Operational Collaboration between the World Bank and Non-

Governmental Organziations. Operations Policy Department, World Bank, 1995, pp.7-9. 34 The typology the World Bank uses divides them into Operational and Advocacy

2. Nature of the Non-Governmental Organisations (NGOs) Sector

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elected or appointed volunteer boards of directors 35 who are committed to the organisation's mission. For instance, an NGO board determines the mission, strategic direction, and future programming of the organization, ensures and nurtures adequate human and financial resources and actively monitors and evaluates the organisation's executive director/CEO, as well as the financial results. Moreover, the board members approve and systematically implement policies to ensure achievement of the mission of the organisation and to prevent perceived, potential, or actual conflict of interest. Above all, NGOs must operate within the laws and guidelines instituted by the industry in which they operate. Unfortunately in Ghana, NGOs have over the years operated in an environment with minimal standards for measuring their transparency and accountability (see Atingdui, 1995 and Boaten36). In view of this, the immense role NGOs play and the several stakeholders of NGOs such as individuals, trusts and corporate entities where they generate funding for their operations, the people for whose benefit the NGOs operate the society at large and the employees of the organizations, call for NGOs to be effective and efficient. This is the area where Corporate Governance will be the crucial differentiating factor between the success and failure of NGOs. 3. Boards and Corporate Governance

Corporate governance is defined severally by different documents, including codes, Acts/laws, principles, guidelines, reports and so on. Generally, it involves the set of principles and practices adopted by a Board that assures its key stakeholders that the organisation is being managed effectively and with appropriate probity. It provides the structure through which the objectives of the organization are set, and the means to obtaining those objectives and monitoring performance. The famous Cadbury Committee (1992) defines corporate governance as the system by which companies are directed and controlled. It includes the structures, processes, cultures and systems that engender the successful operation of the organizations (Keasey et al 1997). Earlier writers like Cochran and Warwick (1988) define corporate governance as: "...an umbrella term that includes specific issues arising from interactions among senior management, shareholders, boards of directors, and other corporate stakeholders." To sum up Oman (2001) defines corporate governance as the private and public institutions, including laws, regulations and accepted business practices, which in market economy, govern the

35 Has other names like Boards, Trustees, Executive Committees or Councils, Steering committees 36 www.generallawconsult.com/docs/ILO_NEWSLETTER_TRUS T_BILL.pdf (April 25, 2008)

relationship between corporate managers and entrepreneurs ("corporate insiders") on one hand, and those who invest resources in corporations, on the other. From the above, it is clear that there is no single model of corporate governance but on a whole focuses on board of directors (e.g. IFAC, 2001; OECD, 1999-2004), i.e. board size, composition, appointment and removal, evaluation and so on (see also the Combined Code on Corporate Governance, 2003 and the Irish Development NGOs Code of Corporate Governance, 2008). A board should be constituted with a clearly defined role. Hilmer (1994) argues that not to deny the board’s additional role with respect to shareholder protection, it must ensure that corporate management is continuously and electively striving for above-average performance, taking account of risk. Oftentimes, these board functions are achieved via sub committees known as board committees. Specifically on NGOs, they must have a high performance board which is in control of their roles and reviews their activities to ensure effectiveness. Supporting the above, a research conducted by the Centre for African Family Studies (CAFS), 2001, revealed that, the boards size of NGOs vary from five to twelve members elected by the members of the NGO. Further, NGOs have developed criteria for appointment of Board members while in many others Board members are friends and family members of the founder. Moreover, the term of office and limits on the length of service for Board members vary from one organization to the other, but in most cases are between two to three years for a maximum of two terms. In the case of larger NGOs, the board may set out the functions of sub-committees, officers, the chief executive, other staff and agents in clear delegated authorities (FTC, Kaplan, 2007). 4. Research Methodology

This study employed a comparative case approach in the analysis which involved a comparison of the governance structures among the four (4) main categories of NGOs in Ghana. This is to ascertain whether they exhibit differences or similarities in their governance systems. To achieve the above, some fundamental elements of corporate governance such as board existence, size, composition, appointment and removal, as well as performance evaluation were examined in the context of the Ghanaian NGO regulatory framework. The study sampled thirty (30) NGOs drawn from the various categories by which NGOs are registered in Ghana, that is, the community based indigenous, national indigenous, national affiliates of international organization, and international organization operating locally. To allow the analysis to take all the four categories into account, only twenty of the NGOs, five from each

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category were used. Data was collected through the administration of open and close-ended questionnaires as well as personal interviews. In addition, we relied on published information and other secondary sources of data Ministries, Departments and Agencies especially Ministry of Manpower, Labour & Employment. The results are presented and analysed using cross tabulations. 5. Data Analysis and Discussion of Results

As mentioned earlier, governance has become an issue of world-wide importance as the efficiency and accountability of organizations is now a matter of both public and private interests. It is generally concerned with processes, policies, procedures, systems and practices, both formal and informal, the manner in which they are applied and followed, the relationships that these processes create or determine, and the nature of these relationships. In recent years, there are many areas of organisational life which are affected by corporate governance but the fundamental area is the board of directors.

5.1 NGOs Boards and Corporate Governance

Following from earlier discussion, corporate governance cannot work without the informed involvement of the board of an organisation including NGOs, hence the need to establish boards, taking into account the composition and the size. 5.1.1 Board Existence, Size and Composition From the data collected, only 2 respondents from the international and community based NGOs, representing 10% indicated that they don’t have board of directors. This shows that most NGOs in Ghana acknowledge the importance of having BOD. The existence of board of directors is the heart of corporate governance. Jensen (1993) contends that the board has an ostensible role in providing high-level counsel and oversight to management in addition to corporate internal problems, underscoring the importance of the board in corporate governance. See table I (a) for details.

Table I (a). Existence of BOD Type of NGO National Indigenous

National Affiliates

International

Community Base

Total

Yes

5 25.0%

5 25.0%

5 20.0%

4 20.0%

81 90%

No

0 0.0%

0 0.0%

1 5.0%

1 5.0%

2 10.0%

Total

5 25.0%

5 25.0%

5 25.0%

5 25.0%

20 100.0%

Source: Field Data (2008) With respect to the frequency of meetings and issues discussed during such meetings, the majority constituting 50% of the 20 respondents led by the international and national affiliate NGOs, representing 20%, and 15% respectively hold board meetings quarterly (see table I (b)). The issues often discussed range from, approval of reports including budgets, administration, financial and staff matters, strategic and policy formulations, as well as consideration of new projects/programmes. Best practice recommends that the frequency of meetings will depend on the company’s situation and on internal and external events and circumstances. Daily meetings may need to be held on exceptional circumstances. As a general rule, full board meetings should be no less than quarterly and quite possibly monthly.

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The boards are made up both Executive Directors (EDs) and Non Executive Directors (NEDs). Although literature recommends a balance of EDs and NEDs so no group dominate in decision making, out of the 14 respondents who responded to this question, the majority,50% have only 1 ED, followed by 21.7% indicating that there are 3 EDs on their boards. Further, the presence of females on the boards showed that there is at least one female on the boards of each of the four categories of NGOs who responded to the question. Further on the issue of the chair (person running the board) and the CEO (person running the NGO) being the same person, 77.8% of the 18 respondents disagree. It is also worth noting that none of the international NGOs agree with the assertion, meaning the other categories have CEOs who act as the board chair as well. See tables II (a-c).

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table I (b). Frequency of Meetings National indigenous Not stated

1 5.0% 2 10.0% 1 5.0% 1 5.0% 1 5.0% 5 25.0%

Annually Monthly Quarterly Twice annually Total

Type of NGO National International affiliates 0 .0% 2 10.0% 1 5.0% 3 15.0% 0 .0% 5 25.0%

Community based

1 5.0% 0 .0% 0 .0% 4 20.0% 0 .0% 5 25.0%

1 5.0% 1 5.0% 1 5.0% 2 10.0% 0 .0% 5 25.0%

Total 3 15.0% 5 25.0% 3 15.0% 10 50.0% 1 5.0% 20 100%

Source: Field data (2008) Table II (a). Board Composition: Number of Executive Directors Type of NGO

Number of Executive 1 3 4 6 8 Total

National Indigenous

National Affiliates

International

Community Base

Total

2 14.3% 1 7.1% 1 7.1% 1 7.1% 0 0.0%

2 14.3% 1 7.1% 0 0.0% 0 0.0% 1 7.1%

0 0.0% 1 7.1% 1 7.1% 0 0.0% 0 0.0%

3 21.4% 0 0.0% 0 0.0% 0 0.0% 0 0.0%

7 50.0% 3 21.4% 2 14.3% 1 7.1% 1 7.1%

5 35.7%

4 28.6%

2 14.3%

3 21.4%

14 100.0%

Source: Field Data (2008) Table II (b). Chair and CEO must be the same National Indigenous 2 11.1% 2 11.1% 4 22.2%

Yes No Total

National Affiliates 1 5.6% 4 22.2% 5 27.8%

Type of NGO International 0 0.0% 5 27.8% 5 27.8%

Community Base 1 5.6% 3 16.7% 4 22.2%

Total 4 22.2% 14 77.8% 18 100.0%

Source: Field Data (2008) Table II (c). Number of Female on Board 0 1 2 3

National indigenous 0 .0% 1 6.3% 3 18.8% 1 6.3%

Type of NGO National affiliates International 1 0 6.3% .0% 1 0 6.3% .0% 3 0 18.8% .0% 0 0 .0% .0%

Community based 0 .0% 1 6.3% 0 .0% 1 6.3%

Total 1 6.3% 3 18.8% 6 37.5% 2 12.5%

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 4

0 .0% 0 .0% 5 31.3%

7 Total

0 .0% 0 .0% 5 31.3%

3 18.8% 6.3%

0 .0% 0 .0% 2 12.5%

4 25.0%

3 18.8% 1 6.3% 16 100.0%

Source: Field Data (2008) Finally on the board size, the results ranged from 14 to 4 with only one (1) respondent from an international NGO having a board size of 14. This is not surprising as the other International NGOs

indicating a board size in the following descending order, 13, 9 and 7. Overall, majority of the NGOs have a board size of 7 directors as shown on table III.

Table III. Board Size

4 5 7 9 13 14 Total

National Indigenous 0 0.0% 2 11.8% 1 5.9%


1 5.9% 0 0.0% 0 0.0% 4 23.5%

Type of NGO International 0 0.0% 0 0.0% 1 5.9%

Community Base 2 11.8% 0 0.0% 2 11.8%

Total 2 11.8% 4 23.5% 6 35.3%

0 0.0% 1 5.9%

1 5.9% 1 5.9%

0 0.0% 0 0.0%

2 11.8% 2 11.8%

0 0.0% 5 29.4%

1 5.9% 4 23.5%

0 0.0% 4 23.5%

1 5.9% 17 100.0%

Source: Field Data (2008) 5.1.2 Appointment and Removal of Board Members

This is another critical issue under governance. Out of the 14 NGOs, 64.3% of the respondents affirmed that they have laid down criteria for appointing board

members and listed some as shown on tables IV (a & b) below. From table IV (b), most of the NGOs consider experience, exposure, competence and commitment as the key conditions.

Table IV (a). Existence of criteria for appointing Board Members

Yes No Total



Type of NGO International

Community Base 1 7.1% 2 14.3% 3 21.4%

2 14.3% 0 0.% 2 14.3%

Total 9 64.3% 5 35.7% 14 100.0%

Source: Field Data (2008) Table IV (b). List of criteria for appointing Board Members

Financial contribution Willingness to serve Experience, exposure, competence and commitment Geographic location Nomination Total Source: Field Data (2008)

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Freq 1 4 11 2 2 20

Percentage 5.00% 20.00% 55.00% 10.00% 10.00% 100.00%


Furthermore, most of the NGOs observed that board members are appointed by the executive directors including the founder/initiator of the NGO. More of the national indigenous NGOs made this

disclosure. However, most of the international NGOs use the voting system by members at a general assembly. See table IV (c) below for the details.

Table IV(c). Mode of Appointment onto Boards Type of NGO National

National

international

Community

Indigenous

Affiliates

based

Total

Not stated

1 (5.00%)

1 (5.00%)

1 (5.00%)

3(15.00%)

6 (30.00%)

Board chair

0 (.00%)

1 (5.00%)

0 (.00%)

0 (.00%)

1(5.00%)

Executive Directors, including the founder Voting members of general assembly Total

4 (20.00%)

1 (5.00%)

1 (5.00%)

2 (10.00%)

7 (35.00%)

0 (.00%)

2 (10.00%)

3 (15.00%)

0 (.00%)

5 (25.00%)

5 (25.00%)

5 (25.00%)

5 (25.00%)

5 (25.00%)

20 (100.00%)

Source: Field Data (2008) As expected of every new board, 50% of the 15 respondents observed that, orientations are organised for any new board member. They cited programmes like running an NGO, report writing and presentation skills, projects and proposal management as well as management trainings. On the issue of the eligibility for re-appointment and maximum term to serve on the board, 87.5 % of

the valid respondents stated that all board members are eligible for re-appointment after completing their tenure. Moreover, 84.6% disclosed that, board members have a maximum tenure of two (2) terms. The NGOs that strongly supported this are the national indigenous and international NGOs. Table IV (d & e) gives the details.

Table IV (d). Orientations for Board Members

Valid

Missing Total

Frequency

Percent

Valid Percent

Cumulative Percent

10

50.0

66.7

66.7

No

5

25.0

33.3

100.0

Total System

15 5 20

75.0 25.0 100.0

100.0

Yes

Source: Field Data (2008) Table IV (e). Maximum Terms for Board Members Type of NGO

2.0 4.00 5.00 Total

National Indigenous 4 30.8% 0 0.0% 0 0.0% 4 30.8%

National Affiliates 2 15.4% 1 7.7% 0 0.0% 3 23.1%

International 4 30.8% 0 0.0% 0 0.0% 4 30.8%

Community Base 1 7.7% 0 0.0% 1 7.7% 2 15.4%

Total 11 84.6% 1 7.7% 1 7.7% 13 100.0%

Source: Field Data (2008) Like private organisations, non performing directors of NGOs must be removed. Although most of them claim they don’t remember the directors that have been remove over the last five (5) years, 18 out

of 20 respondents representing 90% disclosed they have criteria for removing non-performing director. Shown in table IV (f) are the criteria mentioned.

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table IV (f). Criteria and Reasons for removal of non-performing Directors Freq. 5 3 2 3 1 4 18

If no enthusiasm is shown If fail in two projects Death Conflict of interest Fraud Members may vote against that member at AGM Total responses

Percentage 27.78% 16.67% 11.11% 16.67% 5.56% 22.22% 100.00%

Source: Field Data (2008) 5.1.3 Performance Evaluation of Boards

Boards generally, should undertake formal and rigorous regular evaluation of its own performance and that of individual director to determine whether members continue to contribute effectively and demonstrate commitment to their roles. From the data collected 58.8% of the NGOs, led by the national indigenous and followed by the international NGOs do evaluate the performance of their boards.

With respect to the frequency and how the evaluation is done, almost all stated it is an annual ritual. They further explained that, the evaluations are done using appraisal forms (questionnaires), interviews and sometimes engage the services of local and external consultants for the exercise. What’s more, the issues often considered during the evaluations are the extent of interest of member, ability to raise funds for projects, the success of projects as well as a comparison of members’ duties and responsibilities as against set standards. See table IV below.

Table V. Evaluation of NGO Boards Type of NGO International

National Indigenous

National Affiliates

Yes

4 23.5%

2 11.8%

3 17.6%

1 5.9%

10 58.8%

No

1 5.9% 5 29.4%

2 11.8% 4 23.5%

2 11.8% 5 29.4%

2 11.8% 3 17.6%

7 41.2% 17 100.0%

Total

Community Base

Total

Source: Field Data (2008) 5.2 Board Committees

Also known as standing committees, they provide the board an opportunity to delegate their powers and responsibilities and most importantly, enhance the independence of their activities, especially in the area of remuneration. Some of the pertinent committees evidenced in literature are the Audit, Risk, Remuneration, and Nomination committees. Oftentimes, they are made up of non executive directors of the organisation. They may exist all year round or exist to accomplish a goal and then cease to exist37. In Ghana, some of the NGOs have committees to help their boards, tables VI (a & b) show the results. 6. Conclusions and Recommendations

Recent corporate failures in the US and other parts of the world underscore the importance of corporate governance in every organization as well as NGOs in view of their unique nature and roles played in the 37

http://www.managementhelp.org/boards/brdcmtte.htm

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society. Although they have proven their effectiveness in holding large institutions and governments accountable and exposing them to public scrutiny, very little has been done in their governance assessment, thus they have been operating in environments with minimal standards for measuring their transparency and accountability. Much of corporate governance studies have indeed focused on profit making organizations especially publicly traded companies. Ghana has witnessed the proliferation of NGOs but much corporate governance pronouncement has concentrated on public i.e. listed companies leaving the development and implementation of good corporate governance among NGOs to individual NGOs. It is against this background that this study examined the governance practices of NGOs in Ghana in line with the concept of Corporate Governance to improve their governance and general activities. The concept of corporate governance is very broad but one of the key aspects of a firm that it affects is the Board of directors and its characteristics, hence this study focused on the boards and its characteristics of NGOs in Ghana.

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table VI (a). Existence of Audit Sub-Committee Type of NGO

Yes No Total



International 4 21.1% 1 5.3% 5 26.3%

Community Base 1 5.3% 3 15.8% 4 21.1%

Total 9 47.4% 10 52.6% 19 100.0%

Source: Field Data (2008) Table VI (b). Audit Sub-Committee Type of NGO

None Ad hoc Committee Programs committee

Finance Performance assessment and disciplinary Trainers sub committee Total



International 0 0.0% 0 0.0% 1 10.0%

Community Base 0 0.0% 1 10.0% 0 0.0%

0 0.0% 0 0.0% 0 0.0% 2 20.0%

Total 3 30.0% 2 20.0% 1 10.0%

0 0.0% 0 0.0% 1 10.0%

2 20.0% 1 10.0% 0 0.0%

0 0.0% 0 0.0% 0 0.0%

2 20.0% 1 10.0% 1 10.0%

3 30.0%

4 40.0%

1 10.0%

10 100.0%

Source: Field Data (2008) Evidence shows that, a lot still needs to be done in the NGO sector of Ghana. For instance, there is no specific legislation(s) tailored towards the regulation of the Ghanaian NGO industry and codes on governance of NGOs or reference guidelines for NGO Boards in Ghana like in other countries. However, most NGOs in Ghana recognize the importance of having boards, so they have boards in place. They meets quarterly and often handle matters ranging from approval of reports, including budgets, administration, financial and staff matters, strategic and policy formulations, as well as considering new projects/programmes. Some board sizes seem too large (14), with the international NGOs leading. Further, the boards appear to benefit from NEDs who dominate most of the boards. However, the NEDs on the local NGOs boards are often friends and family members. Most of the international NGOs operate the twotier governance system as the board chair is different from the CEO. Furthermore, all the NGO boards are gender sensitive as there is at least one female on the board of each of the four categories of NGOs. Board members are appointed and removed using laid down criteria which are not written among the

local NGOs. This is confirmed by the differences in the appointing processes. Among the international NGOs, the appointments are made by voting members at general assembly, whilst the others use the executive directors including the founders. Orientations organised for newly appointed board members appears to centre on running the NGO. As a result, evaluating board members has been a challenging task for most of the NGOs, even though they say that is done annually using internal tools and sometimes engaging the services of local or external consultants. To discharge their responsibilities, most NGO boards have sub-committees but have nothing to do with achieving good corporate governance, i.e. audit and risk committees. In the light of the above, we recommend the development of codes/by-laws or reference guidelines for NGOs in the area of governance. It should address roles and functions of boards versus management, values, philosophy, vision and mission, procedures for board operations, criteria for Board appointments, principles of good governance and evaluation mechanisms and the activities of vital sub-committees for audit and risk management.

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РАЗДЕЛ 3 КОРПОРАТИВНОЕ УПРАВЛЕНИЕ В АВСТРАЛИИ SECTION 3 NATIONAL PRACTICES OF CORPORATE GOVERNANCE: AUSTRALIA

CORPORATE GOVERNANCE, BOARD RESPONSIBILITIES, AND FINANCIAL PERFORMANCE: THE NATIONAL BANK OF AUSTRALIA Ameeta Jain*, Dianne Thomson** Abstract This paper examines board responsibilities and accountability by management and Board of Directors in relation to the National Australia Bank’s (NABs) performance. The NAB, an international financial service provider within the top thirty most profitable banks in the world, is compared with the Australian major banks. The evidence suggests that NABs poor performance was consistent with a lack of accountability, poor corporate governance and board dysfunction associated with fraudulent currency trading and the subsequent AUD360 million foreign currency losses. The NAB’s performance is investigated by utilising accounting-based measures of profitability and cost efficiency as proxies for performance. Following the foreign currency trading losses in 2004 the NAB under-performed the other major Australian banks in terms of profits, cost to income ratio and growth in assets. In terms of profitability and cost efficiency NAB had the lowest ROE and ROA with a 19.7% fall in net profit and the highest cost to income ratio of 57.4% of any of the five largest banks. This case study provides an Australian example of poor corporate governance and suggests that financial institutions and regulators can learn from the NAB’s experience. Failure to have top-down accountability can have significant impact on over-all performance, profitability and reputation. In particular, it suggests that management and Boards need to review their risk management procedures and regulators need to be more pro-active in their prudential oversight of financial institutions. Keywords: Bank performance, Corporate governance, Board dysfunction, Regulation *School of Accounting Economics and Finance, Deakin University, 221 Burwood Highway, Burwood VIC 3125 Phone: 03 9244 6151 **School of Accounting, Economics and Finance, Deakin University, 221 Burwood Highway, Burwood Victoria, 3109, Australia. Phone: 61 3 9244 6173; Fax: 61 3 9244 6283, Email: [email protected]

“Corporate governance is fundamentally about such questions as what business is for – and in whose interests companies should be run, and how. Wider issues such as business ethics through entire value changes, human rights, bribery and corruption, and climate change are among the great issues of our time that increasingly cross-cut the rarefied worlds of corporate boardrooms”. (Elkington, 2006, p. 56)

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 1. Introduction

The aim of this paper is to explore the vigilance of a financial institution’s board in terms of their control and risk management of resources. The case study is focused on the responsibilities of the board of directors in an Australian bank, the National Australia Bank (NAB), their internal control audit outcomes, and their performance for shareholders. The literature contains numerous articles relating to the role of corporate boards, corporate governance, agency theory and the flow from corporate failures. However, the focus of this study is on the problems associated with a lax oversight role of a firm operating in the financial industry, which is charged with the management of community funds. Shareholder impairment can still arise even if the corporation does not fail. Woodward, Bird and Sievers (2001) considered corporate governance to be a catch all phrase which is ‘used to refer to management issues, incorporations and the mechanisms by which management can be supervised and made accountable to its members, employees creditors and the community’. Corporate accountability is not a new concept and implies answerability, applicability and universality to different stakeholders who are concerned with the activities of the firm. Accountability can be voluntary although it also can be enforced by regulators where non compliance results in some form of penalty (Newell, 2002). In recent years the focus on voluntary and to a lesser extent regulatory accountability has been directed towards corporate governance, in particular the activity of the board of directors and the internal control systems (de Andres, Azofra & Lopez, 2005). Governments are aware that breaches of corporate governance in the modern corporate environment will continue, therefore binding legislation and regulatory requirements have been passed to reduce opportunities for excess risk taking and to strengthen the integrity of corporate performance. In addition non-binding principles such as those contained in the OECD Principles of Corporate Governance (2004) and the Australian Stock Exchange (ASX) Principles of Good Corporate Governance (2003) and Best Practice Recommendations (the guidelines), provide opportunities for corporate boards to protect shareholders rights. The same rationale can be applied to other stakeholders concerned with the governance principles underpinning corporate results. This paper examines board responsibilities and accountability by management and Board of Directors in relation to the National Australia Bank’s (NABs) performance. The research objective is encompassed in the following question: ‘Does poor corporate governance and lack of board oversight impact on financial performance, profitability and the share returns of a major bank?’ The corporate governance problems faced by the National Australia Bank in 2004 are used as a case study to answer this question

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The information available in the public arena is examined to describe a flow of events during 2003-4 that underpin NABs financial outcomes and the subsequent reduced return to shareholders. The essence of the subsequent constraints imposed by regulators and or other concerned parties on the firm, together with internal changes will be coupled with the study’s flow of events to explain the role of directors and their vigilance particularly in relation to the internal control system. The remainder of the paper outlines the literature on board responsibilities and internal control issues. This is followed by a brief history of the bank and the essence of the corporate governance and management problems. Profitability and cost measures of the five largest Australian banks are examined and compared over the period 2004-2005. A discussion of the findings is then followed by the limitations of the paper and its conclusion. 2.

Literature Review

2.1 Corporate Failure and Loss of Board Control

In an analysis of the major corporate collapses in the last two decades, Acquaah-Gaisie (2005) states that the major causes of corporate accountability failure have been due to: • presence of weak boards of directors • breach of director’s duties • poor management practice • poor accounting and auditing standards • breach of auditing standards • investment bankers greed • bribery and corruption • ostentation and waste The role of the board of directors, and the accounting and auditing standards is strongly evident. The Index of Confidence in Corporate Reporting Survey (CPA Australia, 2002) further substantiates the view that poor chief executive officer (CEO) and board performance is implicated in corporate failure. The survey respondents were found to have very low confidence in corporate financial reporting, with 73% responding that they believed that company boards and the top two executives were to a great degree responsible for the corporate collapses in Australia. Less blame was laid on external auditors, internal auditors and the rest of management. Globally, the international collapses of Enron, WorldCom, Arthur Anderson and Parmalat, have eroded shareholder confidence in big business. In Australia a number of major corporate scandals have also occurred since the 1990s. These include financial institutions such as the State Bank of Victoria, State Bank of South Australia, Pyramid Building Society, HIH, and more recently the WestPoint property trust in 2006, and Bridgecorp and Fincorp Property Trusts


in 2007. The major Australian banks, whilst not suffering a corporate collapse, have not been immune from financial downturns. The Australian financial system experienced the worst losses in almost a century in 1990–1992, when the sum of individual bank losses exceeded AUD9 billion (equivalent to 2.25% of GDP and one-third of total shareholding funds (Gizycki & Lowe, 2000). Westpac Banking Corporation (WBC) experienced the largest percentage loss of 1.6% of GDP (AUD6.37 billion) followed by Australia and New Zealand (ANZ) bank with 0.85% of GDP (AUD4.69 billion), both in 1993. NAB recorded the next largest loss of the major banks with a 0.54% loss in 2001. Corporate crises have been viewed as a generalized loss of control over organizational behaviour. The Australian Office of Bankruptcy (AOB) Annual Reports confirmed that over half of all corporate collapses could have been averted with good corporate governance. The AOB attributes the major causes of corporate failure to bad luck (1%), internal factors triggered by external factors (15%), and approximately 50% from internally generated problems that could have been controlled by managers (McRobert & Hoffman, 1997). These explanations of corporate failure confirm the conventional views regarding the causes of failure, but could be just as easily seen as the symptoms of failure. The key management danger areas are high gearing, the toleration of loss-making divisions for too long, concealment of bad debts and defects in management, all of which can be traced back to a lack of board oversight (Australian Prudential Regulatory Authority, 2004). 2.2

Agency Relationships

There are a number of relationships, a nexus of contracts that provide the resources or services to produce the output of a business firm. Intrinsic to these contracts is a delegation of authority for decision making from one party to another. For the performance of these services the principal relinquishes some of the decision-making authority to the agent, for example, the shareholder to the manager of the corporation, and management delegate authority to staff and contractors – the well-known agency relationship (Jensen & Meckling, 1976). Agency theory assumes that individuals act opportunistically in their own self-interest, which may not be aligned with the goals of owners, that is the return to shareholders. Incentives are provided through contractual arrangements to prompt the alignment of individual goals with the goals of the firm. Associated with this delegation of authority are the agency costs associated with management’s lack of efficiency or opportunistic behaviour. One of these is the monitoring cost of auditing the content of the financial reports. An audit attests their reliability to external parties, thus reducing the cost to the firm of attracting future capital. Hence, congruent goals

between the board of directors, management and other stakeholders in a given firm would result in increased efficiency, throughput and profits with resultant higher stock prices. Boards have an oversight role to ensure that the firm conducts its activities according to regulatory and legislative requirements and abides by standards of good corporate governance. This necessitates that policies, processes and controls, risk management policies and procedures, are in place throughout the firm, and these are closely monitored on an ongoing basis. In addition, this oversight role includes the systems that assure stakeholders that the financial reports contain information that is reliable and unbiased. More recently, Child and Rodriguez (2003) outline the ‘double agency’ and ‘multiple agency’ theories. They describe its occurrence where different groups of people in the firm make strategic operational decisions, magnifying the problems of accountability and control. It increasingly occurs as boards rely on information from the firm’s employees or agents and in turn delegate implementation of their decisions to their employees. The strategic alliances that are formed with other firms external to the firm creates the possibility of double or even multiple agency problems occurring. The agent in this case may be an insider or a direct employee/ board member of the firm or may be external and belong to a partner firm. Williamson (1970) states that the board tries to overcome the external agency problems by relying on output controls and/or results. Firms rely on the internal controls of their processes and systems to underpin the reliability of the information communicated to top management, which then directly or indirectly via management decisions flows to the performance information provided to external parties. It is often the case in joint ventures, where each participating party has its own rationale for entering into an alliance, with each requiring that their interests be protected. In effect the mangers can be seen to be serving multiple masters, each with their own interest. This has been extended as common agency theory, where all relationships between principals and agents are included. It recognises that the board is not only a means to control the agents, but the board itself functions as an agent of its owners, the shareholders. (Huse, 2007). A variant of agency theory is stakeholder theory, where the shareholders are substituted by stakeholders. In this interpretation every stakeholder does not have the same position and stake as the shareholders. Shareholders usually invest for capital growth and are an amorphous mass of people or institutions (Crowther & Renu Jatana, 2005). In this context there remains little if any control on managers as shareholders tend to sell their holding if the shares do badly. Agency theories have been the subject of criticism with experts blaming the agency theory for corporate collapses such as Enron, wrong in its focus and its negative impact on society. Huse (2007) states

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that experts in game theory believe that agency theories only highlight a one-way relationship. He further argues that corporate governance is a game involving multiple actors with no clear demarcation between principals and agents. Arthur et al (1993) present a counter-argument to these widely held beliefs. They suggest that firms create long-term wealth for their owners because these owners or shareholders are widely dispersed and cannot interfere in the running of the firm; the running of firms is best left to managers motivated by debt and capital structure. They stress that the relationship between principals and agents is one of mutual benefit. Aguilera et al (2007) refute agency theory which assumes that in managing the principal-agency problem between shareholders and managers, firms operate better. They consider that agency theory ignores linkages between corporate practices and performance and devotes little attention to the distinct contexts in which firms are embedded. They consider that stakeholder theory better explains the impact of a wide range of firm-related actors. Naughton (2002) criticises agency theory as it highlights only one aspect of corporate governance and its failure, ignoring the entire social, political and organisational mileu in which the firm operates. Managers cannot diversify the risks associated with a firm; should a firm fail the manager will lose their job. Managers therefore try to eliminate the risks associated with volatile investments and sudden variations in firm value and income by hedging against failure. This form of risk management does result in the reduction of agency costs (Cannon, Godwin and Goldberg, 2008). This paper does not deal with the other multiple facets of risk management which also result in improved firm performance. 2.3 Corporate Governance and the Board of Directors

There have been a number of studies that have examined the relationship between corporate governance, board function and performance. Studies by Collett and Hrasky (2005), Chiang (2005) and Doucouliagos and Hoque (2005) find a positive relationship between share price performance and firm performance, whilst Heracleous (2001), KoracKakabadse et al (2001) and Kiel and Nicholson (2003) don’t necessarily find a relationship. The evidence is not clear-cut but intuitively there would appear to be a positive correlation between good corporate governance practice and good corporate performance. By contrast, Sonnenfeld (2004) dismisses as myths, the many studies that attempt to measure good governance by suggesting a relationship between board structure and performance, board structure and equity, and the independent board. His point is illustrated by companies that experienced governance

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crises, such as Enron and HIH. These companies all met the measures that are standard for assessing board function, such as director attendance (nearly perfect in Enron’s and HIH’s case), board size, number of other boards the directors sit on and number of independent directors. These are outmoded standards according to Sonnenfeld (2004), and the real question of how to assess and improve governance performance is yet to be answered. The question of how to measure the human side of governance procedures is still a challenge. Legal and accounting mandates such as the APG510 (Australian Prudential Regulatory Authority, 2006a) and the ASX Principles of Good Governance (Australian Stock Exchange, 2003) address only part of the challenge. It would appear that the human dynamics of boards, where leadership ability, decision-making processes, conflict management, transparency, inclusion of agents in the decision making and monitoring process and the like, can differentiate a firm’s governance. There is mounting evidence that the functioning and characteristics of the board of directors is associated not only to firm performance, but to the distribution of power within the firm (Lara, Osma and Penalva, 2007). Nicholson and Kiel (2004) describe the functioning of a board as multidimensional and its decision-making influenced by multiple factors. They formulated a diagnostic framework to analyse where and how boards are going wrong. The key inputs to the board performance relationship are organisation type, the company’s legislative and societal framework, the organisation’s constitution and lastly, company history, which reflect the broader influences of past events. The key elements that impact current corporate governance expectations are past performance, corporate culture, corporate values and decisions on board composition that will affect how the board functions. Further, these authors found that no single theory: stewardship, agency nor resource dependence theory can offer a complete explanation of the corporate governance – corporate performance relationship. Board dysfunction may contribute to major corporate collapses and non-compliance with the law. It is often caused by a desire for board members to fall into line with prevailing views and majority decisions (Westphal and Khanna, 2003). Board members may be appointed because of their ability to be collegiate and not question management decisions, with members that ask too many questions being seen as trouble makers (Becht, Bolton and Roell, 2005). Board directors who have brought about changes such as increased board independence, firing a CEO for poor performance or separating the role of CEO from Chairman have found themselves ostracised at board meetings by the other board members. According to Westphal and Khanna (2003), the phenomenon of the ‘corporate cold shoulder’ helps create a dysfunctional board. Daily and Dalton (1993, p. 65) state that ‘officers and boards of directors for the large scale


firm lack the discretion – or the wherewithal – to effect changes in policies and outcomes’. It is not the number of the board members but rather their skill base, which seems to lead to better outcomes for the board. Monks (1998) believes that non-executive or “independent” members of the board are pivotal for good corporate governance but is highly critical of the processes that lead us to believe that members of the board that are “nominated” or “elected”, are “independent” and that shareholders “vote” for their choice of nominees. Monk’s view is that the legal terms are used contrary to their commonly accepted usage. That the members of the board are in fact appointed by the CEO and incumbents tend to dilute the board’s legitimacy generally, but most specifically in determining the CEO’s remuneration. The duality of the board and management compromises the very function that the board is supposed to perform: that of being the watchdog for the shareholder (Sharma, 2004). Irrespective of the ownership pattern of the corporation, independent boards have been shown to be associated with a lower incidence of fraud and improved corporate governance. However, the definition of ‘independent’ remains open to interpretation by governments and courts (Harvard Law Review, 2006). Whilst various models to ensure board independence such as disinterested member, objective monitors and unaffiliated professional have been proposed, there is no single perfect working model (Van den Berghe and Baelden, 2005). Matheson (2005) found that the causes of board dysfunction are almost completely related to poor communication and lack of teamwork skills. He found that disconnected board members are not committed to a clear direction and they lack an understanding of the principles and the laws of corporate governance and accountability. Consistent with agency theory, they pursue personal agendas and further, the lack of team spirit, distrust and inability to accept alternate points of view creates factions within the board, leading to ineffective communication, refusal to accept compromises, no contribution to the common goal and unnecessary argument amongst others. Matheson’s prescribed formula for alleviating these ills requires that the board should have a formalised role and function, be provided with a code of conduct and be trained in conflict management. There should be regular annual evaluations by an independent authority, the engagement of skilled facilitators and increasing the moderating role of chairmen so their role is similar to that of the speaker in parliament. Shen (2005) points out that no amount of legislation in isolation will ensure adequate performance by board members. The things that matter are remuneration, stock options and ownership, to increase effectiveness of both executive and nonexecutive directors.

The following case study of the National Australia Bank focuses on its poor corporate governance practices due to lack of transparency of operations, the lack of oversight function of the board, and the failure of the board’s risk assessment and control functions. The factors that played a key role in NABs case were the corporate values and corporate culture that focused on profitability and ignored risk procedures. 3.

Research Method

The case study is of an Australian bank that has significant operations throughout the country and international affiliations. The bank was chosen for this study because it offered suitable insights into the responsibility of the board and auditors as a result of the financial transactions that adversely impacted the bank’s performance. The use of only one case study is supported by Yin (2003) and Ahrens and Dent (1998). These latter authors consider accounting should be studied in an organisational context (in this paper accounting includes the auditing function). Their results are connected to a theoretical framework. Yin (2003) suggests a single case-study can be used where the case represents an ‘extreme or unique’ case. The occurrences and outcomes of activities within the National Australia Bank represent a ‘unique and extreme’ situation which is considered applicable for a single case study. Using content analysis, secondary data sources including annual reports, were analysed as proprietary information was unavailable. Given the specific issues associated with this firm are not able to be generalised to the entire financial community; the issues are consistent with a generalised scope of board responsibility (See Table 1). These aspects were the primary focus when analysing the data. The term corporate governance is used in the sense of Board responsibility for the oversight function. Insert Table 1 here

In addition, NAB’s performance against the other four large banks in Australia (Commonwealth Bank of Australia (CBA), Australia and New Zealand Bank (ANZ), Westpac Banking Corporation WBC) and St. George Bank) is compared over the period 2004 to 2005. The annual reports of all five institutions and KPMG Financial Institutions Performance Surveys 2004-2005 were analysed for cost and profit ratios, share price and total shareholder as measures of performance and profitability. 4. 4.1

Discussion and Findings Background

The National Australia Bank (NAB) is an international financial service provider with its

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business located in Australia, the United Kingdom, New Zealand and the USA. It is the largest financial services institution listed on the Australian stock exchange and is within the 30 most profitable financial services organisations in the world. National Australia Bank Limited traces its history back to the establishment of the National Bank of Australasia in 1858, it became a public limited company after incorporating on June 23rd, 1893. NAB is the largest financial institution listed on the Australian Stock Exchange by total assets. In September 2007, it was among the 30 most profitable financial service organizations in the world with total assets of more than AUD564.6 billion. NAB is an extremely profitable bank with in excess of AUD2 billion in profits reported in 2005 and AUD4.1 billion in 2006 but acknowledged publicly that poor governance procedures and board dysfunction had impacted on its reputation and its overall performance in 2004-5. 4.2

Flow of Events

NAB’s venture into U.S offshore mortgage markets in 2001 resulted in HomeSide, a home loan subsidiary of the NAB, losing AUD4.1 billion (Credit Collections World, 2001; Tyson-Chan, 2006). This was due to a miscalculation of interest rates and loan repayment schedules. The exposure of the fraudulent foreign exchange traders occurred in January 2004 and was followed by significant board disruption (see Table 2 for a chronological listing of events). Additionally, NAB and ANZ banks were found to be in breach of the U.S. Securities Exchange Commission (SEC) requirement of auditor independence (Oldfield & Cornell, 2004). Insert Table 2 here

Currency option losses occurred as the Foreign Exchange traders positioned NAB’s foreign currency option portfolio. The expectation was that the falls in the U.S. dollar that occurred in mid-2003 would reverse and that volatility would stabilise. Four traders took part in fictitious trades which allowed the currency options desk to falsely report a $37 million profit in October 2003, when its real position was a $5 million loss, the fictitious profit protected the performance bonuses of the traders but eventually caused losses of AUD360 million to be recorded in 2004. Rather than close out their positions as the market moved against them, the traders chose to conceal their true positions, allowing those positions to deteriorate before they were finally discovered and reported to management by junior employees (Australian Prudential Regulatory Authority, 2004). Once the AUD360 million foreign currency losses became public in January 2004, NAB appointed Price Waterhouse Coopers (PwC) to investigate the irregular trading of foreign currency options. Concurrently, the Australian Prudential

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Regulatory Authority (APRA) undertook a review of the bank’s practices. Almost immediately concerns regarding the independence of the PwC report were raised, as PwC became the “external experts” asked by the NAB to audit the scandal. The independence of the PwC investigation was compromised as they already had a close and extensive relationship with the NAB board, with business links between the bank and PwC likely to cause a number of potential conflicts of interest. In particular, NAB director, John Thorn, who had been the PwC financial services auditor and a PwC senior partner, left PwC in September 2003 to join the NAB board just two weeks later. PwC earned fees of AUD17 million in 2003 from NAB, nearly twice the fees earned by NAB’s own auditor KMPG (Myer, 2004). Elevating this report to the status of an independent report left it open to criticism, particularly as Board member Catherine Walter had already began raising concerns about the independence and probity of the PwC investigation. Walter raised two issues of concern: firstly, the inappropriateness of appointing Graham Kraehe, to the chairman’s position after Charles Allen stepped down. Kraehe had been the board member presiding over the internal risk committee, which had failed in its basic requirement to manage NAB’s risk practices, Secondly, Walter questioned the appropriateness of this committee being charged with the responsibility to oversee an investigation into the breaches of risk policy, the very issues that they had failed to identify in the preceding months. Walter’s concern was that there was the potential to influence the contents of the report and because of the business relationship with NAB; essentially PwC would have been investigating their own work. Deloitte, Touche & Tohmatsu and the law firm, Blake Dawson, were brought in to oversee the probity issues and found that there were no issues that PwC were required to answer. Walter’s allegations of flaws and lack of independence in the PwC investigation were rejected by the Board of directors. A public boardroom split ensued, when due to a loss of confidence, they called for Catherine Walter to resign. Walter resisted the pressure to quit and faced with an Extraordinary AGM, she put forward a counter proposal for all seven non-executive directors to step down as their terms came to an end.38 The NAB board at this stage had become entirely dysfunctional and were unable to work together to give management a clear direction. The inexcusable losses that reflected badly on management and the board of directors should have been dealt with promptly. Instead the NAB board endured a three-month period of criticism and counter criticism in the public arena (McCrann, 2004). To exacerbate matters, the new CEO, John Stewart, was drafted onto the Board Committee to manage the 38

The Board does not have the power to sack board members; it must of necessity call an Extraordinary Annual General Meeting, as only shareholders have the legal right to remove directors.


proposed Extraordinary General Meeting (EGM). This was further seen as a totally inappropriate role for management to be appointed to sit in judgement of Board members; instead this should have been a totally independent committee. Regardless of the veracity of Walter’s allegations regarding the PwC report, the NAB Board failed to handle accountability by allowing Chairman Charles Allan and CEO Frank Cicutto to leave precipitously before the release of the PWC report. Removing these individuals from the public arena left the Board with no one to take responsibility for the events that had occurred at NAB and the breach of their risk systems. A pattern of poor accountability by NAB board members emerged with transparency and disclosure issues not only over the actions of dissident director Catherine Walter. It seemed that the market wanted retribution for the earlier HomeSide losses of 2001, which had not been dealt with adequately by the board in 200139. Within two months of the foreign currency scandal becoming news the NAB board was in disarray. The bank lost a majority of their key personal consisting of their board chairman, CEO, chief financial officer, the head of its corporate and institutional banking division, head of markets, head of risk management and a string of other managers and staff (Bartholomeusz, 2004b).The loss of key staff contributed to part of the market judgment and mark-down of NAB share price over the months that followed. The public expunging of the board and top management positions may have been necessary to remove perceptions – real and imagined – relating to lack of accountability and the breaches of corporate governance internal controls. In APRA’s report to the Parliamentary Inquiry, there is a strong indictment of the NAB Chairman, the head of risk management and the CEO (2004). The chairman of the APRA, John Laker, held the view that the APRA Report on risk management received ‘a fair degree of resistance at NAB’ and was not passed on to the board in January 2003. This report was ignored. The Bank gave a commitment to APRA to meet a timetable for remedial risk management action based on an August 2003 on-site meeting with regulators. Again, neither the Chairman nor the Board took any action. By not passing on a subsequent APRA letter alluding to issues with risk 39

For a more detailed explanation of the NAB losses on HomeSide (AUD4.1 billion) that followed their naive venture into offshore mortgage markets in 2001 and the currency option losses caused by the traders positioning NAB’s foreign currency option portfolio in expectation that the falls in the US dollar that occurred in mid-2003 would reverse and that volatility would stabilise see Thomson and Jain (2006). Rather than close out their positions as the market moved against them, the traders chose to conceal their true positions, allowing those positions to deteriorate before they were finally discovered and reported to management by junior employees (APRA, 2004). Frank Cicutto, the then CEO, stated that traders at the center of the scandal had exploited weaknesses in the bank’s internal procedures to hide trading losses and protect bonuses.

management practices, the board let an operational and compliance void be exploited by the traders while their superiors did nothing. 4.2

Control Measures

The OECD Principles of Corporate Governance relating to the Responsibilities of the Boards requires the board to be fully informed, act in good faith and with due diligence (See Table 1). It is questionable whether NAB board of directors could claim that they had taken their responsibilities seriously enough. Before the much publicised losses in 2003 NAB formed a new committee called the Principal Board Audit Committee (PBAC). Its role was to discuss and investigate any high-risk issues that were raised by either the Internal Audit or the external auditors, KPMG. NAB also introduced a new Internal Audit rating system that would directly report to the PBAC. The chairman and then CEO were part of new Audit Committee with direct lines of accountability and responsibility to the Board (National Australia Bank, 2004). Despite the committee being held responsible for reviewing risk management practices, there were no meetings held during 2003 although warnings had been issued concerning risk management practices by both the external auditor as early as 2001 and APRA in mid-2002 following an on-site visit to the bank (Grant, 2005). The internal Audit Committee failed to discover fraudulent practices in their review of NAB accounts but over the next couple of years the external auditor was to flag areas of concern that were rated minor, for example, KPMG listed in both their 2001 and 2002 Reports to the Audit Committee that there were some 50 items of possible weaknesses in need of attention. These were classified as minor, not representing a threat to the integrity of the accounts and as such they did not attract the attention of the PBAC. In 2003 KPMG signed off on the accounts, but now the concerns had been upgraded and were listed as major concerns. At the same time, an APRA report detailing issues of concern relating to risk management practices in currency dealing rooms was handed to the chairman in January 2003 (exactly one year before the foreign currency scandal broke) but failed to deliver any action (Australian Prudential Regulatory Authority, 2004). In light of the NAB experience, auditors and regulators are now unlikely to attach a major/minor issue to a report or allow a report to go un-actioned. Each concern will have to be dealt with by the audit committee before auditors will sign off and regulators will be looking for compliance by boards or generic, more expensive regulator models for risk. Following the foreign currency losses APRA’s review considered the NAB internal control frameworks satisfactory and that faults that occurred lay with the implementation of existing safeguards rather than the design of the safeguards themselves. Frank Cicutto, the then CEO, stated that traders at the

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centre of the scandal had exploited weaknesses in the bank’s internal procedures to hide trading losses and protect bonuses. Thus losses could be attributed to an operating environment characterized by lax and unquestioning oversight by line management; poor adherence to risk management systems and controls; and weaknesses in internal governance procedures. This type of behaviour is congruent with double/ multiple agency issues endemic in every organization, and in the self-interest aspect of human nature (Child and Rodrigues, 2003). Even if the report had been tabled, self interest may have prevented individual Board members from acting in the best interests of NAB. Fear of being ostracized and the ‘corporate cold shoulder’ may have prevented Board members from acting on information or questioning other board member responsibilities. NAB’s issues of fraudulent trading in their foreign currency room and board dysfunction were severe. To complicate management issues further a new CEO was appointed. This was in the midst of falling margins in its British operations and increased regulatory costs as it prepared for international accounting reforms. The bank needed a strategic direction, but there was no effective leadership team to guide it (Bartholomeusz, 2004 a). During the April to May 2004 period, board infighting reached new heights and an Extraordinary General Meeting of shareholders was called to consider resolutions to remove all remaining board directors. NAB competitors started to exploit the reputational damage being done to the number one bank in Australia by targeting a range of NAB’s customers including corporations, medium- to small-sized businesses as well as their retail customers and clients. NAB needed a quick response, at any cost, as total assets were growing at only 2% (See Table 3). This compared to ANZ, the best performer with an asset growth of 32% in 2004 and 13% in 2005 and the finance industry average of 6.8% asset growth.. Some measures implemented immediately were the waiving of mortgage fees, raising interest rates on deposits and the introduction of new products in order to entice consumers. These measures further contributed to NAB’s ballooning cost to income ratio, and in turn affected their bottom-line profitability. 5. Performance Measures: NAB Compared to the Major Banks (20042005)

A review of NAB and the major bank’s performance over the two-year period 2004-2005 found that NAB had the lowest Operating Profit after Tax/ Average Total Assets, (0.79% in 2004, improving to 0.99% in 2005 but still below the sector average of 1.13%). NAB ranked last with return on shareholder equity of 15% in 2004, significantly below the sector average of 18.5% (See Table 3). During this period the sector average was considered by KMPG to be below the industry benchmark of 20%. The average return on

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equity for the sector reached 21.02%, in 31 March 2006, to rise above the benchmark for the majors for the first time, with all the majors, except NAB, achieving the 20% benchmark (KPMG, 2006). Insert Table 3 here

In terms of the Net Interest Income/Average Total Assets Ratio, NAB performed poorly in comparison to its peers, having the lowest ratio at 1.70%. St. George, the smallest of the group, performed the best at 2.31% against a sector average of 2.01% (KPMG, 2005). The larger the Net Interest Margin, other things held constant, the greater will be the contribution to profitability. NAB’s interest margin is the narrowest of all five banks at 2.2% compared to the average of 2.42% (See Table 3). In terms of profitability, NAB was the only major bank to show extremely large declines in both beforetax and after-tax operating profits (-15.8% and -19.7% respectively) in the year 2004. This compared unfavourably to the sector averages of 9.0% and 6.4%. In 2005, NAB, along with the CBA experienced very strong growth. Both these measures returned to positive figures and significantly higher than the industry sector average with before-tax profit recorded at 37.9 % against the sector average of 27.2% and after-tax profit of 30.1%, compared to the average of 25.1% for 2005 (See Table 3). The cost to income ratio (operating costs/operating revenue) was of some concern to NAB, particularly when it jumped to 57.4% in the March 2004 half-year report, up from 50.8% at the same time in 2003 (National Australia Bank, 2004). The ratio is sharply higher than any of its four main rivals, ANZ reported a cost to income ratio of 52.7%, Westpac’s fell to 48%, while St George bank boasted the lowest cost to income ratio of just 45% compared with the sector average at 49.2% (KPMG, 2004). At the time NAB was the largest bank in Australia by capitalization and size of total assets. By no means was it the best performer. It lagged behind the other four major banks in most key financial measurements, and particularly in the cost-to-income ratio, which had risen rather than followed the industry trend downwards. A measure of growth is the increase in total assets. Whilst all banks experienced positive growth in total assets, once again NAB had the lowest growth of the five banks, with 2% increase in total assets in 2005, less than a third of the sector average of 6.8%, and in 2004 at 3.5% only one quarter of the major’s average of 13.1%. Kohler (2004) estimates that further costs to NAB and its shareholders have been in the vicinity of AUD2 billion, measured by the fall in the market value of its shares. Following the currency trading losses NAB’s earning per share were approximately AUD2.50 a share, at a share price of AUD30, the price/earnings was 12 times, whilst CBA and Westpac were selling at 15 times earnings. Two years earlier in 2002, NAB had been earning at 15 times earnings and


if re-rated in 2004 the share price should have been nearer AUD37.50, instead of the AUD28.85. This would be similar to what CBA, NAB’s nearest competitor, was trading at in 2004 (See Table 3). Share price and total shareholder return (TSR) are two further measures of performance, with the former being easily observable and reflecting the market and shareholders’ views directly whilst TSR (expressed as a percentage) can be easily compared from company to company, and benchmarked against industry or market returns, without a bias regarding size. The Global Investor Opinion Survey on Corporate Governance found that 73-78% of investors would be willing to pay a higher share price and that 57% would change their holdings for a well governed company (McKinsey & Company, 2002). NAB had previously experienced a dramatic fall in share price with the announcement of the HomeSide losses in July 2001. The NAB share price experienced a sudden fall of 5.5% on the NYSE (Credit Collections World, 2001). The impact was more dramatic and significant on the ASX with NAB’s ordinary share price falling 33% from a high of AUD35.13 in July to a low of AUD23.80 by September 2001. The announcement of the foreign currency scandals, followed by the very public board controversy, caused NAB share price to fall 19% from a high of AUD32.12 in January 2004 to AUD26.04 by September 2004, followed by a slow partial recovery in the share price (Table 3 and Figure 1).40 Insert Figure 1 here

The TSR performance represents the change in capital value of a listed company over a period (typically 1 year or longer), plus dividend, expressed as a plus or minus percentage of the opening value (Value Based Management, 2006). 41 Given the HomeSide losses of 2001 and the tumultuous board events that followed the currency trader losses in 2004 it was to be expected that there would be some fallout and evidence of market discipline on share price and hence on the more comprehensive TSR performance measure. The TSR provides a compelling picture; recorded at just 7% in 2001 but rebounding back to 38.6% in 2002. The year 2003 saw the TSR fall to -1.8% and fall even in further in 2004 to a low of -5.2%, lower than any of the opening values recorded between 2001 to 2005, but as the share price recovered over the latter half of 2004 the TSR rebounded once again to 32.3% (Figure 2). The TSR is an important measure of performance for shareholders and investors. The positive 32.3% in 2005 reflected the improvement in NAB’s capital 40

The share data in Figure 1 doesn’t capture the full extent of the share price drop in 2001 as the data is year-end share price. 41 Calculation of Total Shareholder Return Formula (TSR) = (Share Price at the end of the period - Share Price at the beginning of the period + Dividends) / Share Price at the beginning of the period = Total Shareholder Return.

value. This provided a signal to the likely direction the share price would follow, the return to the investor and giving some indication of whether to invest in the share or not. Insert Figure 2 here

The comparison between NAB and its peers’ data is sufficiently strong to draw some inferences regarding board governance issues and performance. In every measure - the measures of profitability, cost ratios and share price fluctuations that are shown in Table 3, and Figures 1 and 2, NAB has the lowest profitability measures and highest cost ratios of the five banks included in the major banks grouping. The findings provide strong evidence for suggesting that the events that NAB suffered during the 2001-2004 years had a significant impact on their profitability, ROA, ROE, cost-to-income ratio, TSR and share price. 6. 6.1

Regulatory and Voluntary Outcomes Regulatory Requirements

The consequences of the NAB board and risk committee failure to address the risk issues noted by the regulators and other foreign exchange industry players in the previous twelve months were costly for NAB. APRA required NAB to comply with and implement a series of 81 remedial actions with on-site supervision imposed until the actions were fully implemented. NAB’s approval to use an internal model to determine market risk capital was withdrawn and the currency option desk closed to corporate business until all areas of concerns in the APRA Report were addressed. A number of risk management strategies had to be implemented prior to NAB’s foreign currency option desk could re-open over a year later in May 2005. This included increased monitoring of all market risk limits with mandatory “hard” limits and trigger or “soft limits” which included a defined response. Furthermore, the regulator raised NAB’s internal target total capital adequacy ratio to 10%, up from the Group’s previous internal capital ratios of 9-9.5% (APRA, 2004).42 NAB dealt with the additional need for capital by raising $2 billion of subordinated debt and a $1.2 billion underwriting for its dividend reinvestment plan in order to keep the $0.83 cents semi-annually dividend payout unchanged while still meeting the new 10% capital requirements. Their plan to use an investment bank to underwrite the dividend reinvestment plan meant that investors should have been made aware of the fact that NAB was disguising an ordinary capital raising in the form of a dividend (Hughes, 2004).

42

Australian Banks adhere to the international capital adequacy requirement of a minimum 8% risk-weighted capital.

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The aim of an independent board is to reduce agency costs (Harvard Law Review, 2006). Independence makes the board accountable to shareholders for performance and is also the key to increasing informational transparency. To this end, the Prudential Standard APG510 (Australian Prudential Regulatory Authority, 2006a) policy document prescribes minimum standards for good corporate governance, which also include board renewal, minimum expertise levels, diligence, prudence and oversight function levels. The parallel policy Prudential Practice Guide: Governance APS510 (Australian Prudential Regulatory Authority, 2006b) dictates that a company board in Australia must have an audit committee. The scope of Board role and functions now extends beyond its fiduciary and regulatory function to include compliance with the law of the land. The board is now ultimately responsible for all decisions and actions of the corporation (Australian Prudential Regulatory Authority, 2006a, 2006b). Section 16 of the APG510 requires that a Board must have a majority of independent directors at all times and that the chairman must be an independent director and cannot have been the CEO in the previous three years. Clear requirements are made for independent directors and independence must comply with the ASX Corporate Governance Council’s Principles of Good Governance and Best Practice Recommendations. The board needs to have a charter of roles and responsibilities, which may include: • delegation of authority • ensuring the requisite skills of management and board members • fulfilling residency requirements for companies registered in Australia • must be available to meet APRA • on request, providing external auditor with the opportunity to raise matters directly with the board • ensuring a composition that complies with legislation • ensuring representation consistent with shareholding • appointing a Board Audit committee • reviewing audit plans • ensuring auditor independence • evaluating risk • having effective risk management plans and committees in place • establishing performance assessment indicators for itself • having a formal board replacement policies (Australian Prudential Regulatory Authority, 2006a, 2006b). 6.2

Voluntary changes

The board culture that had developed at NAB had been described as ‘too big, too old, too male, too full of ex CEOs and too many insiders’ (Cornell, 2004).

108

The resulting board was one that had the right ingredients to create a dysfunctional board that would quickly apply the corporate cold shoulder to any board member who was willing ask the hard questions and disturb the board equilibrium. The review of NAB’s practices by APRA suggests that problems existed in the culture of the institution for some time. The environment was seen as lax; those responsible for overseeing risk management failed to either identify or follow up the limit breaches and other irregularities coming from the foreign exchange desk. Cornell (2004) stated “Stewart (the new CEO) was not just unwinding the past five years of mismanagement under Cicutto, but he is also unwinding the disasters from the preceding CEO”. The apparent complacency by the management and the Board seems to have stemmed from the HomeSide incident, if not before. Maiden’s (2004) view is that seeds were sown in 2001 when no director or board member took responsibility or the ‘fall’ for the AUD4.1 billion losses that occurred. NAB board and management recognized the public backlash that occurred against the bank when the foreign currency losses and subsequent board dispute revealed that there were shortcomings in its culture and management systems. In response to stakeholders’ needs for greater transparency and accountability NAB committed to a strategy to change the culture of the institution and rebuild trust and relationships. To accelerate cultural change the bank developed a new set of Corporate Principles and Behaviours with the cultural change being reinforced by leadership change at Board and senior management levels. Lynne Peacock, an executive director of the National in Europe, was moved to the Melbourne office and appointed the responsibility to oversee cultural change and improve NAB’s governance processes. Six months later a new streamlined leadership team was finalized that comprised a mix of executives, some from each of the three existing businesses and a number of external executives with a range of business experience (National Australia Bank, 2004b). To complement these strategies NAB developed a new business structure based on its three regional businesses (UK, NZ and Australia) within the group framework so that each business can focus on its own needs and develop strategies appropriate to its own local needs and opportunities (National Australia Bank, 2005a). 6.3 Accountability and the Role of the Regulator

How accountable was APRA as the banking industry's key financial regulator? There would seem to be a need for increased and more effective monitoring by the regulator and the question should be asked whether APRA was proactive enough. It appeared that there was considerable laxness in APRA’s oversight of NAB with a failure to act promptly to


warning signals (National Australia Bank, 2004). Additionally, APRA’s reliance on the PwC investigation into the foreign currency losses seemed inappropriate. In future, to avoid potential conflicts of interest the regulator may need to have sufficient resources to run its own independent audit committee/ investigative committee rather than relying on one of the big four accounting firms to undertake the factual part of the review, as happened in the NAB review. Mandatory ‘arm’s length’ investigation and more powers to be granted by legislation to the regulatory body may mitigate some of these concerns. The Wallis Report (1997) established APRA as a light-handed regulator, but the collapse of HIH in 2001 led to strong criticism that the regulator had been ‘asleep at the wheel’. The subsequent Royal Commission into the HIH AUD5.3 billion collapse found that APRA had several deficiencies, including staffing shortfalls, outdated legislation and an inadequate supervisory methodology. Post-HIH these inadequacies have been addressed and APRA has been given greater investigatory responsibilities (Grant, 2005). Whilst APRA’s response to NAB’s trading losses and breaches of risk management guidelines was swift and severe in terms of the conditions imposed upon NAB in March 2004, the impact of its actions were blunted when it is realised that the regulator had concerns as early as 2003. Following on-site visits in 2003, APRA expressed these concerns to the NAB board and management but failed to follow-up. Warnings should have been issued that unless the foreign currency irregularities were investigated and cleared to both the internal and external auditors’ satisfaction that closure of the foreign trading desk would occur. The lack of proactive behaviour by APRA in the NAB instance was similar to what occurred in regard to the HIH case. It appeared that APRA’s own simulation of HIH data on proposed new capital standards found that HIH would have failed those capital requirements as far back as 1995. There was no consideration of bringing that information to the APRA board level and calling HIH to account. The APRA Chairman, Jeffery Carmichael, when asked, agreed that it was something that APRA should have done (Jay, 2001). Whilst there are signs that the regulator may have been insufficiently proactive, particularly prior to 2003, it could be argued that its prompt actions once the NAB foreign currency losses became public in January 2004 prevented further losses occurring at the bank and prevented a loss of confidence occurring in the financial institution (Australian Prudential Regulatory Authority, 2004). The foreign currency trader misfortune has resulted in all traders being found guilty in a court of law (Murray, 2006). 7.

Limitations of the Paper

The use of a single case study has traditionally been viewed as a ‘poor base for generalising’ and may limit the external validity of this research (Yin, 2003).

However, the findings can be applied to other financial institutions in the same geographical location who fail to install similar measures of monitoring and control for their agents and sub agents. The findings in terms of the agency theory aspect and the ensuing ASX charter of rules can be generalised to any board and its members, albeit stemming from different situation. That is the shareholder and indeed stakeholders may be penalised for failure to install adequate control and monitoring systems. The limitations of this study extend to those associated with the issue of data which was obtained from information available in the public arena. The use of content analysis and its application to secondary data introduces a degree of subjectivity into the study, and its findings should be interpreted accordingly. 8.

Conclusion

Despite the NAB suffering significant losses during the period 2000-2005, at no time was it at risk of a potential bank failure. However, similar to HIH, World Com and Enron, NAB directors appear to have failed to respond to early danger signals. A junior member of staff, acting as a whistleblower, brought to management attention the practices of the foreign exchange desk that occurred unchecked due to lax oversight and failure to implement the NABs own risk management systems. The case study indicates that the NAB directors failed to ensure transparent systems of control and accountability of the divisions within the organisation. Lack of ongoing monitoring systems and complacency by management appears to have led to significant falls in profitability, loss of shareholder value and climbing cost ratios. The comparison of the NAB’s performance with the other major Australian banks in 2004-2005 tells a compelling story of underperformance that is consistent with the events that occurred. NAB under-performed all other major Australian banks in terms of profits, cost to income ratio and growth in assets. In the measures of profitability and cost efficiency examined, NAB had the lowest ROE, ROA and net interest income/average assets and the highest cost to income ratio of any of the five largest Australian banks. Additionally, these measures of profitability and costs for NAB were below the industry sector average. The falling profitability and increasing cost structures are consistent with the self interest and inefficiency aspects of agency theory and multiple agency theory. The good intentions of the NAB Board were not sufficient to protect the interests of the shareholders. Shareholders were the ultimate losers as market forces saw the NAB stock price fall by 19% providing support for the contention that poor corporate governance and lack of board control resulted in a negative impact on shareholder return.

109


The focus of this study has been on the shareholder, but the outcomes of control and regulation will reflect on all stakeholders interested in the activities of the corporation. Matheson (2005) believes that clear formalized roles for board members and training would alleviate most board dysfunction. The implementation of these suggestions would do much to improve board performance and accountability. It remains in the shareholders interest to continue to monitor both board and management function, while in turn they should monitor the actions of their contractors. The results of this study support a more proactive stance by management and regulators. As management and regulators react to issues of public concern resulting from a firm’s activities the adverse outcomes have already had financial consequences for many of the NAB shareholders. It is apparent that a lax Board, in relation to their oversight role to monitor the regulatory and voluntary policies and procedures, can result in loss of reputation and shareholder unease. This case study provides an Australian example of poor corporate governance and suggests that financial institutions and regulators can learn from the NAB’s experience. Failure to have topdown accountability can have significant impact on over-all performance, profitability and reputation. In particular, it suggests that management and Boards need to review their risk management procedures and regulators need to be more pro-active in their prudential oversight of financial institutions. References 1.

2.

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Acquaah-Gaisie, G., (2005), 'Towards More Effective Corporate Governance Mechanisms', Australian Journal of Corporate Law, vol. 18, pp. 1-47. Aguilera, R. V., Filatotchev, I., Gospel, H. & Jackson, G., (2007), 'An Organisational Approach to Comparative Governance: Costs, Contingencies and Complementaries', Organisational Science, vol. forthcoming. Ahrens, T. & Dent, J. F., (1998), 'Accounting and Organisations: Realising the Richness of Field Research', Journal of Management Accounting Research, vol. 10, no. 1-39. Arthur, N., Garvey, G., Swan, P. & Taylor, S., (1993), 'Agency Theory and "Management Research": A Comment', Australian Journal of Management, vol. 18, no. 93-102, p. 1. Australian Prudential Regulatory Authority, (2004), Report into Irregular Currency Options Trading at the National Australia Bank, APRA, Canberra. Australian Prudential Regulatory Authority, (2006a), Prudential Standard APS 510, APRA. Australian Prudential Regulatory Authority, (2006b), Prudential Practice Guide: Governance APG510, APRA, Canberra. Australian Stock Exchange, (2003), Principles of Good Corporate Governance Practice Reccomendations, viewed May 24 2007, .

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Bartholomeusz, S., (2004 a), 'Inexperience a Bigger Risk for NAB', The Age, 5 April 2004. Bartholomeusz, S., (2004b), 'Walter Holds A Pistol at NAB Board's Heads', The Age. Becht, M., Bolton, P. & Roell, A., (2005), Corporate Governance and Control European Corporate Governance Institute, Working Paper No. 02/2002, updated August 2005, Social Science Research Network, viewed 13 May 2006, . Cannon, D., Godwin, J. H. & Goldberg, S. R., (2008), 'Corporate Governance and Enterprise Risk Management', Journal of Corporate Accounting & Finance, vol. 19, no. 2, pp. 83-5. Chiang, H., (2005), 'An Empirical Study of Corporate Governance and Corporate Performance', The Journal of American Academy of Business, vol. 6, no. 1, pp. 95101. Child, J. & Rodrigues, S. B., (2003), Corporate Governance and New Organisational Focus: The Problem of Double and Multiple Agency, Working Paper 2003S, University of Birmingham, Birmingham. Collett, P. & Hrasky, S., (2005), 'Voluntary Disclosure of Corporate Governance Practices by listed Australian Companies', Corporate Governance, vol. 13, no. 12, pp. 188-96. Cornell, A., (2004), 'Closed World of the NAB Nexus', The Australian Financial Review, March 6, 2004, p. 24. CPA Australia, (2002), Index of Confidence in Corporate Reporting Surveys, viewed 30 May 2006, . Credit Collections World, (2001), HomeSide Takes a Hit, viewed 4 May 2005, . Crowther, D. & Renu Jatana, M. L., (2005), Agency Theory: A Cause of Failure of Corporate Governance, viewed 20 March 2008, . Daily, C. M. & Dalton, D. R., (1993), 'Board of Directors Leadership and Structure: Control and Implications', Entrepreneurship, Theory and Practice, vol. 17, no. Spring, pp. 65-82. de Andres, P., Azofra, V. & Lopez, F., (2005), 'Corporate Boards in OECD Countries: Size, Composition, Functioning and Effectiveness', Corporate Governance, vol. 13, no. 2, pp. 197-210. Doucouliagos, H. & Hoque, M. Z., (2005), Corporate Governance and Australian Bank Stock Prices, Deakin University, Melbourne. Elkington, J., (2006), 'Governance for Sustainability', Corporate Governance: An International Review, vol. 14, no. 6, pp. 522-9. Gizycki, M. & Lowe, P., (2000), 'The Australian Financial System in the 1990s', paper presented to The Australian Economy in the 1990s, The Reserve Bank of Australia Conference, Sydney. Grant, R., (2005), Australia's Corporate Regulators the ACCC, ASIC and APRA, Research Brief No. 16, 2004-05, Australian Government Regulation Taskforce, viewed 4 May 2006, $10b

6

6

10

14

4

5

5

PANEL B -DESCRIPTIVE STATISTICS Variable Q PROFIT RAWMDO MDO RAWTOP5 TOP5

120

Mean 1.290 4.211 10.55 -4.242 50.02 0.0074

Median 1.137 7.630 1.044 -4.553 48.87 -0.0452

Maximum 9.397 49.97 81.79 1.502 84.61 1.704

Minimum 0.2125 -48.68 0.0194 -8.545 21.90 -1.272

Std. Dev. 1.258 14.27 17.14 2.824 15.07 0.6630

Skewness 5.643 -0.9260 2.210 0.0729 0.2574 0.3539

Kurtosis 36.64 5.315 5.463 -1.267 -0.289 0.1404

Jacque-Bera 2622 18.31 53.36 37.98 23.09 18.08

Count 50 50 50 50 50 50


Table 1 continued RDSALE 4.705 0.0022 49.65 0.0000 12.31 2.999 8.588 140.0 26 LEV 26.85 25.39 86.91 0.034 16.69 1.197 2.838 6.241 50 MKTRISK 0.8168 0.7400 2.710 -0.070 0.5478 1.361 2.746 15.56 50 FIRMRISK 0.2006 0.1800 0.5500 0.070 0.1033 1.607 2.698 21.71 50 SALES ($M) 3578 1183 29463 49.30 6325 2.816 8.036 118.9 50 LIQ 1.500 1.463 6.704 0.2729 0.9886 3.181 15.32 400.7 50 PAYOUT 102.4 71.95 900.7 0.0000 146.9 5.025 27.44 1018 35 P/E 27.74 19.67 180.4 4.878 32.19 3.974 16.68 364.9 35 RETPROFIT ($M) 718.3 111.0 12995 -661.01 2366 4.573 21.02 851.1 50 The notation used in the above table is as follows: Q is the average of annual Tobin’s Q values for 2002 and 2003. Annual Tobin’s Q is calculated as [(year-end book value of debt + year-end market value of equity) / year end book value of assets]; PROFIT is the average annual return on capital for 2002 and 2003. Annual profit rates are calculated as [(net income / capital employed) x 100]; RAWMDO is the average year-end percentage of ordinary stock owned by directors calculated over 2002 and 2003; MDO is the natural log of [RAWMDO / (100RAWMDO)]; RAWTOP5 is the percentage of ordinary stock owned by the five largest shareholders during 2003; TOP5 is the natural log of [RAWTOP5 / (100-RAWTOP5)]; RDSALE is the average ratio of annual R&D expenditure to annual sales, and is the average of the 2002 and 2003 ratios; LEV is the average ratio of debt to the book value of assets, and is calculated as the average of the 2002 and 2003 ratios; MKTRISK is the β coefficient obtained from a weekly regression of stock returns on weekly market returns; FIRMRISK is the standard error of the β estimate obtained to measure MKTRISK; SALES is the average annual sales results obtained in 2002 and 2003; LIQ relates to the average yearend current ratio in 2002 and 2003, where current ratio is calculated as (Current Assets / Current Liabilities). With regard to banking institutions, LIQ is calculated as (loans / deposits). For insurance companies, LIQ is determined by (Premiums / Claims); PAYOUT is the average annual payout ratio over 2002 and 2003 as is calculated as [(annual dividends paid to ordinary shareholders / total annual net income) x 100]; P/E is a measure of market timing and is calculated as (stock price / EPS) and averaged over 2002 and 2003; and, RETPROFIT is the average annual balance of retained earnings over 2002 and 2003 including legal reserves and the current year’s net profit.

Kurtosis refers to the shape of the probability distribution of a given variable. Essentially, it measures the height of the peak and the size of the tails. As a normally distributed variable should have kurtosis of 3, some variables in this data set display non - normality. Of particular concern are the variables: Tobin’s Q, liquidity, payout ratio, P/E ratio and retained profits. The non-normality observed in Tobin’s Q could be of particular concern as it is one of two competing endogenous measures of firm performance. Non-normality of some remaining exogenous variables may be mitigated via a suitable transformation, however, that was not undertaken here to maintain similarities with this existing literature. The important principle to be appreciated from these descriptive statistics is the fact that with some non-normal variables results may differ across competing models. 5.

Results And Discussion

5.1 Two Equation Model 5.1A OLS Results Initially, a 2 equation model comparable to that of Welch (2003) has been tested. Leverage has not been classified as an endogenous variable in either the ordinary least squares or two stage least squares analysis. As illustrated by results contained in Table 2A the ordinary least squares regression yielded insignificant results with regard to the variables explaining performance when measured by Tobin’s Q. As illustrated by results contained in Tables 2A, the ordinary least squares regression yielded insignificant results with regard to the variables explaining performance when measured by Tobin’s Q. Neither the basic nor biased ordinary least squares tests uncovered any variables exhibiting significant results. As these results may have been flawed by the

inclusion of imperfect data, a regression with the exclusion of research and development expenditure to sales has also been executed. However, the subsequent results also gave no insight into the determination of performance and have not been included in the analysis. Interestingly, where Tobin’s Q is the performance measure, performance and ownership structure do not exhibit a significant relationship. However, when profit is employed as the performance measure (as seen in Table 2B), managerial ownership is a significantly negative predictor of corporate performance. Although this appears contrary to the incentive alignment hypothesis put forward by Jensen and Meckling (1976), this may support the management entrenchment concept advanced by Morck et. al (1988). As previously explained, the management entrenchment theory supports the notion that managerial ownership may adversely impact on performance by frustrating takeover bids thereby preserving incumbent management’s inefficient administration. Additionally, profit was not significant in explaining insider ownership. The ordinary least squares regression did produce more significant results regarding explanation of management ownership. Pursuant to the results in Table 2A and Table 2B, market risk, sales and the media and finance industry dummy variables were all significant in explaining ownership level. The positive coefficient for the media industry is consistent with the notion that this industry exudes amenity potential above and beyond that generated by profitability (see Demsetz and Lehn (1985)). Consequently, management ownership is more concentrated within this industry. In contrast, the negative coefficient for firms within the finance industry supports the view that excessive regulation within this industry imposes unwanted constraint upon shareholders. As noted in

121


Demsetz and Villalonga (2001,p.222)“regulation severely circumscribes what management and outside

investors can do with the assets owned by these firms”.

Table 2A. Regression Results for Two Equation Model Where Performance is Measured by Average Annual Tobin’s Q Performance

Ownership

Variable

OLS

BIASED OLS

2SLS

Variable

OLS

BIASED OLS

2SLS

INTERCEPT

1.628 (3.598***) -0.0239 (-0.0757) 0.0228 (0.9902) -0.2256 (-0.549) -0.0055 (-0.4304) -0.3825 (-0.5763) -0.7381 (-1.11) -0.2589 (-0.3827)

1.247 (2.157**) -0.0821 (-1.055) 0.0589 (0.1814) 0.0222 (0.9668) -0.0879 (-0.2041) -0.0059 (-0.4634) -0.2082 (-0.3048) -1.003 (1.413) -0.3884 (-0.5656)

1.646 (2.221**) 0.0039 (0.0316) -0.0267 (-0.0806) 0.0227 (0.9586) -0.2288 (-0.5349) -0.0055 (-0.4264) -0.3921 (-0.5320) -0.7282 (-0.9807) -0.2536 (0.7048)

INTERCEPT

-5.557 -6.232*** 0.0045 0.2396 2.552 2.295** -1.423 -1.352 -0.4327 -0.3992 3.145 3.315*** -2.636 -0.5663 -2.559 -4.126*** -

-4.686 -4.606*** 0.0004 0.0227 2.314 2.107** -1.836 -1.731* -0.5824 -0.5466 3.240 3.481*** -3.588 -0.7807 -2.68E-10 -4.375*** -0.4075 (-1.668)

-1.638 -0.6925 -0.0199 -0.8640 1.577 1.298 -3.520 -2.253** -1.207 -1.056 3.063 3.307*** -2.126 -0.4674 -2.63E-10 -4.337*** -2.239 (-1.78*)

MDO TOP5 RDSALE RDDUM LEV MEDIA FINANCE UTILITY

LEV MEDIA FINANCE UTILITY MKTRISK FIRMRISK SALES Q

R2 0.1178 0.1411 0.1178 R2 0.5363 0.5658 0.5696 Adjusted R2 -0.0292 -0.0264 -0.0543 Adjusted R2 0.4591 0.4811 0.4857 Note: T-statistics are reported below the coefficient estimates and documented within ( ). * denotes significant to 10% level; ** denotes significant to the 5% level; and, *** denotes significant to the 1% level. The notation used in the above table is as follows: Tobin’s Q is the average of annual Tobin’s Q values for 2002 and 2003. Annual Tobin’s Q is calculated as [(year-end book value of debt + year-end market value of equity) / year end book value of assets]; MDO is the natural log of [RAWMDO / (100-RAWMDO)]; TOP5 is the natural log of [RAWTOP5 / (100-RAWTOP5)]; RDSALE is the average ratio of annual R&D expenditure to annual sales, and is the average of the 2002 and 2003 ratios; RDDUM is a dummy variable equalling 0 where the firm reports R&D expenditure and 1 where is fails to; LEV is the average ratio of debt to the book value of assets, and is calculated as the average of the 2002 and 2003 ratios; MEDIA is a dummy variable equalling 1 where the firm operates in the media industry and 0 where it operates elsewhere; FINANCE is a dummy variable equalling 1 where the firm operates in the finance industry and 0 where it operates elsewhere; UTILITY is a dummy variable equalling 1 where the firm operates in the utility industry and 0 where it operates elsewhere MKTRISK is the β coefficient obtained from a weekly regression of stock returns on weekly market returns; FIRMRISK is the standard error of the β estimate obtained to measure MKTRISK; and, SALES is the average annual sales results obtained in 2002 and 2003.

Table 2B. Regression Results for Two Equation Model Where Performance is Measured by Average Accounting Profit Performance

Ownership

Variable

OLS

BIASED OLS

2SLS

Variable

OLS

BIASED OLS

2SLS

INTERCEPT

7.126 (1.343) -2.678 (-0.7239) 0.0473 (0.1753) -5.423 (-1.125) -0.0446 (-0.2979) 2.559 (0.3288) 0.1954 (0.0251)

-0.3523 (-0.0533) -1.614 (-1.813*) -1.051 (-0.2831) 0.0362 (0.1378) -2.716 (-0.5516) -0.0528 (-0.3619) 5.985 (0.7662) -5.014 (-0.6178)

-6.299 (-0.7614) -2.823 (-2.064**) -0.6287 (-0.1700) 0.1404 (0.5323) -3.126 (-0.6548) -0.0254 (-0.1755) 9.540 (1.16) -7.045 (-0.8501)

INTERCEPT

-5.558 (-6.233***) 0.0045 (0.2396) 2.552 (2.296**) -1.424 (-1.352) -0.4327 (-0.3992) 3.145 (3.316***) -2.637 (-0.5663) -2.559 (-4.127***)

-4.358 (-3.467***) 0.0030 (0.1603) 2.305 (2.065**) -1.818 (-1.678) -0.4184 (-0.3897) 3.305 (3.489***) -7.546 (-1.282) -2.75E-10 (-4.362***)

-3.853 (-2.993***) -0.0118 (-0.5732) 2.727 (2.507**) -2.043 (-1.887*) 0.1940 (0.1744) 2.748 (2.891***) -3.311 (-0.7271) -2.53E-10 (-4.192***)

MDO TOP5 RDSALE RDDUM LEV MEDIA FINANCE

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LEV MEDIA FINANCE UTILITY MKTRISK FIRMRISK SALES


Table 2B continued UTILITY

5.148 (0.6489)

2.604 (0.3317)

1.294 (0.1644)

PROFIT

-

-0.0411 (-1.342)

-0.198 (-1.795*)

R2 0.0574 0.1274 0.1461 R2 0.5363 0.5559 0.5701 2 Adjusted R -0.0997 -0.0429 -0.0205 Adjusted R2 0.4591 0.4692 0.4862 Note: T-statistics are reported below the coefficient estimates and documented within ( ). * denotes significant to 10% level; ** denotes significant to the 5% level; and, *** denotes significant to the 1% level. The notation used in the above table is as follows: PROFIT is the average of annual return on capital values for 2002 and 2003. Return on capital is calculated as [(net income / capital employed) x 100]; MDO is the natural log of [RAWMDO / (100-RAWMDO)]; TOP5 is the natural log of [RAWTOP5 / (100-RAWTOP5)]; RDSALE is the average ratio of annual R&D expenditure to annual sales, and is the average of the 2002 and 2003 ratios; RDDUM is a dummy variable equalling 0 where the firm reports R&D expenditure and 1 where is fails to; LEV is the average ratio of debt to the book value of assets, and is calculated as the average of the 2002 and 2003 ratios; MEDIA is a dummy variable equalling 1 where the firm operates in the media industry and 0 where it operates elsewhere; FINANCE is a dummy variable equalling 1 where the firm operates in the finance industry and 0 where it operates elsewhere; UTILITY is a dummy variable equalling 1 where the firm operates in the utility industry and 0 where it operates elsewhere MKTRISK is the β coefficient obtained from a weekly regression of stock returns on weekly market returns; FIRMRISK is the standard error of the β estimate obtained to measure MKTRISK; and, SALES is the average annual sales results obtained in 2002 and 2003.

An entity’s size, as measured by sales, is a negative predictor of ownership regardless of the performance measure engaged. This result is consistent with Demsetz and Villalonga (2001) and seeks to highlight that as a corporation grows in size, a larger investment is required by shareholders to own a given percentage of stock when compared with a smaller firm. Lastly, market risk is a strong positive forecaster of management ownership, although firm-specific risk produced insignificant results. This is consistent with the results of Demsetz and Villalonga (2001) who also reported market risk as a significantly positive influence on management stockholdings. Although this appears contrary to market pragmatism, two theories are elucidated in this study. One possible cause of the positive coefficient reported for market risk may be the fact that as risk increases, management tie their funds up in businesses where they have an acute understanding. Additionally, firms exhibiting higher levels of risk may insist on their management team purchasing stock to ensure incentive alignment. 5.1B Two Stage Least Squares Results In addition to the ordinary least squares analysis, a two-stage least squares regression has also been conducted to account for the endogeneity of ownership. Although results for these tests yielded similar results to the ordinary least squares approach, there were some subtle distinctions. Once again, the variables explaining performance, as measured by Tobin’s Q, did not produce significant results. This is consistent with the findings of Demsetz and Villalonga (2001) and highlights that the ownership structure of an entity is unique to the individual corporation. Although a dispersed group of shareholders intensifies the agency problem, it also generates compensating advantages. However, where accounting profit is used as the performance indicator, management stock ownership is a more highly significant and negative predictor of performance compared with the ordinary least squares approach. Once again, this is consistent with the

management entrenchment hypothesis put forth by Morck et. al. (1988) and reinforced by Hermalin and Weisbach (1991), but challenges the theory of incentive alignment advanced by Jensen and Meckling (1976). With regard to the determinants of managerial ownership, it appears as though both measures of performance have a negative impact on director’s interests within an entity. Although this is contrary to the notion that impressive performance would lead management to acquire more stock, perhaps they choose to sell stock during periods of prosperity “in the expectation that today’s good performance will be followed by poorer performance” (Demsetz and Villalonga, p.228). This is also reinforced by the findings of Loderer and Martin (1997) who assert that managers of organisations with impressive Tobin’s Q results will choose to liquidate part of their stockholdings to diversify their wealth. The only other notable disparity between ordinary least squares and the two-stage least squares regression was the fact that the media dummy variable was no longer significant where Tobin’s Q was employed as the performance measure. However, where profit is utilised as the performance gauge, firms within the media industry continue to display ownership characteristics consistent with this ‘amenity potential’ concept previously expounded. 5.2 Three Equation Model 5.2A OLS Results The ordinary least squares results for the three equation model yielded similar results to those obtained under the two equation system. Again, we summarise the results from employing profit as an alternative to Tobin’s Q. The variables employed to explain performance were all insignificant where Tobin’s Q indicates performance. However, in a similar manner to the two equation framework, managerial ownership continues to negatively effect on profitability in a significant manner. Additionally, market risk, firm size and the media dummy variable continued to impact on the level of managerial ownership in the same fashion as occurred under the two equation model. The only element that differed

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within the three equation framework was the fact that the finance industry dummy variable was no longer a significant negative predictor of ownership concentration. Ordinary least squares presented some intriguing results for the equation explaining leverage. Of the nine variables engaged, only liquidity was significant in describing the extent of a corporation’s leverage. Results indicate that liquidity is a negative predictor of leverage within an entity which appears confounding. It was anticipated that liquidity would positively impact on a firm’s leverage due to the fact that it would facilitate the payment of short-term

interest as it falls due. However, the negative coefficient reported for liquidity challenges this idea. The only plausible reason for liquidity impacting negatively on a firm’s debt to asset ratio is the fact that it is generally firms with funding shortages that choose to lever upwards. However, as debt financing generally relates to long-term funding requirements, opposed to present cash flow issues, this hypothesis is not robust. These results highlight the need for further research into the determinants of leverage within an organisation’s capital structure.

Table 3A.OLS Results for Three Equation Model Where Performance is Measured by Average Annual Tobin’sQ Variable INTERCEPT MDO TOP5 RDSALE RDDUM LEV MEDIA FINANCE UTILITY

Performance OLS BIASED OLS 1.476 (5.250***) -0.0572 (-0.1888) 0.0266 (1.262) -0.227 (-0.5577) -0.3558 (-0.5436) -0.7132 (-1.087) -0.3533 (-0.5575)

1.247 (2.157**) -0.0821 (-1.055) 0.0589 (0.1814) 0.0222 (0.9668) -0.0879 (-0.2041) -0.0059 (-0.4634) -0.2082 (-0.3048) -1.003 (1.413) -0.3884 (-0.5656)

Variable INTERCEPT LEV MEDIA FINANCE UTILITY MKTRISK FIRMRISK SALES Q

Ownership OLS BIASED OLS -5.454 (-7.067***) 2.571 (2.344**) -1.431 (-1.375) -0.3540 (-0.3465) 3.132 (3.344***) -2.541 (-0.5539) -2.56E-10 (-4.169***) -

-4.686 (-4.606***) 0.0004 (0.0227) 2.314 (2.107**) -1.836 (-1.731*) -0.5824 (-0.5466) 3.24 (3.481***) -3.588 (-0.7807) -2.68E-10 (-4.375***) -0.4075 (-1.668)

Variable INTERCEPT SALES MKTRISK FIRMRISK LIQ Q PAYOUT PAYPEDUM P/E RETPROFIT

Leverage OLS BIASED OLS 42.77 (5.756***) -7.62E-10 (-1.147) 2.883 (0.3978) -23.42 (-0.5919) -6.17 (-2.46**) -0.0116 (-0.28) 3.97 (0.5572) -0.1272 (-0.6754) 7.19E-10 (0.5212)

45.16 (5.689***) -8.08E-10 (-1.209) 2.659 (0.3656) -23.60 (-0.5946) -6.031 (-2.392**) -1.698 (-0.8754) -0.0213 (-0.4953) 3.426 (0.4776) -0.0868 (-0.4467) 7.75E-10 (0.5595)

R2 0.1139 0.1411 R2 0.5357 0.5658 R2 0.2378 0.2521 Adjusted R2 -0.0097 -0.0264 Adjusted R2 0.4709 0.4811 Adjusted R2 0.0891 0.0839 Note: T-statistics are reported below the coefficient estimates and documented within ( ). * denotes significant to 10% level; ** denotes significant to the 5% level; and, *** denotes significant to the 1% level. The notation used in the above table is as follows: Q is the average of annual Tobin’s Q values for 2002 and 2003. Annual Tobin’s Q is calculated as [(year-end book value of debt + year-end market value of equity) / year end book value of assets]; MDO is the natural log of [RAWMDO / (100-RAWMDO)]; TOP5 is the natural log of [RAWTOP5 / (100-RAWTOP5)]; RDSALE is the average ratio of annual R&D expenditure to annual sales, and is the average of the 2002 and 2003 ratios; RDDUM is a dummy variable equalling 0 where the firm reports R&D expenditure and 1 where is fails to; LEV is the average ratio of debt to the book value of assets, and is calculated as the average of the 2002 and 2003 ratios; MEDIA is a dummy variable equalling 1 where the firm operates in the media industry and 0 where it operates elsewhere; FINANCE is a dummy variable equalling 1 where the firm operates in the finance industry and 0 where it operates elsewhere; UTILITY is a dummy variable equalling 1 where the firm operates in the utility industry and 0 where it operates elsewhere MKTRISK is the β coefficient obtained from a weekly regression of stock returns on weekly market returns; FIRMRISK is the standard error of the β estimate obtained to measure MKTRISK; SALES is the average annual sales results obtained in 2002 and 2003; LIQ relates to the average year-end current ratio in 2002 and 2003, where current ratio is calculated as (Current Assets / Current Liabilities). With regard to banking institutions, LIQ is calculated as (loans / deposits). For insurance companies, LIQ is determined by (Premiums / Claims); PAYOUT is the average annual payout ratio over 2002 and 2003 as is calculated as [(annual dividends paid to ordinary shareholders / total annual net income) x 100]; PAYPEDUM is a dummy variable equalling 1 if the firm had negative EPS, or 0 where EPS was positive; P/E is a measure of market timing and is calculated as (stock price / EPS) and averaged over 2002 and 2003; and, RETPROFIT is the average annual balance of retained earnings over 2002 and 2003 including legal reserves and the current year’s net profit.

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 3B. OLS Results for Three Equation Model Where Performance is Measured by Average Accounting Profit Performance

Ownership

Leverage

Variable

OLS

BIASED OLS

Variable

OLS

BIASED OLS

Variable

OLS

BIASED OLS

INTERCEPT

5.895 (1.790*) -2.948 (-0.831) 0.0780 (0.3164) -5.434 (-1.140) 2.777 (0.3622) 0.3976 (0.0518) 4.381 (0.5902)

-0.3523 (-0.0533) -1.614 (-1.813*) -1.051 (-0.2831) 0.0362 (0.1378) -2.716 (-0.5516) -0.0528 (-0.3619) 5.985 (0.7662) -5.014 (-0.6178) 2.604 (0.3317)

INTERCEPT

-5.454 (-7.067***) 2.571 (2.345**) -1.431 (-1.375) -0.3540 (-0.3465) 3.133 (3.344***) -2.541 (-0.5539) -2.56E-10 (-4.169***) -

-4.358 (-3.467***) 0.0030 (0.1603) 2.305 (2.065**) -1.818 (-1.678) -0.4184 (-0.3897) 3.305 (3.489***) -7.546 (-1.282) -2.75E-10 (-4.362***) -0.0411 (-1.342)

INTERCEPT

42.77 (5.756***) -7.62E-10 (-1.147) 2.883 (0.3978) -23.42 (-0.5919) -6.171 (-2.46**) -0.0116 (-0.2799) 3.970 (0.5572) -0.1272 (-0.6754) 7.19E-10 (0.5212)

43.08 (4.305***) -7.65E-10 (-1.131) 2.856 (0.3880) -24.50 (-0.5307) -6.151 (-2.390**) -0.0128 (-0.0473) -0.0125 (-0.2712) 3.876 (0.5178) -0.1242 (-0.6172) 7.20E-10 (0.5151)

MDO TOP5

RDDUM LEV MEDIA FINANCE UTILITY

LEV MEDIA FINANCE UTILITY MKTRISK FIRMRISK SALES PROFIT

SALES MKTRISK FIRMRISK LIQ PROFIT PAYOUT PAYPEDUM P/E RESERVES

R2 0.05542 0.1274 R2 0.5357 0.5559 R2 0.2378 0.2378 Adjusted R2 -0.07638 -0.0429 Adjusted R2 0.4709 0.4692 Adjusted R2 0.0891 0.0664 Note: T-statistics are reported below the coefficient estimates and documented within ( ). * denotes significant to 10% level; ** denotes significant to the 5% level; and, *** denotes significant to the 1% level. The notation used in the above table is as follows: The notation used in the above table is as follows: PROFIT is the average of annual return on capital values for 2002 and 2003. Return on capital is calculated as [(net income / capital employed) x 100]; MDO is the natural log of [RAWMDO / (100-RAWMDO)]; TOP5 is the natural log of [RAWTOP5 / (100-RAWTOP5)]; RDSALE is the average ratio of annual R&D expenditure to annual sales, and is the average of the 2002 and 2003 ratios; RDDUM is a dummy variable equalling 0 where the firm reports R&D expenditure and 1 where is fails to; LEV is the average ratio of debt to the book value of assets, and is calculated as the average of the 2002 and 2003 ratios; MEDIA is a dummy variable equalling 1 where the firm operates in the media industry and 0 where it operates elsewhere; FINANCE is a dummy variable equalling 1 where the firm operates in the finance industry and 0 where it operates elsewhere; UTILITY is a dummy variable equalling 1 where the firm operates in the utility industry and 0 where it operates elsewhere MKTRISK is the β coefficient obtained from a weekly regression of stock returns on weekly market returns; FIRMRISK is the standard error of the β estimate obtained to measure MKTRISK; SALES is the average annual sales results obtained in 2002 and 2003; LIQ relates to the average year-end current ratio in 2002 and 2003, where current ratio is calculated as (Current Assets / Current Liabilities). With regard to banking institutions, LIQ is calculated as (loans / deposits). For insurance companies, LIQ is determined by (Premiums / Claims); PAYOUT is the average annual payout ratio over 2002 and 2003 as is calculated as [(annual dividends paid to ordinary shareholders / total annual net income) x 100]; PAYPEDUM is a dummy variable equalling 1 if the firm had negative EPS, or 0 where EPS was positive; P/E is a measure of market timing and is calculated as (stock price / EPS) and averaged over 2002 and 2003; and, RETPROFIT is the average annual balance of retained earnings over 2002 and 2003 including legal reserves and the current year’s net profit.

Thus, where leverage is incorporated as an endogenous variable, ordinary least squares highlights that ownership structure only impacts on performance where profitability is the performance gauge, whilst performance has little effect on managerial ownership. 5.2B Two Stage Least Squares Results Tables 4A and 4B illustrate that results for the twostage least squares analysis were comparable to that reported for the two equation system. Once again, none of the variables seeking to explain performance, as measured by Q, were significant. However, in a similar manner to the previous two stage tests, managerial ownership had a statistically significant and negative influence on performance where profit was engaged as the performance measure. Additionally, market risk, firm size and the finance industry dummy variable were significant in

predicting director’s interests within an organisation which is consistent with the two-stage least squares results reported previously. However, where both performance measures were significant in explaining ownership under the two equation framework, they remain negative but insignificant results within a three equation system. This seeks to illustrate that once the endogeneity of leverage is taken into account, performance is not significant in the prediction of ownership.

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 TABLE 4A. 2SLS Results for Three Equation Model Where Performance is Measured by Average Annual Tobin’s Q

Variable INTERCEPT MDO TOP5 RDSALE RDDUM LEV MEDIA FINANCE UTILITY

Performance 2SLS 1.058 (1.072) -0.0007 (-0.0059) -0.0957 (-0.2912) 0.0329 (1.338) -0.2424 (-0.5667) 0.0155 (0.5647) -0.3202 (-0.4348) -0.7168 (-0.9682) -0.4716 (-0.6756)

Variable INTERCEPT LEV MEDIA FINANCE UTILITY MKTRISK FIRMRISK SALES Q

Ownership 2SLS -2.931 (-1.070) -0.0030 (-0.0618) 1.800 (1.502) -2.919 (-2.003*) -1.207 (-1.046) 3.106 (3.188***) -2.449 (-0.5083) -2.61E-10 (-4.278***) -1.634 (-1.334)

Variable INTERCEPT SALES MKTRISK FIRMRISK LIQ Q PAYOUT PAYPEDUM P/E RESERVES

Leverage 2SLS 53.84 (6.243***) -6.78E-10 (-1.070) -3.450 (-0.4624) 9.816 (0.2423) -1.783 (-0.5781) -15.97 (-2.253**) -0.0243 (-0.6084) 3.404 (0.5005) -0.0295 (-0.1598) 1.19E-09 (0.8964)

R2 0.1208 R2 0.5618 R2 0.3237 2 2 Adjusted R -0.0508 Adjusted R 0.4763 Adjusted R2 0.1715 Note: T-statistics are reported below the coefficient estimates and documented within ( ). * denotes significant to 10% level; ** denotes significant to the 5% level; and, *** denotes significant to the 1% level. The notation used in the above table is as follows: Q is the average of annual Tobin’s Q values for 2002 and 2003. Annual Tobin’s Q is calculated as [(year-end book value of debt + year-end market value of equity) / year end book value of assets]; MDO is the natural log of [RAWMDO / (100-RAWMDO)]; TOP5 is the natural log of [RAWTOP5 / (100-RAWTOP5)]; RDSALE is the average ratio of annual R&D expenditure to annual sales, and is the average of the 2002 and 2003 ratios; RDDUM is a dummy variable equalling 0 where the firm reports R&D expenditure and 1 where is fails to; LEV is the average ratio of debt to the book value of assets, and is calculated as the average of the 2002 and 2003 ratios; MEDIA is a dummy variable equalling 1 where the firm operates in the media industry and 0 where it operates elsewhere; FINANCE is a dummy variable equalling 1 where the firm operates in the finance industry and 0 where it operates elsewhere; UTILITY is a dummy variable equalling 1 where the firm operates in the utility industry and 0 where it operates elsewhere MKTRISK is the β coefficient obtained from a weekly regression of stock returns on weekly market returns; FIRMRISK is the standard error of the β estimate obtained to measure MKTRISK; SALES is the average annual sales results obtained in 2002 and 2003; LIQ relates to the average year-end current ratio in 2002 and 2003, where current ratio is calculated as (Current Assets / Current Liabilities). With regard to banking institutions, LIQ is calculated as (loans / deposits). For insurance companies, LIQ is determined by (Premiums / Claims); PAYOUT is the average annual payout ratio over 2002 and 2003 as is calculated as [(annual dividends paid to ordinary shareholders / total annual net income) x 100]; PAYPEDUM is a dummy variable equalling 1 if the firm had negative EPS, or 0 where EPS was positive; P/E is a measure of market timing and is calculated as (stock price / EPS) and averaged over 2002 and 2003; and, RETPROFIT is the average annual balance of retained earnings over 2002 and 2003 including legal reserves and the current year’s net profit.

Table 4B. 2SLS Results for Three Equation Model Where Performance is Measured by Average Accounting Profit Performance

Ownership

Leverage

Variable

2SLS

Variable

2SLS

Variable

2SLS

INTERCEPT

-2.326 (-0.2117) -2.814 (-2.067**) -0.4251 (-0.1162) 0.0959 (0.3504) -2.957 (-0.6207) -0.1744 (-0.5701) 9.352

INTERCEPT

-4.436 (-2.776***) 0.0082 (0.1939) 2.655 (2.398**) -1.986 (-1.862*) -0.1110 (-0.1026) 2.821 (2.833***) -3.540

INTERCEPT

43.31 (5.151***) -7.65E-10 (-1.137) 2.540 (0.3295) -23.35 (-0.5831) -6.063 (-2.293**) -0.1186 (-0.1452) -0.0107

MDO TOP5 RDSALE RDDUM LEV MEDIA

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LEV MEDIA FINANCE UTILITY MKTRISK FIRMRISK

SALES MKTRISK FIRMRISK LIQ PROFIT PAYOUT


Table 4B continued FINANCE UTILITY

(1.140) -6.875 (-0.8338) 2.195 (0.2824)

SALES PROFIT

(-0.7555) -2.55E-10 (-4.225***) -0.1806 (-1.669)

PAYPEDUM P/E RETPROFIT

(-0.2528) 4.012 (0.5558) -0.1286 (-0.6741) 7.51E-10 (0.5313)

R2 0.1526 R2 0.5719 0.2382 2 Adjusted R -0.0127 Adjusted R2 0.4884 0.0668 Note: T-statistics are reported below the coefficient estimates and documented within ( ). * denotes significant to 10% level; ** denotes significant to the 5% level; and, *** denotes significant to the 1% level. The notation used in the above table is as follows: The notation used in the above table is as follows: PROFIT is the average of annual return on capital values for 2002 and 2003. Return on capital is calculated as [(net income / capital employed) x 100];; MDO is the natural log of [RAWMDO / (100-RAWMDO)]; TOP5 is the natural log of [RAWTOP5 / (100-RAWTOP5)]; RDSALE is the average ratio of annual R&D expenditure to annual sales, and is the average of the 2002 and 2003 ratios; RDDUM is a dummy variable equalling 0 where the firm reports R&D expenditure and 1 where is fails to; LEV is the average ratio of debt to the book value of assets, and is calculated as the average of the 2002 and 2003 ratios; MEDIA is a dummy variable equalling 1 where the firm operates in the media industry and 0 where it operates elsewhere; FINANCE is a dummy variable equalling 1 where the firm operates in the finance industry and 0 where it operates elsewhere; UTILITY is a dummy variable equalling 1 where the firm operates in the utility industry and 0 where it operates elsewhere MKTRISK is the β coefficient obtained from a weekly regression of stock returns on weekly market returns; FIRMRISK is the standard error of the β estimate obtained to measure MKTRISK; SALES is the average annual sales results obtained in 2002 and 2003; LIQ relates to the average year-end current ratio in 2002 and 2003, where current ratio is calculated as (Current Assets / Current Liabilities). With regard to banking institutions, LIQ is calculated as (loans / deposits). For insurance companies, LIQ is determined by (Premiums / Claims); PAYOUT is the average annual payout ratio over 2002 and 2003 as is calculated as [(annual dividends paid to ordinary shareholders / total annual net income) x 100]; PAYPEDUM is a dummy variable equalling 1 if the firm had negative EPS, or 0 where EPS was positive; P/E is a measure of market timing and is calculated as (stock price / EPS) and averaged over 2002 and 2003; and, RETPROFIT is the average annual balance of retained earnings over 2002 and 2003 including legal reserves and the current year’s net profit.

Interestingly, with regard to the two-stage least squares analysis of leverage, liquidity is only significant in explaining a corporation’s borrowing decisions where accounting profit is used as the performance measure. Where return on capital is used to gauge a firm’s performance, liquidity remains a significantly negative predictor of leverage. In contrast, where Tobin’s Q is employed, it is a statistically negative forecaster for a firm’s borrowing requirements. Once again, this result appears to contradict the original predictions for performance. It was anticipated that an entity’s performance would impact positively on leverage due to the tax shields offered by debt. However, the negative impact that performance has on leverage is consistent with the pecking order theory of financing outlined by Myers (1984), whereby firms prefer to fund operations through retained earnings rather than debt or equity. Based on this theory, the coefficient for retained earnings should also be negative. This is due to the fact that as a corporation’s reserves expand, the entity will become less reliant on debt financing. As retained profits reported a positive and statistically insignificant relationship with leverage, this justification is not robust. The confounding results with regard to the factors affecting leverage warrants further research. Perhaps there are elements overlooked within this current study that have high explanatory power with regard to the level of debt undertaken by firms. The results highlighted in this section offer important implications for the management of corporations. Particularly, the main finding that was consistent through the initial two equation model and subsequent three equation system was the fact that

director ownership impacts negatively on profitability. This may influence the manner in which executive remuneration is administered within Australian corporations, and indeed other marketbased economies throughout the world. These results highlight that stock ownership may not be an efficient tool to induce management to undertake valuemaximising initiatives. Consequently, this paper casts doubt on several widespread practices used to enhance corporate governance. Particularly, the justification regarding the increasing use of executive stock and option plans is based on the assumption that performance will increase due to the incentive alignment theory. The empirical evidence within this paper, and reinforced by Cho (1998), suggests that compensation schemes such as these may have an adverse effect on performance. Furthermore, a similar situation may occur within those companies which compel incumbent management to purchase stock in the firm. 6.

Conclusion

This paper has attempted to ascertain the relationship between ownership structure and firm performance. Many previous studies have classified ownership as an endogenous variable when seeking to explain performance. Consequently, a two equation system has been established to assess the nature of this relationship. The research documented within the current investigation distinguishes itself from prior examinations due to the fact that leverage is also classified as endogenous. Consequently, a three equation econometric model has been developed and empirically investigated using a sample of fifty

127


companies listed on the ASX over the period 20022003. Ordinary least squares and a two stage least squares analysis have been undertaken to establish whether ownership and performance are linearly related. With regard to the initial two equation system, ordinary least squares results indicate that ownership structure and performance, as measured by Tobin’s Q, have a statistically insignificant relationship. Where a two stage least squares analysis is employed, Tobin’s Q has a significantly negative impact on the level of managerial ownership. Where profit is utilised as the performance measure, managerial ownership is a significantly negative predictor of performance under ordinary least squares and two stage least squares analysis. These findings are congruent to those expounded by Morck et. al (1988) with regard to the management entrenchment hypothesis. Interestingly, in contrast to the ordinary least squares analysis, profitability, like Tobin’s Q, has a significantly negative effect on director’s interests. This seeks to illustrate the fact that management may wish to liquidate part of their stockholding during prosperous periods to diversify their wealth. To further investigate the relationship between ownership structure and corporate performance, a reclassification of variables has been undertaken. Specifically, a three equation model was developed based on the notion that leverage is endogenous to the system. Where Tobin’s Q was engaged as the performance measure, ordinary least squares and two stage least squares examinations yielded insignificant results. Management ownership continued to negatively affect performance, as measured by profitability. Finally, where both performance measures were significant in explaining ownership structure under the two equation model, they are statistically insignificant when leverage is reclassified. This seeks to illustrate that once the endogeneity of leverage is accounted for, performance is not significant in predicting ownership. Whether there is an improvement when systems of equations are estimated and tested against each other in a FIML framework has not been undertaken within this literature. In this framework it is possible to artificially nest two and three equation systems within a comprehensive model. Then leverage can be treated as exogenously, recursively or simultaneously determined. It is also possible to specify a system that is exactly identified by a variation of the matrix rank condition. This is an area for future research.

2. 3. 4.

5. 6. 7. 8.

9.

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Berle, A. & Means, G. 1932, The Modern Corporation and Private Property, The Macmillan Company, New York.

20.

Cho, M-H. 1998, ‘Ownership structure, investment and the corporate value: An empirical analysis’, Journal of Financial Economics, vol.47, pp.103-21 Core, J., Guay, W. & Larcker, D. 2003, ‘Executive equity compensation and incentives: A survey’, FRBNY Economic Policy Review, April, pp.27-50 Craswell, A., Taylor, S. & Saywell, R. 1997, ‘Ownership structure and corporate performance: Australian evidence’, Pacific-Basin Finance Journal, vol.5, pp.301-23 Demsetz, H. 1983, ‘The structure of ownership and the theory of the firm’, Journal of Law and Economics, vol.26, pp.375-90 Demsetz, H. & Lehn, K. 1985, ‘The structure of corporate ownership: Causes and consequences’, Journal of Political Economy, vol.93, pp.1155-77 Demsetz, H. & Villalonga, B. 2001, ‘Ownership structure and corporate performance’, Journal of Corporate Finance, vol.7, pp.209-33 Faccio, M. & Lasfer, M.A. 1999, ‘Managerial ownership, board structure and firm value: The UK evidence.’, Working Paper Series, Cass Business School and Vanderbilt University Hermalin, B. & Weisbach, M. 1991, ‘The effects of board composition and direct incentives on firm performance’, Financial Management, vol.20, pp.10112 Hillegeist, S. & Penalva, F. 2003, ‘Stock option incentives and firm performance’, Working Paper Series, Kellogg School of Management and IESE Business School Himmelberg, C., Hubbard, R. & Palia, D. 1999, ‘Understanding the determinants of managerial ownership and the link between ownership and performance’, Journal of Financial Economics, vol.53, pp.353-84 Holderness, C., Kroszner, R. & Sheehan, D. 1999, ‘Were the good old days that good? Evolution of managerial stock ownership and corporate governance since the great depression’, Journal of Finance, vol.54, pp.45-69 Hsiao, C. 1983, ‘Identification’, Handbook of Econometrics, vol.1, Ch.4, Eds. Griliches, Z. & Intriligator, MD., North-Holland Hutchinson, M. & Gul, F. 2004, ‘Investment opportunity set, corporate governance practices and firm performance’, Journal of Corporate Finance, vol.10, pp.595-614 Jensen, MC. & Meckling, WH. 1976, ‘Theory of the firm: Managerial behaviour, agency costs and ownership structure’, Journal of Financial Economics 3, pp.305-360 Jones, D., Kalmi, P. & Mygind, P. 2003, ‘Choice of ownership structure and firm performance: Evidence from Estonia’, Working Paper Series, William Davidson Institute Kayhan, A. & Titman, S. 2003, ‘Firms’ histories and their capital structure’, Working Paper Series, National Bureau of Economic Research Kmenta, J. 1971, ‘Elements of econometrics’, Macmillan Publishing, New York Kole, S. 1995, ‘Measuring managerial equity ownership: A comparison of sources of ownership data’, Journal of Corporate Finance 1, pp.413-435 Loderer, C. & Martin, K. 1997, ‘Executive stock ownership and performance: Tracking faint traces’, Journal of Financial Economics, vol.45, pp.223-55

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 21. Magnus, JR. & Neudecker, H. 1988, ‘Matrix differential calculus with applications in statistics and econometrics’, John Wiley & Sons, New York 22. McConnell, J. & Servaes, H. 1990, ‘Additional evidence on equity ownership and corporate value’, Journal of Financial Economics, vol.27, pp.595-612 23. Morck, R., Schleifer A. & Vishny, R. 1988, ‘Management ownership and market valuation: An empirical analysis’, Journal of Financial Economics, vol.20, pp.293-315 24. Myers, S. 1984, ‘The capital structure puzzle’, The Journal of Finance, vol.39, pp.575-92 25. Myers, S. & Majluf, N. 1984, ‘Corporate financing and investment decisions when firms have information investors do not have’, Journal of Financial Economics, vol.13, pp.187-221

26. Panno, A. 2003, ‘An empirical investigation on the determinants of capital structure: the UK and Italian experience’, Applied Financial Economics, vol.13, pp.97-112 27. Simoneti, M. & Gregoric, A. 2004, ‘Managerial ownership and corporate performance in Slovenian post-privatization period’, Working Paper Series, European Corporate Governance Institute 28. Welch, E. 2003, ‘The relationship between ownership structure and performance in listed Australian companies’, Australian Journal of Management, vol.28, pp.287-305 29. Zhou, X. 2001, ‘Understanding the determination of managerial ownership and its relationship to firm performance: Comment’, Journal of Financial Economics, vol.62, pp.559-71

Appendix 1. Summary of Previous Studies Authors Demsetz & Lehn (1985)

Morck, Schleifer & Vishny (1988) McConnell & Servaes (1990)

Hermalin & Weisbach (1991) Loderer & Martin (1997)

Craswell, Taylor & Saywell 1997

Cho (1998)

Ownership Measures 1. % of stock held by top 5 shareholders 2. % of stock held by top 20 shareholders 3. Herfindahl measure of ownership concentration 4. % of shares controlled by 5 largest individuals / families 5. % of stock controlled by institutional investors % of stock held by directors 1. % of shares held by insiders 2. % of shares held by blockholders 3. % of shares held by institutions % of stock held by incumbent CEO and former CEOs still on BOD % of stock held by officers and directors

1. % of shares held by directors 2. % of shares held by institutional investors % of stock held by directors

Performance Measures

Methodology

Results

Post-Tax Accounting Profit / Book Value of Equity

OLS

No significant relationship

1. Tobin’s Q 2. Accounting Profit

Piecewise Linear Regression

Significant non-monotonic relationship

Tobin’s Q

OLS

Significant Curvilinear Relationship

Tobin’s Q

Piecewise Linear Regression

Significant non-monotonic relationship

Tobin’s Q

Simultaneous Equations

Proxy Q (MV Equity / BV of Net Assets)

1. Linear Regression 2. Curvilinear Regression 3. Piecewise Regression

Himmelberg, Hubbard & Palia (1999) Holderness, Kroszner & Sheehan (1999)

% of stock held by insiders, managers and directors

Tobin’s Q

% of stock held by officers and directors

Tobin’s Q

1. Piecewise Linear Regression 2. 2SLS 3. 3SLS 1. Piece Linear Regression 2. Piecewise Quadratic Regression Piecewise Linear Regression

Demsetz & Villalonga (2001)

% of stock held by CEO, top management and directors


1. OLS 2. 2SLS

Welch (2003)

1. % of stock held by management and directors 2. % of stock owned by 5 largest shareholders


1. OLS 2. 2SLS 3. General Non-Linear Model

Tobin’s Q

Ownership fails to predict performance, but performance is a negative predictor of ownership Weak curvilinear Relationship

Performance affects ownership, but ownership fails to predict performance Quadratic form ownership influence on corporate performance Significant non-monotonic relationship



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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Appendix 2. Order Condition Calculations for 2 Equation System Let: G∆ = Number of non-zero endogenous variables in the gth equation G = Number of non-zero endogenous variables in the system of equations = Number of non-zero pre-determined variables in the gth equation K* K = Number of non-zero pre-determined variables in the system of equation K** = Number of non-zero pre-determined variables not appearing in the gth equation From Kmenta (1971) the order condition is expressed as: K** ≥ G∆ – 1, where K** = K – K* For equation 1: G∆ = 2, as there are two endogenous non-zero variables within this equation (Q, MDO) K** = 3, as there are six pre-determined variables within the system and only three pre-determined variables within equation 1 (TOP5, RDSALE, LEV) Therefore: K** ≥ G∆ – 1 = 3 ≥ 1, highlighting that equation 1 satisfies the order condition. For equation 2: G∆ = 2, as there are two endogenous non-zero variables within this equation (Q, MDO) K** = 2, as there are six pre-determined variables within the system and only four pre-determined variables within equation 2 (LEV, MKTRISK, FIRMRISK & SALES) Therefore: K** ≥ G∆ – 1 = 2 ≥ 1, highlighting that equation 2 satisfies the order condition.

Appendix 3. Order Condition Calculations for 3 Equation System Let: G∆ = Number of non-zero endogenous variables in the gth equation G = Number of non-zero endogenous variables in the system of equations K* = Number of non-zero pre-determined variables in the gth equation K = Number of non-zero pre-determined variables in the system of equation K** = Number of non-zero pre-determined variables not appearing in the gth equation From Kmenta (1971) the order condition is expressed as: K** ≥ G∆ – 1, where K** = K – K* For equation 1: G∆ = 3, as there are three endogenous non-zero variables within this equation (Q, MDO & LEV) K** = 7, as there are nine pre-determined variables within the system and only two pre-determined variables within equation 1 (TOP5 &RDSALE) Therefore: K** ≥ G∆ – 1 = 7 ≥ 2, highlighting that equation 1 satisfies the order condition. For equation 2: ∆ G = 3, as there are three endogenous non-zero variables within this equation (Q, MDO & LEV) K** = 6, as there are nine pre-determined variables within the system and only three pre-determined variables within equation 2 (MKTRISK, FIRMRISK & SALES) Therefore: K** ≥ G∆ – 1 = 6 ≥ 2, highlighting that equation 2 satisfies the order condition. For equation 3: G∆ = 2, as there are two endogenous non-zero variables (Q & LEV) K** = 2, as there are nine pre-determined variables within the system and seven pre-determined variables within equation 1 (SALES, MKTRISK, FIRMRISK, LIQ, PAYOUT, P/E & RETPROFIT) Therefore: K** ≥ G∆ – 1 = 2 ≥ 2, highlighting that equation 3 satisfies the order condition.

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Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Appendix 4. List of Firms from the Final Sample Firm Name Altium AMP Ansell APN News & Media Axon Instruments Austereo Group Australian Gas & Light Co. BHP Billiton Billabong International Brandrill Burns Philp & Co. Burswood Centro Properties Cochlear Collection House Commonwealth Bank of Australia Computershare Crane Group David Jones Energy Developments Envestra Foodland Associated Fosters Group Futuris Corp. Harvey Norman Holdings Hutchison Telecommunications Australia Intellect Holdings James Hardie Industries NV Jupiters Lihir Gold Macquarie Bank Mayne Group Mirvac Group National Foods Newcrest Mining News Corporation Novus Petroleum Orica Patrick Corporation Powertel Publishing and Broadcasting QANTAS QBE Insurance Group Rio Tinto Santos Seven Network Sims Group Southcorp Stockland Toll Holdings

ASX Code ALU. AMP ANN APN AXN AEO AGL BHP BBG BDL BPC BIR CEP COH CLH CBA CPU CRG DJS ENE ENV FOA FGL FCL HVN HTA IHG JHX JUP LHG MBL MAY MGR NFD NCM NCP NVS ORI PRK PWT PBL QAN QBE RIO STO SEV SMS SRP SGP TOL

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ORGANISATION CHANGE AND ITS IMPACT ON AUSTRALIAN BUILDING SOCIETIES’ PERFORMANCE Di Thomson* Abstract The paper examines the relation between changing ownership structure and performance of Australian building societies. An analysis and discussion of the theories of organizational development and change is undertaken to explore the mutual building societies’ motivation for change. The financial performance measures, provided by financial ratios of the major mutual building societies in Australia, are examined to assess the behaviour of building societies under different governance structures in the 1980s and 1990s. The theoretical and empirical literature has suggested that mutual deposit-taking institutions should have lower profitability and higher operating expenses than their publicly listed counterparts. Accounting ratios are observed over time to investigate if governance change in mutual deposit-taking organizations accounted for any discernable differences in profitability and cost efficiency pre- and post- demutualization. The study finds support for the contention that demutualized building societies will have higher profitability and lower costs than their mutual counterparts. The study is confined to investigation of the six largest building societies that undertook the demutualization process. It could be extended to the entire building society sector. The results have implications for investors, managers and ‘owners’ of firms that retain their mutual structure, suggesting the demutualization will benefit these groups. There is no study that compares mutual deposit-taking institutions pre- and post-conversion in Australia. Keywords: Building societies, organisation change, demutualization, performance. *School of Accounting, Economics and Finance, Deakin University, 221 Burwood Highway, Burwood Victoria, 3109, Australia. Phone: 61 3 9244 6173; Fax: 61 3 9244 6283 Email:[email protected]

Introduction

There has been considerable interest in the theory and practice of organisation change. Similarly there has been a great deal of attention given to the processes that lead to and result from change within organisations. Demutualization, the shedding of mutuality or co-operative ownership for shareholder ownership, has been a global phenomenon of organisational change, concentrated among building societies and life-offices during the 1980s and 1990s. In the United States more than 1,000 mutual savings and loans (S&Ls), the American equivalent of building societies, have converted during the 20-year period (Hemmings and Siler, 1995). In Britain the decline was just as dramatic, falling from 1000 building societies in 1937 to just 137 by 1987 (Drake, 1989). In Australia the number of building societies fell from 139 to 14 between 1980 and 2004 with only three retaining their mutual status (AAPBS, 1989 and APRA Insight 2007).43 Since 1995, none of the

43

The three building societies that have maintained their mutual organizational structure are Newcastle Permanent Building Society, Greater Newcastle Permanent Building Society and Heritage Building Society. These three mutuals’ performance is compared to

132

remaining building societies in Australia have converted to bank status; three life insurance companies and one credit union have since demutualized. Organisational change within the finance industry is of interest to regulators, other industry sectors, investors and consumers alike, as both mutual and stock deposit-taking firms have co-existed for over one hundred years. Authorised deposit-taking institutions (ADIs) that change their governance structures and form of ownership from mutual to publicly listed or stock companies are of even greater interest as these institutions have operated under both forms of ownership. 44 Observing the performance of these institutions, both before and after organisational change may shed light on the relationship between the Building Society sector average and with those building societies that have demutualized. 44 Mutuals or co-operatives are the terms used to describe a specific ownership structure of ADIs whereby membership entitles the right to deposit or borrow with one vote attached to the membership, regardless of each member’s financial commitment to the company. Stock firms or publicly listed companies are the terms used to describe firms that list on the stock exchange and where ownership is represented by shares in the enterprise, with each share representing one vote. In both instances the former terms are the more familiar terms in the U.S. literature, whereas co-operative and publicly listed company are the more common terms in Australia.


performance and governance mechanisms. This relationship has been well researched in the United States, generally finding that the mutual form of ADI is less efficient and less profitable than its stock counterpart. 45 While there have been a number of Australian studies investigating the performance of building societies and credit unions, no study has yet been undertaken exploring the effect of the change in ownership on operating performance of Australian building societies that have embarked on the demutualisation process. This paper explores Australian building societies’ impetus for organisational change and examines whether there is a relationship between organisation structure and performance. The first section of the paper provides a brief overview of organisational change and institutional theory in relation to ADIs. It goes on to review the various theoretical and empirical explanations for the expected difference in behaviour of mutual and stock financial institutions. Following sections look at the operating performance of the converting institutions in terms of profitability and cost efficiency ratios pre- and postdemutualization. In the final section some concluding remarks are made and areas for future research are identified. Theories of Organisational Change and Performance

Van de Ven and Poole (1995, p.510) commence their exposition of organisational change theories with the view that ‘… explaining how and why organizations change has been a central and enduring quest of scholars in management and many other disciplines’. They postulate four theories of organisational development and change: the life-cycle, teleological, dialectical and evolutionary models. Each model has a different driver motivating change and is relevant to some degree in explaining the reason why a building society takes the step of changing its organizational structure from a mutual to that of a stock-listed firm. Van de Ven and Poole’s theoretical models can be applied to the main motivations, which are to continue growth, maintain profitability and reduce the greater regulatory burden faced by non-bank ADIs prior to 1998. According to Van de Ven and Poole (1995) the teleological model views development as a cycle of goal formulation, implementation, evaluation, and modification of goals based on what was learned by the entity. Mutual building societies can only increase their capital base through retained earnings, while stock ADI firms can raise funds through a variety of external stock and debt offerings. This striking difference in their ability to raise capital has significant implications for the firm’s business 45

See for example, Hester (1968), Brigham and Petit (1969), Nicols (1967), Verbrugge, Shick and Thygerson (1976), O’Hara (1981), Masulis (1987) Mester, (1987, 1991, 1992, and 1993), Cummins et al (1999).

practice. Hence the firm moves towards implementing a different organisational structure to accommodate its development and growth by converting from a mutual to a stock-listed ADI. Hegel’s dialectic model, postulated by Kane (1977, 1981, 1984) and Thomson and Abbot (2001) is a means to explain the changing forces within the banking and finance industry. These authors outline the confrontation and conflict between opposing entities that generate this dialectical cycle as the financial institutions and the regulators colliding to produce avoidance behaviour. This is followed by the synthesis, where the finance regulators deregulate or re-regulate ADI behaviour, which in time becomes the thesis for the next cycle of a dialectical progression. Thomson and Abbott (1998) found that the main motivations for organisational change by building societies have been regulatory costs, incentive-conflict between owners and management (principal-agent issues) managerial motives and access to capital. This dialectical view is further supported by evidence from the second wave of building society demutualizations that occurred in the first half of the 1990s. Regulatory costs were major factors driving the demutualization process in Australia and may help explain the near demise of the building society industry worldwide as the antithesis stage of the dialectic. Since the formation of the new regulatory body, the Australian Prudential Regulatory Authority in 1998 (the synthesis), and the application of a level regulatory playing field for all ADIs, there have been no further conversions from mutual building societies to stock-listed ADIs. Van de Ven and Poole (1995) outline their evolutionary model of change and development as a repetitive sequence of variation, selection, and retention events among entities in a designated population. Competition for scarce resources between entities generates natural selection among competitors and suggests that firms will need to choose an organisational structure that enhances performance. The transaction cost, principal-agent and Xinefficiency literatures are relevant to ADIs that evolve their organisational structure from mutual to stock-listed firms with consequent implications for performance. Berle (1932) and Coase (1937) recognized that ownership structure (the assignment of property rights within the firm) affects firm performance. The separation of ownership and control, the existence of information asymmetries, agency problems and the fact that managers of mutuals cannot participate in the 'profitable performance' of the firm by stock options causes them to maximize non-profit maximizing goals. Instead mutual managers participate by means of excessive salary and perquisite behaviour. The theory of decision-making in mutual organizations suggests that operating expenses in mutuals will reflect a marked ‘expense preference’ behaviour on the part of managers. Deshmukh et al (1982) suggests, that in view of the negligible pressures exerted by the

133


‘nominal owners’ (customers/owners), the more appropriate behavioural assumption on the manager’s part would be personal utility maximization. This can be achieved by profit diversion without fear of takeover, as the mutual ADI’s value cannot be sold in the market. This principal-agent view of the problem is further supported by Leibenstein (1966) who believes that in the absence of competitive market forces, managers may pursue goals of maximizing their own self-interest via the accumulation of excess staff, salaries and additional emoluments rather that the goal of profit maximization.46 The lack of internal efficiency, due to organisational structure, implies that mutual associations should have higher expenses, be less cost efficient and have lower profitability than stock-listed companies. Earlier U.S. empirical studies (see Footnote 3) examining the relative performance of stock compared to mutual ADIs tend to favour the stocks in terms of operating efficiency. More recent studies by Cole and Mehran (1997) find that firm performance of mutual S&Ls improves significantly after demutualization. Similarly, Cummins, Weiss and Zi (1999) discover that consistent with the expensepreference hypothesis, stock property-liability insurers are more cost efficient than their mutual counterparts. Berger and Humphrey’s (1997) international survey summarizes and critically reviews 130 studies of financial institution efficiency. They find, similar to Leibenstien, that X-inefficiency – the differences in management’s ability and willingness to control costs or promote revenues – appear far more important than either scale or scope efficiencies. Worthington (1998a, 1998b, 1999, 2000a and 2000b) addresses the lack of Australian studies measuring the efficiency of non-bank ADIs by examining the sources of efficiency differences (X-inefficiency) of Australian credit unions and building societies. Worthington (1998a) finds that the institutional and regulatory frameworks under which mutual credit unions operate appears to be the most important determinant of their efficiency or inefficiency. Worthington’s (2000a) paper addressing cost-efficiency in credit unions found that the typical credit union’s costs were 30% above what could be considered efficient on the basis of observed best practice. This has relevance to building societies as prior to the regulatory changes in 1998, that brought all deposit-taking institutions under the same regulatory umbrella, building societies and credit unions were supervised by the Australian Financial Institutions Commission hence would expect similar regulatory impact on their operating performance.

46

Neo-classical theories of the firm traditionally have assumed that factor inputs are used within the firm as efficiently as possible, ie operating at lowest cost possible. Leibenstein (1966) challenged this view and approached the issue of operating efficiency by suggesting that firms do not allocate resources in an optimal fashion if least cost combination of factor inputs are not used. This suboptimal use of resources is evidence of X-inefficiency.

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Organisational change and performance

Despite the large number of studies examining financial institution performance there are no studies exploring the effect of organisational change on the operating performance of demutualizing Australian building societies. Mutual and stock-listed ADIs continue to exist and operate along side each other in a competitive environment. Hence a review of preand post-demutualization performance of the major Australian building societies may provide useful insights for other industry sectors that have mutual organisations (for example, credit unions, health funds and motoring associations) and policy implications for regulators. Primary source data was used to examine the preand post-conversion financial performance of the six largest converting building societies from 1983 to 1994. These institutions were located across the mainland states of Australia and included Advance Bank (1985, NSW), Challenge Bank (1987, Western Australia), Bank of Melbourne (1989, Victoria), Metway Bank (1988, Queensland), St. George Bank (1992, NSW) and Adelaide Bank (1994, South Australia) with the year of demutualization and state of origin in brackets. Secondary source data, from the KMPG Financial Institutions Surveys, was used to compare the performance of the demutualizing ADI sector (these six institutions) relative to the building society sector average, the three remaining mutual building societies and where data was available for the major banks over the period 1988 to 1994.47 The comparison of pre- and post-conversion data was accomplished by setting the year of conversion for all ADIs as year zero, with pre-and postconversion years designated as ‘years one and two years before’ and ‘years one and two after’ respectively, to give a comparative five year window on each converting ADI. 48 The five year window is considered to be an adequate period to consider change as Esho and Sharp’s (1995) investigation of the characteristics of the cost functions of Australian building societies found that the speed of adjustment to long-run equilibrium costs is quite rapid with almost 83% of the total adjustment completed in the initial period. Event studies normally compare share price movements before and after an event to evaluate 47

A smaller number of ratios and shorter time frame were utilised in the comparison of demutualizing versus mutual building societies to ensure the use of consistent ratios. A severe limitation in comparison of data over time is the lack of consistency in ratios included in the KPMG Financial Institutions Surveys. For the demutualizing building societies, the ratios were calculated from their financial statements and annual reports. 48 This five-year period occurs at a different time for each demutualizing ADI as the conversion dates occurred at random times over the decade, but it provides a time period of t-2 to t+2 years either side of the year of conversion to allow each ADI to be compared at an identical phase in their demutualizing process.


its significance. In the case of a demutualizing firm there is no market value information or share price to compare before and after the event. Instead using accounting ratios and time-trend analysis provides a history and a standard of the ADIs past versus its current performance. Esho and Sharpe (1996) justify using accounting ratios in their study examining the X-efficiency of Australian building societies. They found that accounting ratios - averaged over seven to ten year periods - produced efficiency rankings similar to those obtained with the more complex stochastic econometric frontier approach utilized in their study. Edey and Gray (1996) likewise suggest that despite the lack of sophistication of accounting ratios, the use of output measures based on financial statement data effectively illustrates trend behaviour. For example, they found that changes in total assets illustrated the major increases that have occurred since the early 1980s in financial-sector productivity. They suggest that the relatively sophisticated stochastic cost frontier approach to measuring Xefficiency and firm performance rankings may have little advantage over simple accounting expense ratio analysis. The pre- and post-conversion ratio results of the individual building societies are listed in Table 1. The accounting ratios chosen for analysis were the key ratios for profitability and cost efficiency. They include return on average equity, operating expenses/average assets, non-interest income/average assets, operating income/operating expenses and other ratios found to be significant in prior research. 49 Table 2 compares the performance of demutualizing building societies with those building societies that retained their mutual structure, the building society sector average and some limited comparison with the major banks. The relative averages of the various financial sectors are important for comparison purposes as these demutualizing ADIs come from one sector and enter another upon completion of the demutualization process. The regulatory body, at the time, the Reserve Bank of Australia required these organisations to undertake a two-step process; demutualize and convert to bank status. Profitability Measures

Profitability is most important to the basic notion of a firm’s success. It ultimately determines the extent to which the owners’ interests are served, and for mutual institutions the extent to which earnings are generated to support the capital position of the firm. A number of ratios such as return on average equity (ROAE), net interest margin, and total income/average assets are used to measure profitability. If most or all of these ratios indicate a difference pre-and post49

For example, see Hannan and Mavinga (1980), O’Hara (1981), Mester (1987, 1991, 1992, 1993), Maclachlan (1993), Esho and Sharpe (1995), Ralston (1995), Worthington (1998).

demutualization it would seem to indicate a link between organizational change and performance. Return on Average Equity

Profitability has not been a major criterion for measuring performance in building societies due to their mutual status and their inability to raise external capital. The equity component of the capital base of the stock-listed banks is clearly defined as share capital, reserves and retained profits. For mutual buildings societies equity should be defined on a comparable basis to that of banks. The appropriate measure for this purpose is the general reserves of building societies. A firm with relatively high profitability measures can be considered to be efficient in the sense that it provides a high rate of return on funds (profit after tax) to investors and shareholders. The rate of return on equity can be examined as the mutual evolves into a stock ADI. The evidence from Table 1 provides general support for the contention that ADIs will report higher profitability as they move from mutual status to stocklisted entities. Table 2 compares the value-weighted average ROAE of demutualizing building societies relative to the other industry sectors. The demutualizing building societies’ ROAE remained positive throughout the study but fell to a low of 5.9 per cent, while the major banks experienced negative 1.2 percent ROAE in 1992. This illustrates that the riskier commercial portfolios show up in the downturn of the business cycle following the significant 1991 recession in Australia. By contrast the Building Societies Sector Average (BSSA) and the Mutual Building Societies Average (MBSA) showed steady ROAEs throughout the period. This anomaly can be explained by the higher quality of the mutuals’ loan portfolios and the lower risk associated with home lending. Net Interest Margin

The behavioural characteristics of the mutual ADI lead to expectations of lower net interest margins relative to a stock-listed entity. This is confirmed by Smith’s (1986) test of the variant objective function hypothesis (borrower-saver accommodation) for cooperatives, finding that they are neutral between the interests of their borrowing and saving member/owners. The narrower the margin between the deposit and lending rates the more a society can benefit both types of member, but in practice, market forces will constrain a society’s discretion over its deposit and lending rates. The firm’s competitive pressure and amount of fixed interest loans would constrain any possible rise in margins after conversion. The value-weighted average for the demutualizing building societies’ net interest margin ranged from 3 per cent to 3.8 per cent during 1988 to 1994.

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Table 1. Demutualizing Building Societies Performance Data - Pre- and Post-conversion 2 years before

1 year before

Year of Conversion

1 year after

Non-interest Expense/ AA

5.0

4.0

3.2

2.5

2.2

Total Quality Capital / Total Assets

7.0

7.1

7.0

6.2

7.0

Total Expenses / Total Income

92.6

91.0

86.5

87.1

86.5

Operating Expenses / Average Assets

4.9

3.8

3.2

2.3

2.0

Growth In Profits After Tax

4.2

26.0

26.2

25.2

23.9

Adelaide Bank *94

2 years after

Growth In Total Assets

72.5

-1.3

32.1

29.5

-1.9

Operating Income / Average Number Of Employees

132.4

109.9

119.2

128.7

136.1

Fixed Assets / Total Assets Operating Income / Operating Expenses

9.4

3.8

2.6

1.8

1.6

121.0

125.3

139.1

153.1

165.9

Operating Expenses / Operating Income

82.6

79.8

71.9

65.3

60.3

Profits After Tax / Average Equity

12.2

14.6

15.1

14.4

15.6

Total Income / Assets

6.0

5.0

4.5

3.7

3.5

Net Interest Margin

3.9

3.3

3.1

2.5

2.5

3.0

Advance *85 Non-interest Expense/ AA

2.8

2.6

2.7

3.2


4.6

4.8

7.2

7.1

6.7


94.5

91.6

92.6

94.0

92.7


2.8

2.6

2.7

3.1

3.0


9.5

55.8

2.0

35.3

29.7


18.0

15.8

13.2

23.4

35.3


na

53.9

57.3

70.5

84.0

Fixed Assets / Total Assets

5.1

4.8

4.6

4.4

5.3

127.2

141.0

133.9

126.7

137.4

Operating Income / Operating Expenses Operating Expenses / Operating Income

78.6

70.9

74.7

79.0

72.8


10.1

12.0

8.2

8.0

8.3


3.6

3.7

3.7

4.0

4.1

Net Interest Margin

3.2

3.9

3.9

3.6

3.2

Bank of Melb *89 Non-interest Expense/ AA

2.6

3.0

3.2

2.8

2.8


4.8

5.9

7.6

6.1

7.0


98.1

93.1

92.9

93.9

88.7


3.0

3.3

2.9

2.9

3.1

337.4

125.3

27.2

5.2

31.3


-3.2

13.1

21.9

30.1

11.9


68.2

82.3

81.4

91.2

109.7



3.0

3.2

2.5

2.0

2.3

Operating Income / Operating Expenses

108.6

121.3

129.4

130.1

118.3


92.1

82.5

77.3

76.9

84.5


7.8

12.4

10.6

8.9

10.8


3.3

4.1

3.9

3.8

4.2

Net Interest Margin

3.4

4.4

3.8

3.6

3.7

Source: Financial Statements from the Annual Reports of the ADIs. Various years 1983-1996

136


Table 1 cont’d Demutualizing Building Societies Performance Data - Pre- and Post-conversion

Challenge * 87

2 years before

1 year before

Year of Conversion

1 year after

2 years after


3.3

3.3

1.3

3.0

3.1


2.8

3.0

5.8

6.5

5.7


97.1

97.6

89.5

90.6

92.1


3.2

3.2

1.2

2.7

2.8

-45.7

28.8

30.7

172.0

-9.6

Growth In Profits After Tax Growth In Total Assets

16.9

6.5

11.0

26.2

22.1


61.5

64.4

36.8

94.7

110.1

1.2

1.3

0.9

0.8

0.8

Operating Income / Operating Expenses


112.4

111.9

163.5

159.7

145.3


89.0

89.3

61.2

62.6

68.8


9.2

10.5

8.2

14.6

11.4


3.7

3.7

2.0

4.7

4.4

Net Interest Margin

2.8

3.0

1.8

4.1

3.5


3.6

3.6

3.5

3.3

3.9


1.0

1.0

1.0

5.1

6.4


97.4

97.9

90.6

85.1

91.2

Metway * 88


3.6

3.6

3.5

3.3

3.8


44.1

-24.6

136.5

292.3

15.8


11.9

7.6

19.9

16.6

34.5


62.1

55.8

70.7

85.6

96.9


1.9

1.7

1.5

1.3

1.4

110.1

108.4

136.0

163.6

140.5

Operating Income / Operating Expenses Operating Expenses / Operating Income

90.8

92.2

71.9

61.1

71.2


20.5

13.2

20.8

28.3

16.1


7.3

7.1

7.7

7.8

8.5

*Net Interest Margin

3.7

3.6

4.4

4.7

4.8


2.9

3.0

2.9

2.9

2.4


4.9

6.3

6.0

6.2

6.4


94.0

91.7

89.8

86.6

81.6


2.8

2.7

2.6

2.5

2.4


0.3

0.1

12.7

29.7

53.7

St George *92


11.7

10.6

9.8

25.9

35.0


92.3

97.7

107.8

123.8

158.0

Fixed Assets / Total Assets Operating Income / Operating Expenses

4.7

4.6

4.3

3.6

2.6

135.4

145.0

150.3

153.3

170.4


73.8

69.0

66.5

65.2

58.7


12.7

11.3

11.5

12.4

13.4


3.9

4.2

4.2

4.2

4.1

Net Interest Margin

3.8

4.0

4.0

3.9

3.7

Source: Financial Statements from the Annual Reports of the ADIs. Various years 1983-1996

137

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 2. Comparison of Demutualizing Building Societies Relative to the Building Societies Sector and Major Bank Averages Demutualizing Building Societies Value-weighted average * Profit After Tax / Average Equity Net Interest Margin Operating Expenses / Average Assets Operating Income / Operating Expenses Operating Income / Average Assets Operating Expenses / Operating Income Total Income / Average Assets

1988 12.8 3.9 3.1 139.9 4.3 71.5 4.2

1989 12.2 3.7 2.9 139.2 4.1 71.8 3.9

1990 10.8 3.4 2.8 138.2 3.9 72.4 4.1

1991 9.7 3.8 2.7 144.8 3.8 69.0 4.4

1992 5.9 3.7 2.5 150.1 3.8 66.6 4.4

1993 13.3 3.6 2.6 150.8 3.9 66.3 4.1

1994 17.0 3.6 2.5 158.4 4.0 63.0 4.0

Building Societies Sector Average # Profit After Tax / Average Equity Net Interest Margin Operating Expenses / Average Assets Operating Income / Operating Expenses

na na 3.0 1.33.2

na na 3.0 133.5

11.9 na 3.1 131.7

10.2 na 3.2 na

11.1 na 3.2 142.8

10.5 na 3.6 na

10.6 na na na

Mutual Building Societies Average ^ Profit After Tax / Average Equity Operating Expenses / Average Assets Operating Income / Operating Expenses

na 3.4 146.1

na 3.4 146.2

16.2 3.2 159.1

12.8 3.6 159.3

14.6 3.6 153.0

13.1 3.8 Na

13.6 3.4 na

Major Banks^^ Profit After Tax / Average Equity Net Interest Margin Operating Expenses / Average Assets

13.7 5.7 na

15.6 5.3 3.4

10.6 4.9 3.3

7.0 4.6 3.2

-1.2 4.4 3.4

8.9 4.4 3.5

14.3 na na

Source: Financial Statements from the Annual Reports of the ADIs and from KPMG Financial Institutions Performance Surveys, Various years. * The value-weighted average is for the six demutualizing building societies. # The Building Society sector average includes all building societies, both mutual and stock-listed institutions ^ The three remaining mutual building societies ^^ Major banks data has been obtained from J.B. Were

More important than the movement in the net interest margin around year of conversion is the fact that prior to demutualization, the net interest rate margins experienced by the building society sector were significantly narrower than the Australian major banks. The net interest margin for the major four banks was above 5 per cent from 1989-1990, and 4.5 per cent in the following years (RBA, International Comparisons of Bank Margins, 1994) reflecting their different lending philosophies. Convergence in net interest margins across all financial institutions has occurred since 1991 reflecting the more competitive nature of the markets that ADIs operate within. Table 2 provides the data on sector average interest margins of the demutualizing ADIs. Asset utilisation

Asset utilisation can be used to evaluate either profitability or operational efficiency as it reflects whether assets are being employed as earning assets. Table 1 indicates that the majority of the building societies operated within a close range of each other with little deviation from the value weighted-average demonstrated in Table 2. The broad conclusion drawn from the empirical data is that the level of profitability of converting

138

building societies rises after conversion. This is borne out in the data in Table 1 that shows growth in profits after tax, general increases in the ROAE, and asset utilisation after conversion. The significantly lower interest margins at the time of conversion supports the theoretical and empirical explanations that mutuals would have lower profitability than their stock-listed counterparts. Cost Efficiency Measures

Management is responsible for the trading performance and risk profile of their ADI relative to industry peers therefore any significant and ongoing change in accounting ratios that reflect performance can be attributed to management decisions. In the absence of accounting ratios that measure managerial expenses explicitly a number of measures that look at operating cost ratios can be used as crude proxies. These include non-interest expense/average assets, operating expenses/total assets, operating expenses/operating income and operating income/operating expenses.


Sinkey (1975) suggests that the following ratios reflect the manager’s ability to control the performance of the ADI. High operating expenses to operating income and fixed assets/total asset ratios are likely to reflect preferences by mutual managers for perk-taking behaviour. Expense preference theory and prior studies by Edwards (1977) and Taggart (1978) suggest that in the absence of pressure from owners and/or competitive market conditions, mutual managers may expend firm resources in the form of higher levels of staff expenditure, more expenditure on physical office surroundings and other managerial amenities. Accordingly, looking at the various expense ratios can assess cost efficiency. Operating Expense Ratios

The operating expenses/total assets ratio provides a good indicator of operating efficiency if all deposittaking institutions produce a homogeneous output and pay identical prices for factors of production. Australian building societies operate under the same regulator, produce very similar financial services and products and have little room for price differentiation. In these circumstances it is reasonable to assume that products and prices are homogenous. Multiple regression techniques can be employed in an attempt to hold constant output mix and factor prices. Whilst these techniques are useful and have been used in many United States studies in relation to the issues of behaviour and performance, multivariate analysis is inappropriate in this study due to small sample size. Four of the six demutualizing building societies experienced declining operating expenses/total assets in the 5-year window around their demutualization, providing support for the contention that stock ADIs should improve their cost ratios post-demutualization. A clear picture regarding efficiency comparisons for both demutualizing ADIs and mutuals ADIs for the period 1988 to 1994 is provided in Table 2. The comparison of the demutualizing ADIs valueweighted average with the BSSA and MBSA shows that the formers’ operating expenses/average assets decline over the period, confirming expectations of lower costs for demutualizing ADIs, whereas the BSSA and MBSA increases over the period supporting the findings of higher operating costs for mutuals in earlier empirical studies. Operating Expenses/Operating Income is a measure of overall cost efficiency. Falling ratios postconversion suggest the view that stock-listed ADIs exhibit greater cost efficiency. Table 1 illustrates a general fall in operating expenses/operating income, the lower ratio reflecting an improvement and therefore an upward trend in productivity for all building societies post-conversion. Those demutualizing ADIs experiencing significant falls in this ratio in the year of conversion were: Adelaide Bank 9%, Challenge 28% and Metway 30%. St George Bank experienced a fall of 11% in 1988, five years pre-conversion. From an examination of St

George’s balance sheet, it appears that it actually began to operate more like a bank than a building society from that time.50 Advance Bank initially rises post-conversion and then steadily falls whereas Bank of Melbourne’s is the only institution that offers little support for the hypothesis that operating expenses will be lower following conversion with variable ratios over the entire time period. Table 2 demonstrates that the VWA of the demutualizing building societies fell continually from 71% in 1988 to 63% in 1994. Long run improvement across the entire ADI industry is likely to reflect the impact of deregulation of the financial system and technology improvements in addition to organizational change improvements. A further measure of operating efficiency is operating income/operating expense, 51 which indicates the productivity of the deposit taking institutions. Productivity increases would be expected post-conversion and translate to increased cost efficiency. Table 1 shows steep upward growth in productivity for Metway, St. George, Bank of Adelaide, and Challenge, although this was followed by subsequent falls in productivity for Challenge, Metway and Bank of Melbourne, but post-conversion they were still significantly higher than the one year pre-conversion data (Advance experienced variable results in its operating income/operating expenses over the period of demutualization) but considering the group of ADIs as a whole, there is a positive upward trend in productivity post-conversion. Likewise, comparing the operating income/operating expense ratios of the demutualizing ADIs with those that have retained their mutual status, finds support for the demutualized building societies having higher productivity than the mutuals (see Table 2). While both the building society sector average and the value-weighted average of the demutualized ADIs are increasing, the latter illustrates higher productivity in the stock-listed ADIs than the mutuals in the years 1988 to 1992.52 Proxy Measures for Managerial Expenses

The fixed assets/total assets ratio provides a proxy measure of managerial expense behaviour in the absence of detailed information associated with expenditure on personnel and office operations and should be included in a discussion of cost efficiency. 50

A comparison of the 1987 and the 1988 Annual Report’s balance sheet reveals a shift away from the traditional operation of the mutual ADI to one that closely resembles a bank balance sheet operation. Discussion re this point with a St George spokesperson from the Finance Department confirmed my opinion. Verbal discussion with Bill Jones from the RBA further supported this view but indicated that senior management changes at St Georges in 1987-88 may also contribute to the changed behaviour. 51 Operating income is calculated from net interest income minus (bad and doubtful debt) plus other income. 52 Operating Income/Operating Expenses data is unavailable in the KPMG Financial Institutions Surveys for mutuals building societies after 1992.

139


All demutualizing building societies illustrate declining ratios immediately post-conversion and part from Advance Bank (see Table 1) these ratios continue to decline to less than 2.6 per cent. These results are extremely supportive of the hypothesis that mutuals will engage in expense preference behaviour. Although these findings must take into account that some converting ADIs operated predominantly in regional markets where property and office space were considerably cheaper than in major capital cities of Sydney and Melbourne.53 Non-interest expenses/Average Assets provides another measure of implicitly measuring managerial expense behaviour. To be consistent with the expense-preference hypothesis, mutual ADIs would be expected to have higher non-interest expenses/average assets than publicly listed ADIs. There is no marked change around year of conversion; rather, Table 1 shows an overall downward trend apart from Metway Bank’s increase two years postconversion providing cautious support for the hypothesis. In the absence of data that explicitly captures managerial expense preference behaviour a further measure is operating income/average number of employees. It can be used to provide a measure of cost effectiveness of staff. Trend data for each ADI shows strong upward movement over the six-year time span, but this may overstate the cost effectiveness of staff as inflation and greater use of information technologies as well as the contingences of the business cycle will impact on these ratios. The improved return per employee may be due in part to factors other than efficiency improvements. The GDP implicit deflator was used to remove the inflation effect on monetary variables and the data figures were deflated to the base year 1989/90. There are significant improvements in demutualizing ADI’s operating income to average number of employees in the year of conversion or the preceding year (see Table 1). These results provide support for the hypothesis of lower costs and greater efficiency in the converted associations compared to their preconversion data. In terms of cost efficiency the broad conclusion that can be made from the empirical data presented is that most cost efficiency measures have shown improvements for converting ADIs. This supports the contention that stock ADIs will have lower costs than mutual ADIs as evident in the falls in Operating Expenses/Average Assets, Operating Expenses/ Operating Income and improvements in productivity (Operating income/Operating expenses) in Table 1. The proxy measures for managerial expense behaviour; Fixed Assets/Total Assets is supportive 53

Adelaide Bank, which operated as a mutual until 1994, had extremely high ratios of 8-14 per cent of fixed assets to total assets compared to the demutualizing weighted average of 2.4-3.7 per cent. It experienced a dramatic drop in the year prior to conversion falling from 9.4 per cent to 3.8 per cent (see Table 1).

140

whilst Non-Interest Expenses/Average Assets shows mixed results. Other factors, such as deregulation of the financial system in the 1980s and significant improvements in technology in the 1990s have been important and had an impact on cost efficiency. Implications

For industries that continue to have mutual firms operating alongside stock-listed counterparts there are clear benefits in terms of improving total quality capital to total assets. Apart from Adelaide Bank, which had a strong capital position pre- and postconversion, all demutualizing building societies had significant improvements in this ratio (See Table 1). For investors in financial stocks the pre- and postconversion data provides evidence of the most cost efficient and profitable ADIs to invest in. By the second year post-conversion two of the regional banks stand out as investment opportunities. St George Bank and Adelaide Bank have both been far more effective in reducing their cost ratios (operating expenses/operating income), to 58.7 and 60 per cent respectively. Both ADIs have increased their productivity levels (operating income/operating expenses) substantially compared to the other demutualized building societies. St George increased from 135 per cent in 1990 to 170 per cent in 1994 and Adelaide Bank increased from 121 percent in 1992 to 165 per cent in 1996. While their other financial ratios are generally superior relative to the other ADIs there is not a lot of difference between the two institutions (see Table 1). Retrospectively assessing these two ADIs by comparing their share price at listing to the present time shows that St George Bank would have generated the best returns. St. George Bank shares listed at $5.83 on the 2/07/1992 and Adelaide Bank shares listed at $4.15 on 1/1/1994. Current share prices as at 1/1/2008 are $29 for St. George Bank and $15.50 for Adelaide Bank (Commsec, 2008). Conclusion

Van de Ven and Poole’s (1995) theories of organizational development and change provide a means to classify the drivers that motivate ADIs to undertake the process of demutualization. Evolution, life-cycle and teleological theories explain the changing needs of these ADIs, whilst the dialectical theory is powerful in explaining the role of financial institutions and regulation. The investigation of the Australian building societies’ conversion experience during the period 1983 to 1994 found evidence to support the initial claim that mutual deposit takings institutions are less efficient when compared to their stock-listed counterparts. Cost efficiency of the building societies that demutualized did improve after conversion with these findings particularly applied to the institutions converting in the 1980s. Operating expenses/average assets fell significantly in the demutualizing ADIs whilst the cost ratio rose for


mutuals over the same period. Productivity, as measured by operating income/operating expenses, rose for both demutualized and mutuals ADIs over the 1988-1994 time period but the rise in productivity occurred sooner and was significantly higher for the demutualizing ADIs. There are less significant changes occurring in the behaviour of the mutual deposit-taking institutions undertaking conversion in the 1990s. St George Bank provides some evidence for this view with its look-alike “bank balance sheet” from 1988 onwards although it did not demutualize until four years later in 1992. This view is further supported by Mester’s (1993) study of S&Ls using 1991 data. The more efficient mutual S&Ls in this later sample suggested that deregulation of interest rates and increased competition may have had the predicted effect of curtailing agency problems in mutual S&Ls. While there may be advantages for the stock form of organisation resulting from greater access to capital markets, Worthington, (2000b) provides growing evidence that building societies have improved their efficiency over time with technological advances and changes in the regulatory regime being the driving forces. As these ADIs become publicly listed companies the threat of takeover also becomes important. Of the six institutions investigated three of these institutions have merged or been taken over. St George Bank absorbed Advance Bank to become the fifth major bank in Australia and Westpac absorbed Bank of Melbourne. Metway Bank merged with the life insurance company Suncorp. The introduction of competitive neutrality to the financial system under the APRA regulatory regime in 1998 seems to have removed the regulatory incentives for further demutualization of building societies with the last demutualization of a building society occurring in 1995 seemingly providing support for this view. The building societies investigated differed significantly in size, as measured by their total assets. This potential influence on the performance ratios chosen for comparison has been mitigated by expressing balance sheet items as a percentage of average total assets, resulting in common-size statements. Where comparisons are made crosssectionally, the size issue is overcome by comparing the individual institution to the value-weighted average of the ADIs as opposed to the equal-weight average. 54 A comparison of the converted and the mutual building societies financial ratios was performed using industry averages. Peacock et al (2003) suggests that an industry average may not provide a desirable target ratio or norm and at best an industry average provides a guide to the financial position of the average firm in the industry. Despite the potential problems, industry averages do provide a yardstick against which performance can be measured

The study undertook an investigation of behavioural change of the same institutions pre- and post-conversion. A limitation of the study is that it only investigates the six largest building societies demutualizing during 1983 to 1994. Further investigation could be undertaken to examine the change in governance mechanism and relationship to performance by utilising data envelope analysis and extending the sample size to include all 14 remaining building societies. Comparison of the performance of remaining mutual building societies with those building societies that have listed on an Exempt Exchange or the Australian Stock Exchange would be of value as the demutualizing ADIs have remained as building societies where the earlier demutualizations examined in this study required both conversion to bank status and listing on the stock exchange simultaneously. Despite the shortcomings, the exploration of proxy measures for the performance of ADIs that undertook the conversion process from mutual building society to stock bank, found support for the contention that demutualized building societies will have higher profitability and lower costs than their mutual counterparts. These results have implications for managers and ‘owners’ of firms that retain their mutual structure. The study is informative for investment strategies as it is able to identify the higher performers post-demutualization and indicate areas of strengths and weaknesses for the individual ADIs to concentrate on. The evidence of improved performance suggests that there are benefits to these firms demutualizing unless narrower interest rate margins and other non-tangible benefits exceed the higher costs.

54

8.

This technique has been used by the Reserve Bank in its publication International Comparisons of Bank Margins (1994).

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INFORMATION LEAKAGE AND INFORMED TRADING AROUND UNSCHEDULED EARNINGS ANNOUNCEMENTS Campbell Heggen, Gerard Gannon* Abstract While there has been much judicial discussion regarding the competency of Australia’s continuous disclosure regime with reference to contemporaneous international standards, there has to date been limited empirical analysis of the Australian system’s effectiveness in preventing selective disclosure and information leakage. This paper presents an empirical study of information content and trading behaviour around unscheduled earnings announcements – comprising of profit upgrades, profit warnings and neutral trading statements – made by ASX-listed companies during 2004. The contention is that informed trading impacts on the stock returns and trading volumes of listed entities, and hence abnormal returns or trading volumes observed prior to an announcement provide evidence of information leakage. The paper models a range of factors that potentially influence firm disclosure practices and contribute to the level information asymmetry in the market during the preannouncement period. Previous research has investigated the influence of firm size and information content in contributing to information leakage. This study further considers the variables of firm growth, capital structure and industry group. Keywords: Information Leakage, unscheduled announcements, Downgrades * Governance Regulation and Performance Research Cluster and Department of Accounting, Economics and Finance, Faculty of Business and law, Deakin University, Burwood Highway, Burwood, Victoria 3125, Australia Fax (61 3) 92546283 Tel (61 3) 92546243 Email: [email protected]

1. Introduction

Transparency and disclosure are central pillars of effective corporate governance practices and the functioning of capital markets. From an investment perspective, full, accurate and timely disclosure of information permits the market to determine intrinsic value. Without access to regular, timely, reliable and comparable information, investors will not be able to evaluate corporate prospects and make informed investment and voting decisions (OECD, 2003b). This will result in poorer allocation of scarce economic resources and a higher cost of capital. Additionally, disclosure and transparency are the building blocks of a market-based system for monitoring companies. Effective disclosure and transparency help set investor confidence that intrinsic value is not being siphoned off or wasted by managers or insiders. It allows shareholders and the public at large to assess management performance, thus influencing its behaviour (OECD, 2003b). The genuine value of cash flows, combined with investors’ confidence in their ability to enjoy these cash flows, determines a company’s extrinsic, or market value. A similar relationship is found at the macroeconomic level. Reliable systemic disclosure generates confidence in market integrity. As a result, capital flowing to equity and debt markets will fully

and fairly reflect the underlying value of the national economy (OECD, 2003a). Consequently, disclosure and transparency not only affect individual companies’ performance and market valuation, but also greatly influence a national economy’s ability to attract domestic and foreign investment. Finally, transparency and disclosure gives the public the opportunity to understand the company’s structure, activities and policies as well as assessing its performance with regard to environmental and ethical standards (OECD, 2003b). Continuous disclosure can be defined as an obligation to promptly disclose new important information concerning a listed company as the information becomes available. This can be contrasted with periodic disclosure, which in the Australian context requires the preparation of annual and halfyear disclosure documents. A central function of Australia’s continuous disclosure regulations is to create a platform that equally distributes price sensitive information (PSI) and maintains an efficient market. Privileged access to material information by analysts, media and major shareholders creates favourable conditions for market manipulation and insider dealings, and consequently harms the integrity of financial markets and general public confidence in securities. The regulation of disclosure naturally

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becomes a most important part of securities regulation and the focus of regulatory action Since September 5, 1994, statutory provisions have expressly supported the Australian Stock Exchange’s (ASX) continuous disclosure requirements contained in Chapter 3 of the ASX Listing Rules.55 The general rule, in accordance with Listing Rule 3.1, is that once an entity becomes aware of any information concerning it that a reasonable person would expect to have a material effect on the price or value of the entities securities, the entity must immediately inform the ASX of that information. Price sensitive information includes information about such things as earnings, mergers, acquisitions, joint ventures, changes in assets, new products or discoveries, developments regarding customers or suppliers (e.g. winning or losing a contract) and changes in control or management (ASIC, 2000). Listing Rule 3.1 is augmented by the operation of Rule 15.7, which provides that a firm may not make further disclosure to anyone until it has received an acknowledgement from the ASX that the information has been released to the market. Rule 15.7 is designed to ensure that the efficiency and integrity of the process of releasing market information is maintained, making the Company Announcements Platform the central collection point for all price sensitive information (ASX, 2003). Risk of informed trading activity and unequitable access to information is therefore significantly reduced, as the ASX acts as the initial conduit through which information is widely disseminated. Under Australia’s current continuous disclosure regime, it should be impossible to leak information: Either all investors hear news at once, or none do. Assuming the market is efficient, changes in security prices reflect the flow of new information to the market. Thus abnormal trading volume or price movements witnessed immediately prior to the release of price-sensitive unscheduled company announcements would provide evidence of information leakage and informed investor trading (Collett, 2004). There has to date been limited empirical analysis of the presence of information asymmetry in Australian markets and the effectiveness of Australia’s corporate disclosure rules in preventing selective disclosure and information leakage. This study examines information content and trading behaviour around unscheduled earnings announcements – consisting of profit upgrades, profit warnings and neutral trading statements – made by ASX-listed companies during 2004. The analysis of earnings forecasts are particularly relevant as these notices provide a clear signal to the market that management of the firm has revised their expectations, or believes that current analyst or market projections are inaccurate. Other types of 55 The provisions were inserted into the Corporations Law by the Corporate Law Reform Act, 1994

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irregular announcement are not considered in this study as they may have variable information content, or provide an ambiguous signal to the market, which creates difficulties in assigning an a priori expectation of the market’s response to the new information. The study will focus on the pre-announcement period to test for information asymmetry and informed trading prior to the official release of the earnings information through the ASX Company Announcements Platform. Further, this study will attempt to identify the variables, or firm characteristics, that influence firm disclosure practices and contribute to the level of information asymmetry in the market during the preannouncement period. Previous research has investigated the influence of firm size and information content in contributing to information leakage. This study further considers the variables of firm growth, capital structure and industry group. We consider capital structure to be of interest as profit forecasts provide early indications of a firm’s continued ability to service its debt requirements and heavily influences the riskiness of its business. Examining a firm’s growth in trading revenue, as a measure of recent performance, explores whether variations in disclosure practices exist between firms that are expanding or contracting appreciably. Finally, industry associations are considered to assist detecting variations in corporate culture across industries. The remainder of this paper is organised as follows: Section II provides an overview of the empirical literature to date concerning information leakage and selective disclosure, and then develops the hypotheses to be addressed. Section III discusses the sample and develops the methodology adopted, while Section IV reports the findings of the empirical analysis accompanied by a brief discussion and Section V states the conclusions of the findings. Policy implications of the results are outlined, and areas of further research are suggested. II . Literature Review 2.1 Informed Trading around Earnings Announcements

A review of the literature indicates that the imposition of statutorily enforced disclosure rules has been largely successful in reducing or eliminating information leakage and informed trading, in particular around earnings announcements. Helbok and Walker (2003) report that evidence of informed trading prior to the release of profit warnings by UK firms does not continue after the introduction of a continuous disclosure obligation. This finding is supported by Collett (2004) who finds no evidence of informed trading in any of his size categories prior to trading statements made by UK firms in the postenactment period. Dedman (2004) acknowledges that this combined contribution to the UK disclosure literature suggests that recent changes to market regulation in the UK have reduced informed trading


around earnings updates to insignificant levels. Similar findings were observed in the USA by Mac (2002), who reports an abatement in unfair trading around earnings announcements subsequent to the introduction of Regulation FD prohibiting selective disclosure by US firms. The study by Jackson and Madura (2003) examined the release of profit warnings by US firms and found evidence to suggest larger firm size and negative information content as contributing factors to increased information asymmetry observed prior to earnings announcements. However, this latter study employed data prior to the introduction of Regulation FD. There is a gap in the literature however, with respect to studies performed on Australian markets. There has to date been limited empirical analysis of Australia’s corporate disclosure rules and the presence of information asymmetry around earnings information announcements. However, there are some related studies that focus related disclosures and frequency of disclosures. Aitken and Czernkowski (1992) measure unexpected returns and trading volume prior to the announcement of Australian takeover offers, during the period 1982 to 1987. The study finds that when the information contained in media reports leaking news before the official announcement is controlled for, a significant proportion (30%) of the price and volume run-up could be eliminated or explained. Their study also found significant abnormal returns 4 days prior to the media-adjusted announcement date. In a series of working papers commissioned by the Australian Securities Commission (ASC 56 ), the Securities Industry Research Centre of Asia Pacific (SIRCA) reviewed Australia’s enhanced disclosure (ED) rules by attempting to identify the impact on listed firms’ disclosure practices, and the market reaction to those disclosures (Brown et al., 1999, Brown et al., 1996c, Brown et al., 1996b, Brown et al., 1996a). 57 Their results generally indicated that although total disclosures increased post-sanctions, disclosures classified as ‘price sensitive’ by the ASX only became more frequent for firms without a large analyst following and for firms which are more likely to have revealed relatively bad news. While their research incorporated all disclosures made in accordance with Listing Rule 3.1, and did not explicitly consider information leakage around announcement events, their results identified the marginal effects of ED on company disclosure policies which have been reflected in current international literature. Namely, there is some evidence that both company disclosure policies, and the level of informational asymmetry in the market 56

Now the Australian Investments and Securities Commission (ASIC) 57 Since September 5, 1994, statutory provisions have expressly supported the ASX Continuous Disclosure Requirements. Ss.793C and 1101B of the Corporations Act allow a court to order compliance with any ASX Listing Rule or to make consequential orders on a contravention of any ASX Listing Rule.

prior to price sensitive announcements, is conditional upon firm size and whether the informational content of the announcement is positive or negative for the disclosing firm. 2.2 The Frequency and Effect of Positive and Negative Announcements

A belief that ED legislation would modify corporate disclosure policies ultimately reduces to an expectation that the introduction of civil and criminal sanctions will have such an effect (Brown et al., 1996c). Skinner (1994) develops an argument based on the expectations adjustment hypothesis of Ajinyka and Gift (1984), which states that the probability an earnings announcement will be pre-empted by voluntary disclosures depends on the absolute size of the earnings surprise. Skinner further argues that due to legal incentives to voluntarily disclose, US firms are much more likely to reveal ‘bad’ earnings news in advance than they are to foreshadow earnings improvements. Collett (2004) demonstrated that both the number of negative trading statements and their absolute impact was much higher than the number and impact of positive trading statements. Similarly, Kasznic and Lev (1995) find that twice as many US firms issue pre-emptive warnings about negative earnings surprises than issue early indicators of positive earnings surprises. Interestingly, Mac (2002) reports that there was comparatively less information leakage for positive surprises than negative surprises, in both the pre- and post- Regulation FD period. 2.3 The Impact of Firm Size

The firm-size differential information hypothesis is provided by Atiase (1980), who proposes that the amount of private pre-disclosure information production and dissemination is an increasing function of firm size (market capitalization). This is supported by Ryan and Taffler (2004) who argue that periodic accounting reporting is an anticipated news release and thus generates extensive prior search activity (e.g. through the earnings forecasting activities of analysts). Other information events however, including those made under a continuous disclosure obligation, occur randomly and cannot be predicted in the same way without incurring substantial speculative search costs. Given company size is shown to be a proxy for the number of analysts following companies, Collet (2004) found strong evidence that the market is less surprised by trading statements from companies which are followed by numerous analysts. Further to this, his results indicated that while profit warnings for large companies produce significant negative abnormal returns on announcement day, the abnormal returns are negligible and insignificant for upgrades. Jackson and Madura (2003) found that the response to profit warnings during the announcement period and

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post-announcement period is more negative for small firms. It may be concluded that as analysts monitor large firms more closely than they monitor small firms, earnings information disclosed by small firms is less likely to be anticipated. 2.4 Other Factors

Whereas price adjustments identify changes in the market’s consensus expectations, irregular trading volume can reflect heterogeneous expectations of individual investors (Bamber, 1986, Collett, 2004). To the extent that information is leaked to individuals, a firm may experience abnormal levels of trading volume prior to an unscheduled announcement. However, if Australia’s continuous disclosure regime is effective, information leakage and hence information asymmetry should not be present in the Australian market. We will also consider abnormal volume effects surrounding unexpected earnings announcements. The level of information asymmetry and information leakage prior to information releases can be attributed to a firm’s willingness to engage in selective disclosure practices. Given the potential legal and reputation costs of breaching disclosure rules, it is proposed that unobservable motivations induce management to engage in selective disclosure. Therefore, the pre-announcement period can be used to test whether company disclosure policies are conditioned by discrete firm characteristics. Previous research has investigated the influence of firm size and information content in contributing to information leakage. This study further considers the variables of firm growth, capital structure and industry group. The effect of firm growth has not been considered by the prior literature. While we can form predictions regarding the influence the variable might have on the magnitude of abnormal returns (i.e. tendency to magnify or offset the information contained in the announcement), it is more difficult to form an a priori expectation concerning whether it would influence a firm’s willingness to leak information. Firms experiencing financial difficulties would appreciably be cautious of the manner in which negative information is released to the market. The firm’s debt to equity ratio is considered to asses whether the level of debt financing (risk) employed by a firm influence its tendency to selectively disclose to favoured shareholders. As with firm growth, capital structure has not been considered as an independent variable by previous studies. Accordingly, we again have no pre-determined a priori expectation concerning its relationship with the magnitude of pre-announcement CARs. As a firm’s trading revenue growth indicates recent financial performance, it may be used to identify firms that are be expanding or contracting. which may lead to less pre-announcement leakage. A firm’s industry group is also considered by this study according to its four-digit Global Industry

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Classification System (GICS) code. This classification has also been overlooked by the supporting literature. Once again, no a priori expectation is advanced. The variable is considered to test whether corporate culture, and the willingness to leak price-sensitive earnings forecasts, varies between industry groups. III. Research Design

The objective of this study is to test for information leakage and informed trading in the Australian stock market, prior to the release of unscheduled earnings announcements. The contention is that informed trading impacts on the stock returns and trading volumes of ASX-listed firms, and hence abnormal returns and trading volumes prior to an announcement would provide evidence of information leakage. The initial data set comprises the complete set of announcements made by ASX-listed firms under their continuous disclosure obligations. The full electronic text of announcements made by ASX-listed firms is distributed through Signal-G electronic records, and subsequently archived on the DatAnalysis Image Signal database. The ASX attaches two-digit event codes to all Signal-G transmissions; this study focuses on item 14 (‘Other’) announcements that have also been flagged as price sensitive by ASX staff. The study considers all announcements made during the sample period extending from January 1, 2004 to December 31, 2004. In total, 3,564 pricesensitive, unscheduled announcements were made during the period. Of these, 489 announcements were identified as containing forecast earnings information. To narrow the study focus on unscheduled earnings announcements, a number of announcements containing potentially confounding information were excluded from the sample. First, announcements that provide actual earnings or sales figures along with some indication of future earnings are eliminated, as the current trading results could bias the market response. Second, announcements including information such as dividend declarations, equity issues, substantial asset sales or administrative matters are eliminated, as the market reaction could otherwise not be fully ascribed to the earnings forecast. Firms are also excluded for insufficient data, where unscheduled announcements were made concurrently with annual or interim reports, or for the presence of confounding events or price sensitive announcements within a five-day window prior to the earnings announcement.

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 1. Sample Characteristics of Unscheduled Earnings Announcements Classification of all unscheduled earnings announcements by ASX-listed firms distributed through Signal-G electronic records by industry and announcement type for the period January 1, 2004 to December 31, 2004. Descriptive statistics for the size of firms included in the sample is denoted by market capitalisation one-day prior to the announcement and is in millions of A$. Industry Group

GICS Code

Upgrade

Neutral

Warning

Energy

1010

2

1

0

Total 3

Materials

1510

14

0

12

26

Capital Goods

2010

13

0

6

19

Commercial Services & Supplies

2020

5

0

5

10

Transportation

2030

0

0

4

4

Automobiles & Components

2510

1

0

2

3

Consumer Durables & Apparel

2520

3

1

3

7

Consumer Services

2530

7

1

4

12

Media

2540

5

2

2

9

Retailing

2550

6

3

3

12

Food & Staples Retailing

3010

3

2

0

5

Food, Beverage & Tobacco

3020

7

2

9

18

Health Care Equipment & Services

3510

3

1

3

7

Pharmaceuticals & Biotechnology

3520

5

0

0

5

Banks

4010

0

3

2

5

Diversified Financials

4020

16

3

2

21

Insurance

4030

3

0

0

3

Real Estate

4040

5

2

1

8

Software & Services

4510

8

2

5

15

Technology Hardware & Equipment

4520

1

0

3

4

Telecommunication Services

5010

2

1

1

4

Utilities

5510

2

0

1

3

111

24

68

203

Mean:

814.26

5315.20

1626.32

1626.28

Median:

124.53

310.76

31.70

87.33

Total

Market Capitalisation (,000,000)

The final sample constitutes 203 unscheduled earnings announcements, as described in Table 1. The sample is divided into announcements that may be classified as a profit upgrade, a profit downgrade (warning), or a neutral trading statement to permit analysis of the information content of each announcement. Defining conclusively an upgrade, neutral trading statement, or profit warning requires a pre-existing market expectation or management forecast. As identified in previous studies, numerical forecasts are often not provided; instead, phrases such as ‘above market expectations’ were common. Accordingly, we adopted an approach similar to that espoused by Collett (2004) to classify the statements: ‘Whilst we could have confined ourselves to unambiguous statements containing a clear signal relative to prior expectation, it was decided that there were sufficient statements exuding optimism or pessimism, but without existing market expectations, to adopt a more judgemental approach.’ (Collett, 2004 p.8)

The content of each announcement and the trading data for disclosing entities is obtained from the Bloomberg and DatAnalysis databases. Trading data to be examined includes both stock returns and trading volumes around the announcements. The study will also examine the effect of specific firm characteristics and the information content of the earnings announcement. 3.1 Measuring Valuation Effects of Information Leakage

Event-study procedures are used to calculate the abnormal pre-announcement returns over several windows ranging in length from one to thirty days. Measuring abnormal returns before the announcement is a means commonly adopted to identify changes in the market’s consensus expectations generated by new information, by distinguishing significant firmspecific price movements from market wide fluctuations (Beaver, 1968, Collett, 2004).

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The abnormal return in any given period is the adjusted market model residual, which is the difference between the stock’s actual return and the predicted return based on the adjusted market model return for that period. Continuously compounded actual daily stock and market index return for each day are employed in the market model estimates and measures of the actual stock return. The potentials for bias of the OLS βi (beta) from the market model due to nonsynchronous data have been widely recognised, and are particularly relevant in Australian markets. This study adopts the Scholes & Williams (1977) adjusted beta to avoid the bias associated with the estimation of parameters using daily returns for securities with infrequent trading. The Scholes-Williams procedure involves the estimation of three simple OLS regressions using the T daily returns within the estimation period: The Scholes Williams estimates for each individual company announcement are calculated using returns during a 200-day estimation period, ending 30 days before the event date [-230, -31].

Rit = α i1 + β i1 (Rm ,t ) + µ1t for t = 1, 2, …, T (1) Rit = α i 2 + β i 2 (Rm ,t +1 ) + µ 2t for t = 1, 2, …, T-1 (2)

Rit = α i 3 + β i 3 (Rm,t −1 ) + µ 3t for t = 2, 3, …, T (3) The Scholes-Williams adjusted beta is then formed as follows:

β iSW =

(β i1 + β i 2 + β i 3 ) (1 + 2 ρ )

(4)

Where: Rm,t+1 is the return on market in period t+1; Rm,t-1 is the return on market in period t-1; βik is the estimated OLS coefficients for k =1, 2, and 3; βiSW is the adjusted Scholes-Williams beta; and ρ is the estimated OLS coefficient of Rm,t on Rm,t-1 (the correlation coefficient)58; The corresponding Scholes-Williams adjusted α (alpha) is formed as follows: T −1    1   T −1  ∑ Rit −  β iSW ∑ Rmt   T − 2   t =2 t =2  

α iSW = 

(5)

Where: αiSW is the Scholes-Williams adjusted alpha. The adjusted alpha and beta of the market model are then used to calculate the predicted returns of each 58

ρ=

148

Cov(Rmt , Rmt −1 ) Var (Rmt ) Var (Rmt −1 )

observation during a 36-day event window [-30, 5]. The market model residual abnormal returns (AR) for each observation during the event window are calculated as follows:

ARit = Rit − E (Rit )

(6)

Where: ARit is the abnormal return for firm i on day t; and E(Rit) is the expected return of the stock based on 200-day Scholes-Williams adjusted betas for each firm i. The observations are segregated into three subsamples, consisting of profit upgrades, profit warnings, and neutral trading statements. Abnormal returns are averaged across N firms for each subsample, giving the average abnormal return (AAR) for each event day:

AARt =

∑ AR

it

(7)

N

Where: AARt is the average abnormal return on day t. Additionally, for the analysis of valuation effects over multiple event days, the cumulative average abnormal return (CAAR) was calculated: t =t 2

CAARw = ∑ AARt

(8)

t = t1

Where: CAARW is the cumulative average abnormal return over an event window W days in length; and t1 & t2 are the first and last event dates, respectively, of event window W. An estimate of the standard deviation was calculated using the 200-day estimation period returns [-230, -31], which excludes the influence of any increased in variance around the event date:

(1199)∑ (AAR − AAR) 200

S AAR =

2

t

(9)

t =1

Where: SAAR is the standard deviation of the average abnormal return; and

AAR is the mean average abnormal return over the 200-day estimation period. Using the standard deviation estimate, upper-tail, lower-tail and two-tailed tests were performed to gauge the significance of both AARs and CAARs. All hypotheses were accepted or rejected according to the t-statistic, formulated as follows: t=

AARt CAARW or t = S AAR W .S AAR

(10)

One-tailed tests were applied to the AARs and CAARs of upgrades (downgrades), given the a priori


expectation that the leakage of positive (negative) information would lead to an increase (decrease) in price. Specifically, upgrades were tested against a null hypothesis of AARs and CAARs being less than or equal to zero, while the null hypothesis for downgrades stated AARs and CAARs greater than or equal to zero. Two-tailed tests were performed for the AARs and CARs of neutral trading statements, given the a priori expectation of nil information content. A null hypothesis of AARs and CAARs equal to zero was applied. 3.2 Measuring Volume Effects of Information Leakage

In contrast to price movements, which reflect a change in the market’s consensus expectations, measuring trading volume activity before the announcement is a means used to identify heterogeneous expectations of individual investors (Bamber, 1986, Collett, 2004). Measuring unexpected trading volume requires a benchmark for expected trading volume. Collett (2004) identifies the percentage of a firm’s outstanding shares trading on a given day, as opposed to normal daily volume, as an appropriate measure due to its ability to adjust for equity issues during the sample period. Daily volume for each day in the sample period is calculated as follows:

VOLit =

SHRTRDit × 100 SHROUTit

(11)

Where: VOLit is the volume for firm i on day t; SHRTRDit is the number of firm i's shares traded on ASX on day t, and SHROUTit is the number of firm i's shares outstanding on day t. Abnormal volume (AVOL) is then calculated as the residual of daily volume less mean daily volume during the estimation period, and is estimated for each observation during a 36-day event window [-30, 5]:

AVOLit = VOLit − VOLi

(12)

Where: AVOLit is the abnormal volume for firm i on day t; and

VOLi is the mean daily volume of firm i during the 200-day estimation period [-230, -31] The observations are again segregated into three sub-samples, consisting of profit upgrades, profit warnings, and neutral trading statements. Abnormal volumes were averaged across N firms for each subsample, giving the average abnormal volume (AAVOL) for each event day:

AAVOLt =

∑ AVOL

it

N

(13)

Where: AAVOLt is the average abnormal volume on day t. For the analysis of volume effects over multiple event days, the cumulative average abnormal volume (CAAVOL) was calculated: t =t 2

CAAVOLw = ∑ AAVOLt

(14)

t =t1

Where: CAAVOLW is the cumulative average abnormal volume over an event window W days in length; and t1 & t2 are the first and last event dates, respectively, of event window W. An estimate of the standard deviation was calculated using the 200-day estimation period volumes [-230, -31], which excludes the influence of any increased in variance around the event date:

(1199)∑ (AAVOL − AAVOL) 200

S AAVOL =

2

t

(15)

t =1

Where: SAAR is the standard deviation of the average abnormal volume; and

AAVOL is the mean average abnormal volume over the 200-day estimation period. Using the standard deviation estimate, upper-tail tests were performed to gauge the significance of both AARs and CAARs. All hypotheses were accepted or rejected according to the t-statistic, formulated as follows:

t=

AAVOLt S AAVOL

or

t=

CAAVOLW W .S AAVOL

(16)

One-tailed tests were applied to the AARs and CAARs for all sub-samples, given the a priori expectation of information leakage leading to an increase in trading volume. Specifically, observations were tested against a null hypothesis of AARs and CAARs being less than or equal to zero. 3.3 Cross-Sectional Model of Firm Characteristics

A cross-sectional model, similar to that adopted by Jackson and Madura (2003), is used to investigate the association between the absolute magnitude of the CARs for profit upgrades and warnings and the discrete firm characteristics specific to the event observation. The primary cross-sectional model is constructed as follows: CARt = δ 0 + δ 1 SIZE + δ 2 GRWTH + δ 3 DBTEQU + δ 4 NEG + µ t

(17)

E (µ t ) = 0

(18)

Where:

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CARt is the tth cumulative abnormal return observation; SIZE is the natural logarithm of the firm’s market capitalisation prior to the event date; GRWTH is the natural log return of the firm’s trading revenue between the current and prior periods; DBTEQU is the firm’s debt to equity ratio for the current period; NEG is a dummy variable assigned a value of one for profit warnings, and zero otherwise; δq, q = 0, …, Q, are the regression coefficients; and µt is the zero mean error term. The model is applied to valuation effects over one-, five-, ten-, twenty- and thirty-day periods prior to the announcement to determine whether the valuation effects are conditioned by firm size, growth, capital structure, or by the announcement’s information content. A second enlarged crosssectional model is developed, which stratifies firms making profit warnings into their relevant GICS industry group: CARt = δ 0 + δ 1 SIZE + δ 2 GRWTH + δ 3 DBTEQU + δ j IND j + µ t (19)

E (µ t ) = 0

(20)

Where: INDj, j = 1, …, 22, is a dummy variable assigned a value of one for profit warnings issued by a firm in a given GICS industry group, and zero otherwise. The enlarged model is again applied to valuation effects over one-, five-, ten-, twenty- and thirty-day periods prior to the announcement. IV. Results And Discussion 4.1 Information Content of Unscheduled Earnings Announcements

The valuation and volume effects during the postannouncement period are examined to determine whether unscheduled earnings announcements contain private information that the market was previously unaware of. The study proposes that management of disclosing firms hold private, price sensitive information, and that unscheduled earnings announcements are made to fulfil obligations imposed by the ASX Listing Rules. Table 2 presents announcement day abnormal returns and abnormal trading volumes, as well as post-announcement CAAR and CAAVOL for profit upgrades, downgrades and neutral trading statements made by ASX-listed firms during the sample period. Table 2, Panel A provides results for profit upgrades. On the actual announcement day, average abnormal returns are 5.63%, significant at the 1% level. For the five-day period following the

150

announcement, a CAAR of –1.86% significant at the 1% level is observed. Similarly, announcement day average abnormal volume of 0.83% and a five-day CAAVOL of 1.00%, both significant at the 1% level, are observed. The magnitude of the postannouncement abnormal return is very high and we can therefore safely conclude that the market has responded to new information on that day. Hence, we may also conclude, that on average, profit upgrade announcements contain significant information content. However, as also implied by Figure 1, significant negative returns following the announcement day indicate that the market on average overreacted to the news, resulting in a price correction three to four days after the information release. Table 2, Panel B provides results for profit warnings. For the announcement day, average abnormal returns are -4.79%, significant at the 1% level. A CAAR of -4.06%, significant at the 1% level, is observed for the five-day period following the announcement. Further, announcement day average abnormal volume of 0.22% and a five-day CAAVOL of 0.88%, both significant at the 1% level, are observed. Again, a highly significant postannouncement abnormal return permits us to conclude that the market has responded to new information on the announcement day. Thus, we may conclude, that on average, profit warning announcements contain significant information content. The net valuation effects of profit warnings appear to be greater in magnitude than for profit upgrades. While the announcement day abnormal return for profit warnings (-4.79%) is less than that of profit upgrades (5.63%), the market takes longer to compound information contained in profit warnings. As indicated by Figure 1, the average two-day valuation effect of profit warnings is -8.55%, also significant at the 1% level. Further, unlike profit upgrades there are no immediate price corrections that suggest the market initially overreacted to the information. Table 2, Panel C provides valuation and volume effects for neutral trading statements. On the actual announcement day, average abnormal returns are 0.61%, and a CAAR of 0.01% is observed for the five-day period following the announcement. Neither result is significantly different from zero. Reported trading volume in the post-announcement period is also insignificant for neutral trading statements. When combined with Figure 1, we may deduce that while the market response to neutral trading statements is positive, as the findings lack significance, the conclusion that on average neutral trading statements contain no information content is warranted. This finding is consistent with the definition of a neutral trading statement adopted, being those announcements that merely reaffirm previously stated projections or forecasts. Hence, the market should have already priced the information at the time of its original release.

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 2. Information Content of Unscheduled Earnings Announcements This table presents the stock price and trading volume effects of unscheduled earnings announcements made by ASX-listed firms, over the sample period of January 1, 2004 to December 1, 2004. The event date (Day 0) is defined as the actual announcement release date through the ASX Company Announcements Platform. AAR (AAVOL) is the average abnormal return (volume) of the cross-sectionally combined observations for the relevant event day. CAAR (CAAVOL) is the cumulative average abnormal return (volume) over the selected multi-day interval. T-statistics are in parenthesis. Panel A: Profit Upgrades Event Window [0] [1, 5] Panel B: Profit Warnings Event Window [0] [1, 5] Panel C: Neutral Trading Statements Event Window [0] [1, 5]

AAVOL(%) or CAAVOL(%) 0.828% (11.206) *** 1.004% (6.076) ***

AAR(%) or CAAR(%) -4.793% (-10.711) *** -4.063% (-4.061) ***

AAVOL(%) or CAAVOL(%) 0.223% (4.779) *** 0.881% (8.432) ***

AAR(%) or CAAR(%) 0.608% (1.094) 0.007% (0.005)

AAVOL(%) or CAAVOL(%) -0.017% -0.179 -0.213% -1.024

* denotes statistical significance at the 10% level ** denotes statistical significance at the 5% level *** denotes statistical significance at the 1% level

7,5% Cummulative Average Abnormal Return

Note:

AAR(%) or CAAR(%) 5.629% (14.685) *** -1.861% (-2.171) ***

5,0% 2,5% 0,0% 0

1

2

3

4

-2,5% -5,0% -7,5% -10,0% Event Day Upgrade

Neutral

Warning

Figure 1. Post-Announcement CAAR for Unscheduled Earnings Announcements

151


4.2 Valuation Effects of Information Leakage

This study contends that markets are efficient in the semi-strong form. This implies that prices fully reflect all publicly available information, and hence that prices may be regarded as the consensus expectations of market participants. To the extent that information contained in unscheduled earnings announcements is leaked to analysts, media or major shareholders, the revaluation of a firm may begin before the official release of the price sensitive information through the Company Announcements Platform. Therefore, if firms were engaging in selective disclosure prior to the official announcement release, we would expect to see security prices, and hence returns, creep up (down) as informed traders revise their positions. Profit Upgrades Figure 2 demonstrates the path of the CAAR for profit upgrades during an event window extending thirty days before and five days after the official announcement date (Day 0). A brief examination identifies that the abnormal returns track a slight positive trend before returning to a relatively constant mean reversion leading up to the announcement date. The substantial spike at day 0 indicates the market’s reaction immediately following the announcement, and the subsequent partial correction three to four days after the announcement.

152

8,0% Cummulative Average Abnormal Return

This study is consistent with Collett (2004) who finds for UK firms making unscheduled trading statements, that the announcement day valuation effect of negative announcements (-15.56%) is greater in magnitude than for positive announcements (4.19%), both being significant at the 1% level. However, Collet reports that the UK market tends to overreact to negative announcements and, on average, firms experienced a positive price correction in the subsequent days trading. Collett also reports similar findings of insignificant valuation effects following the release of neutral trading statements (0.51%). Helbok and Walker (2003) report that UK firms issuing profit warnings on average experience a 17.05% abnormal return on the announcement day. Further, Jackson and Madura (2003) found that US firms issuing profit warnings experience a -10.75% abnormal return on the announcement day. Taken together, this suggests that the Australian market is slower to complete its revaluation and less critical of firm’s issuing profit warnings. Overall, the findings are also consistent with Kim and Verrecchia (1991) who demonstrate that trading volume is proportional to the magnitude of the price change at the time of the announcement and to the degree of pre-disclosure informational asymmetry. This implies that, as observed, trading volume should increase at the time of unanticipated announcements, especially if shareholders have a diverse set of expectations.

7,0% 6,0% 5,0% 4,0% 3,0% 2,0% 1,0% 0,0% -30 -28 -26 -24 -22 -20 -18 -16 -14 -12 -10 -8

-6

-4

-2

0

2

4

Event Day

Figure 2. Profit Upgrade CAAR during Event Window

Table 3 presents the valuation effects around profit upgrade announcements made by ASX-listed firms during the sample period. None of the single day average abnormal returns prior to the announcement are significant and are not reported. A highly significant abnormal return is observed on the announcement day reflecting the release of new information to the market. This table 3 reports CAAR for profit upgrades over select multi-day intervals. All CAAR leading up to the announcement date are positive, but small, and none are significant. These findings indicate that on average, there are no significant changes in market consensus expectations prior to the release of unscheduled profit upgrades by ASX-listed firms during the sample period. This finding is consistent with Collett (2004) who reports that UK firms experience insignificant abnormal returns during a five-day window prior to the release of positive trading statements. Further, this study adds to the literature by examining an extended preannouncement window, including the analysis of numerous multi-day intervals, to improve the likelihood of identifying the effects of information leakage. Profit Warnings Figure 3 demonstrates the path of the CAAR for profit warnings during an event window extending thirty days before and five days after the official announcement date (Day 0). An initial assessment suggests that the abnormal returns for profit warnings track a more substantial negative drift leading up to the announcement, before a brief correction prior to the announcement date. The downward spike from day 0 indicates a two-day revaluation period as the market adjusts to the new information. There does not appear to be evidence of an immediate positive correction to counter an initial overreaction by the market.


Table 3. Valuation Effects Around Profit Upgrades This table presents the stock price effects surrounding profit upgrade announcements made by ASX-listed firms, over the sample period of January 1, 2004 to December 1, 2004. The event date (Day 0) is defined as the actual announcement release date through the ASX Company Announcements Platform. CAAR is the cumulative average abnormal return between day -30 and the relevant event day and over selected multi-day intervals. The t-statistics and p-values are based upon the null hypothesis that CAAR is less than or equal to 0. The alternative hypothesis states that CAAR is greater than zero.

Event Window [-30, -1] [-20, -1] [-10, -1] [-5, -1] [0] [1, 5] Note:

Cumulative Average Abnormal Returns over Multiple Event Days AAR(%) or CAAR(%) t-statistic 1.600% 0.7622 0.471% 0.2750 0.531% 0.4383 0.926% 1.0807 5.629% 14.6852 -1.861% -2.1714

Upper Tail p-Value 0.2235 0.3918 0.3308 0.1406 0.0000

***

0.9844


Cummulative Average Abnormal Return

1.0% -1.0% -30 -28 -26 -24 -22 -20 -18 -16 -14 -12 -10

-8

-6

-4

-2

0

2

4

-3.0% -5.0% -7.0% -9.0% -11.0% -13.0% -15.0% Event Day

Figure 3. Profit Warning CAAR during Event Window

Table 4 presents the valuation effects around profit warnings made by ASX-listed firms during the sample period. Panel A reports the average abnormal return for the cross-sectionally combined observations for each day during the event window whereas Panel B reports CAAR for profit warnings over select multiday intervals. Unlike profit upgrades, the study finds some evidence of abnormal returns during the thirty-day pre-announcement period. Firstly, we observe CAARs of -5.66% for the window [-30, -1] and -4.22% for the window [-20, -1], both significant at the 5% level. Observed CAARs for the windows [-10, -1] and [-5, -

1] are also negative, but are insignificant. Furthermore, an inspection of individual daily average abnormal returns identifies, among other significant results, a cluster of days with significant negative valuation changes between one and two-weeks prior to the announcement date. Specifically, we observe average abnormal return of -1.10%, significant at the 1% level, for event day [-7], and average abnormal return of -0.90%, significant at the 5% level, for event day [-5]. We also observe returns of -0.63% and 0.61% for event days [-9] and [-8] respectively, both significant at the 10% level.

153

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 4. Valuation Effects around Profit Warnings This table presents the stock price effects surrounding profit warnings made by ASX-listed firms, over the sample period of January 1, 2004 to December 1, 2004. The event date (Day 0) is defined as the actual announcement release date through the ASX Company Announcements Platform. AAR is the average abnormal return of the cross-sectionally combined observations for the relevant event day. CAAR is the cumulative average abnormal return between day -30 and the relevant event day (Panel A), and over selected multi-day intervals (Panel B). AAR and SAAR are the mean and standard deviation of average abnormal returns. The t-statistics and p-values are based upon the null hypothesis that AAR (CAAR) is greater than or equal to 0. The alternative hypothesis states that AAR (CAAR) is less than zero. Panel A: Daily Average Abnormal Returns Event

Lower Tail

Day

AAR(%)

t-statistic

p-Value

CAAR(%)

-30 -29 -28 -27 -26 -25 -24 -23 -22 -21 -20 -19 -18 -17 -16 -15 -14 -13 -12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5

0.1763% -0.1005% -0.1066% -0.1134% 0.0770% -0.9632% -0.4041% -0.4667% 1.1190% -0.6604% 0.2828% -0.4973% -0.0115% -0.3251% -0.2540% -0.0922% -0.4393% -0.4055% -0.2070% -0.4537% 0.8282% -0.6284% -0.6041% -1.1029% 0.1300% -0.8984% 0.1010% 0.2973% 0.4727% -0.4113% -4.7929% -3.7548% -0.2892% 0.1728% 0.1955% -0.3872%

0.3939 -0.2246 -0.2383 -0.2535 0.1722 -2.1526 -0.9031 -1.0429 2.5008 -1.4759 0.6320 -1.1115 -0.0258 -0.7264 -0.5677 -0.2061 -0.9819 -0.9062 -0.4626 -1.0140 1.8508 -1.4044 -1.3501 -2.4649 0.2905 -2.0078 0.2258 0.6645 1.0565 -0.9192 -10.7114 -8.3915 -0.6463 0.3862 0.4368 -0.8653

0.6530 0.4113 0.4060 0.4001 0.5683 0.0163 0.1838 0.1491 0.9934 0.0708 0.7359 0.1338 0.4897 0.2342 0.2854 0.4185 0.1637 0.1830 0.3221 0.1559 0.9672 0.0809 0.0893 0.0073 0.6141 0.0230 0.5892 0.7464 0.8540 0.1796 0.0000 0.0000 0.2594 0.6501 0.6687 0.1939

0.1763% 0.0758% -0.0308% -0.1443% -0.0672% -1.0304% -1.4345% -1.9012% -0.7822% -1.4426% -1.1598% -1.6571% -1.6687% -1.9937% -2.2477% -2.3400% -2.7793% -3.1848% -3.3918% -3.8455% -3.0173% -3.6458% -4.2499% -5.3528% -5.2228% -6.1212% -6.0202% -5.7228% -5.2501% -5.6614% -10.4543% -14.2092% -14.4983% -14.3256% -14.1301% -14.5173%

AAR

-0.0077%

SAAR

Panel B: Cumulative Average Abnormal Returns over Multiple Event Days Event AAR(%) or

Note:

154

**

*

* * *** **

*** ***

0.0045

Lower Tail

Window

CAAR(%)

t-statistic

[-30, -1]

-5.661%

-2.3100

0.0110

**

[-20, -1]

-4.219%

-2.1083

0.0182

**

[-10, -1]

-1.816%

-1.2833

0.1005

[-5, -1]

-0.439%

-0.4384

0.3308

[0]

-4.793%

-10.7114

0.0000

***

[1, 5]

-4.063%

-4.0608

0.0000

***


p-Value


Taken together, these results suggest there is significant informed trading activity, causing substantial valuation effects, prior to the release of profit warnings by ASX-listed firms during the sample period. These findings are unanticipated in light of the continuous disclosure obligations imposed on ASX-listed firms, and with reference to recent studies surrounding similar provisions in the United Kingdom and the United States of America. Jackson and Madura (2003) report a highly significant CAAR of -3.53% for the window [-10, -2] preceding the release of profit warnings by US firms, their study was conducted prior to the introduction of legislative provisions prohibiting selective disclosure in the USA. While Mac (2002) reports an abatement of unfair trading in the USA subsequent to the introduction of Regulation FD, his study included both periodic and unscheduled earnings announcements thus jettisoning direct comparison to the findings of this study. Conversely, Helbok and Walker (2003) examined the effects of changes to the London Stock Exchange Guidance Notes in 1994 and the imposition of a continuous disclosure obligation similar to that enacted in Australia. They report significant average abnormal returns during the two days immediately prior to the release of profit warnings for the preenactment period, but find informed trading and average abnormal returns are reduced to insignificant levels in the post-enactment period. The findings of Helbok and Walker are corroborated by Collet (2004) who reports no evidence of information leakage or significant average abnormal returns during the window [-5, -1] for UK firms making negative trading statements in the period 1995-2001. Neutral Trading Statements Following from the results reported in Table 2 and subsequent discussion figures and tables of results are not reported for neutral trading statements. The results can be summarised as follows: Most observations are highly insignificant, with the exception of event day [1], which exhibits an average abnormal return of 0.93%, marginally significant at the 10% level. Notably, average abnormal returns observed on the announcement date and thereafter are conclusively insignificant. This study also finds that CAAR leading up to the announcement date vary in directional signal and are all decidedly insignificant. When considered with previous stated findings regarding the information content of neutral trading statements, it is difficult to conceive that valuation effects witnessed are the result of information leakage and informed trading. If neutral trading statements do not contain any information content that the market was previously unaware, then realistically management does not hold private information with which an informed trader could benefit in the preannouncement period.

4.3 Volume Effects of Information Leakage

This study contends that markets are efficient in the semi-strong form, which entails that prices fully reflect all publicly available information. While valuation effects are examined to identify changes in the market’s consensus expectations, irregular trading volume may reflect heterogeneous expectations of individual investors (Bamber, 1986, Collett, 2004). To the extent that information is leaked to individuals, a firm may experience abnormal levels of trading volume before the official release of the price sensitive information via the Company Announcements Platform. Therefore, if firms were engaging in selective disclosure prior to the official announcement release, we would expect to see a positive increase in trading volumes as informed traders revise their positions. Profit Upgrades Figure 4 presents daily average abnormal volume during an event window extending thirty days before and five days after the official announcement date (Day 0). The substantial increase in volume subsequent to the announcement is consistent with the market reaction to new information contained in profit upgrades. Prior to the announcement, daily trading volumes are generally below average volume levels observed during the estimation period. Table 5 presents the volume effects around profit upgrades made by ASX-listed firms during the sample period. This table reports CAAVOL for profit warnings over select multi-day intervals. None of the single day abnormal volumes before the announcement are significant, and most observations are in fact below the adopted benchmark. Highly significant abnormal volume observed following the announcement is consistent with Kim and Verrecchia (1991), demonstrating that abnormal trading volumes are proportional to the degree of price change at the time of an unanticipated announcement. We observe that all CAAVOL prior to the announcement of profit upgrades are, on average, negative and highly insignificant. These findings indicate that there is no systematic evidence of individuals engaging in informed trading prior to the release of unscheduled profit upgrades by ASX-listed firms during the sample period. This finding is consistent with Collett (2004) who reports that UK firms experience insignificant abnormal volumes for each of the five days prior to the release of positive trading statements. Further, this study adds to the literature by examining an extended pre-announcement window, including the analysis of numerous multi-day intervals, to assist in identifying information leakage occurring before five days prior to announcements.

155


Daily Average Abnormal Volume

0,80%

0,60%

0,40%

0,20%

0,00% -30 -28 -26 -24 -22 -20 -18 -16 -14 -12 -10 -8

-6

-4

-2

0

2

4

-0,20% Event Day

Figure 4. Profit Upgrade AAVOL during Event Window Table 5. Volume Effects around Profit Upgrades This table presents the trading volume effects surrounding profit upgrade announcements made by ASX-listed firms, over the sample period of January 1, 2004 to December 1, 2004. The event date (Day 0) is defined as the actual announcement release date through the ASX Company Announcements Platform. CAAVOL is the cumulative average abnormal volume between day -30 and the relevant event day and over selected multi-day intervals The t-statistics and p-values are based upon the null hypothesis that CAAVOL is less than or equal to 0. The alternative hypothesis states that CAAVOL is greater than zero. Cumulative Average Abnormal Volume over Multiple Event Days Event AAVOL(%) or Window CAAVOL(%) t-statistic [-30, -1] -1.233% -3.0456 [-20, -1] -0.548% -1.6568 [-10, -1] -0.266% -1.1393 [-5, -1] -0.178% -1.0780 [0] 0.828% 11.2059 [1, 5] 1.004% 6.0756 Note: * denotes statistical significance at the 10% level ** denotes statistical significance at the 5% level *** denotes statistical significance at the 1% level

Upper Tail p-Value 0.9987 0.9503 0.8720 0.8588 0.0000 0.0000

Daily Average Abnormal Volume

0,60% 0,50% 0,40% 0,30% 0,20% 0,10% 0,00% -30 -28 -26 -24 -22 -20 -18 -16 -14 -12 -10 -8 -6 -4 -2 -0,10% Event Day

Figure 5. Profit Warning AAVOL during Event Window

156

0

2

4

*** ***

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Profit Warnings Neutral Trading Statements

Figure 5 portrays daily average abnormal volume during an event window extending thirty days before and five days after the official announcement date (Day 0). The substantial increase in volume subsequent to the announcement is consistent with the market reaction to new information contained in profit warnings. Abnormal trading volumes for the two days following the release of a profit warning (0.22% and 0.49% respectively) are considerably smaller than those observed for profit upgrades for the same period (0.83% and 0.76% respectively), again suggesting the market reacts to negative announcements with increased caution in comparison to positive announcements. Prior to the announcement, daily trading volumes are sporadic, though largely mean reverting, with strong evidence of increased trading levels for several days during the period. Table 6 presents the volume effects around profit warnings made by ASX-listed firms during the sample period. Panel A reports the average abnormal volume for the cross-sectionally combined observations for each day during the event window. Consistent with Figure 6, we observe evidence of significant abnormal trading volume during the thirtyday pre-announcement period. Average abnormal volume of 0.06%, significant at the 10% level, observed for day [-5] supports the previously reported average abnormal returns observed for the same day. Together these findings provide conclusive evidence of irregular trading activity around the period one to two weeks prior to official announcement release. Further, abnormal volumes of -0.10% and -0.08% are observed for event days [-15] and [-16] respectively, both significant at the 5% level. These event days, however, do not experience proportional abnormal revenues for the given sample. It is thereby proposed that witnessing isolated abnormal volumes, which do not occur concurrently with significant valuation effects, indicates heterogeneous expectations and informed trading by individual market participants. Table 6, Panel B reports CAAVOL for profit warnings over select multi-day intervals. The findings generally support those expressed for single day observations prior to the announcement day. All CAAVOL are positive, and most are significant. Specifically, CAAVOL of 0.37% for the event window [-20, -1] supports the proposition of substantial irregular trading activity during the threeweek period leading up the release of profit warnings by ASX-listed firms during the sample period. These findings are generally inconsistent with Collett (2004) who also examines trading volume prior to the release of negative trading statements by UK firms. Collett reports no evidence of significant abnormal trading volume for the five-day period prior to announcement.

Previously stated findings of this study indicated that neutral trading statements on average contained no new information that the market was previously unaware of. This finding was consistent with the subsample constraint that neutral trading statements merely reaffirmed prior forecasts or projections to resolve heterogeneous expectations or incorrect market projections, rather than reveal new private information. Accordingly, the study anticipated insignificant trading volume and returns during the event window surrounding neutral trading statements. A brief examination suggests increased trading activity early in the event window, which reverts to a period of consistent sub-normal trading levels leading up to the announcements date. Insignificant (negative) abnormal volume following day 0 indicates there was no increase in trading activity subsequent the announcement release. CAAVOL for all windows during the study period are negative and highly insignificant when testing for abnormally high trading activity. These findings are difficult, but considered broadly may allude to the marginal motivations of management to issue a neutral trading statement to the market which, as previously defined, does no more than to merely reaffirm previously stated forecasts or projections. It is hereby posited that management of firms issuing neutral trading statements, while not holding private information, are generally responding to uncertainty or doubt surrounding their current or future performance. Such uncertainty may indeed be the result of media or market rumours, and hence management provides additional voluntary disclosure to improve transparency and marketability, and further to prevent a potential false market in its securities.59 4.4 Firm Characteristics

The initial findings of this study, as reported above, indicate there is sufficient evidence of information leakage and informed trading prior to unscheduled earnings announcements by ASX-listed firms to merit further analysis. The ensuing discussion presents the findings of this study’s attempt to identify the variables, or firm characteristics, which influence firm disclosure practices and contribute to levels of information asymmetry during the pre-announcement period. Given the potential legal and reputation costs of breaching disclosure rules, it is proposed that unobservable motivations induce management to 59

For example, the following extract is taken from a neutral trading statement issued by Flight Centre Ltd (FLT) on June 30, 2004: ‘In light of recent press speculation at an important point in the current financial year, Flight Centre Ltd wishes to confirm its position on changes in industry commission arrangements and the likely year-end profit outcomes. … The company also reaffirms its profit expectations for 2003-04, in response to unattributed press speculation.’

157


engage in selective disclosure. Prior studies have investigated the influence of firm size and information content in contributing to information leakage. As previously stated, this study extends the current literature by considering the additional variables of firm growth, capital structure and industry group. The methodology used is similar to that adopted by Jackson and Madura (2003) in their study of profit warnings issued by US firms. The cross-sectional OLS model tests whether the absolute magnitude of CARs for profit upgrades and warnings, observed over five event windows, can be attributed to a set of exogenous variables. The final sample consists of 179 observations for each event window. 60 Table 7 summarises the independent variable descriptive statistics (Panel A) and independent variable correlation (Panel B). Panel B indicates that the independent variables exhibit weak correlation, and may be modelled in their original formulation without a need to correct for collinearity. Table 8 presents the results for the primary OLS model, which includes the three independent variables representing firm size, growth and capital structure, and a dummy variable assigned a value of one for profit warnings, and zero otherwise. The dummy variable is used to stratify positive and negative unscheduled earnings announcement to determine whether a firm’s propensity to pre-disclose price sensitive information is conditional upon the information content of the announcement. The R squareds indicate that the primary model explains between 1.7% and 4.2% of the variation in absolute magnitude of CARs observed over the five event windows prior to the announcement day. A brief examination of the results from the primary model indicates the relationship between a firm’s market capitalisation (SIZE) and the magnitude of CARs is inconsistent across the five event windows, and insignificant. Both the rate of growth in trading volume (GRWTH), and the level of debt financing employed by a firm (DBTEQU) appear to have a consistent inverse relationship with the magnitude of CAR, with initial evidence suggesting that the relationship may be significant during several event windows. Finally, the dummy variable assigned to profit warnings (NEG) suggests an inconsistent relationship, which may indicate that a propensity to pre-disclose negative price sensitive information decreases closer to the announcement date. Overall, the primary model has minimal explanatory power for the magnitude of CARs observed during the pre-announcement period for profit upgrades and warnings. A second model is constructed which substitutes the dummy variable for profit warnings (NEG) with a series of dummy 60

Neutral trading statements are removed from the final sample as prior results indicated that on average they did not contain significant information content. Hence, valuation effects observed prior to the announcement day could not be attributed to information leakage, but rather other extraneous factors surrounding the event.

158

variables that each represent profit warnings made by ASX-listed firms during the sample period according to the firm’s industry group (INDj). Table 9 presents the results of the enlarged OLS model that again includes the three dependent variables representing firm size, growth and capital structure, and a series of dummy variables assigned a value of one for profit warnings issued by firms in a given GICS industry group, and zero otherwise. The dummy variable is used to determine whether a firm’s propensity to pre-disclose negative price sensitive information is conditional upon their industry group. The R squareds indicate that the enlarged model explains between 13.4% and 31.3% of the variation in absolute magnitude of CARs observed over the five event windows prior to the announcement day. This represents a considerable improvement of between 10.1% and 29.6% when compared with the parallel results obtained using the primary model. The coefficients for SIZE vary in signal between windows and are close to zero. All coefficients for SIZE are insignificant. These findings are relatively consistent with Jackson and Madura (2003) who, although finding a significant positive relationship between firm-size and the magnitude of CARs oneday prior to announcement, found the relationship was inconsistent and not significant for extended windows prior to the release of profit warnings by US firms. The results of this study may be partially explained by limitations incidental to the data set. The sample mainly consists of smaller companies and therefore may lose some of the variation in information leakage associated with firm size. The independent variable firm growth (GRWTH), defined by this study as a firm’s increase in trading revenue, is previously untested in the supporting literature. Table 9 indicates that GRWTH has an inverse relationship with the dependent variable CAR across all event windows studied. Further, the coefficients for event windows [-10, -1], [-20, -1] and [-30, -1] are all marginally significant at the 10% confidence level. This relationship suggests that firm’s experiencing growth in trading activities are less likely to incur significant valuation effects prior to the announcement date. Arguably, this relationship may be attributed to the fact that firms experiencing trading revenue growth are less likely to make profit warnings, and above this study reports no significant evidence of abnormal trading activity for profit upgrades made by ASX-listed firms during 2004. An inverse relationship between a firm’s capital structure (DBTEQU), as indicated by its debt to equity ratio, and the magnitude of pre-announcement CAR are observed for all event windows studied. Further, the coefficient for DBTEQU is significant at the 10% confidence level for the event window [-10, 1], which corresponds with a period of significant abnormal trading activity prior to profit warnings issued by ASX-listed firms.

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 6. Volume Effects around Profit Warnings This table presents the trading volume effects surrounding profit warnings made by ASX-listed firms, over the sample period of January 1, 2004 to December 1, 2004. The event date (Day 0) is defined as the actual announcement release date through the ASX Company Announcements Platform. AAVOL is the average abnormal volume of the cross-sectionally combined observations for the relevant event day. CAAVOL is the cumulative average abnormal volume between day -30 and the relevant event day (Panel A), and over selected multi-day intervals (Panel B). AAVOL and SAAVOL are the mean and standard deviation of average abnormal volumes. The t-statistics and p-values are based upon the null hypothesis that AAVOL (CAAVOL) is less than or equal to 0. The alternative hypothesis states that AAVOL (CAAVOL) is greater than zero. Panel A: Daily Average Abnormal Volume Event

Upper Tail AAVOL(%) -0.0103% 0.0158% -0.0180% -0.0106% -0.0049% 0.0482% 0.0333% 0.0029% -0.0175% -0.0021% 0.0262% 0.0054% -0.0339% 0.0140% 0.0838% 0.1005% 0.0007% 0.0064% -0.0049% 0.0165% 0.0425% 0.0139% -0.0016% -0.0067% -0.0321% 0.0655% 0.0004% 0.0246% 0.0005% 0.0466% 0.2233% 0.4891% 0.1466% 0.1486% 0.0762% 0.0206%

Day -30 -29 -28 -27 -26 -25 -24 -23 -22 -21 -20 -19 -18 -17 -16 -15 -14 -13 -12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5

AAVOL

t-statistic

p-Value

CAAVOL(%)

-0.2210 0.3380 -0.3844 -0.2259 -0.1050 1.0317 0.7118 0.0625 -0.3747 -0.0447 0.5612 0.1148 -0.7259 0.2987 1.7924 2.1512 0.0147 0.1375 -0.1058 0.3531 0.9092 0.2968 -0.0337 -0.1442 -0.6863 1.4020 0.0081 0.5268 0.0103 0.9972 4.7791 10.4671 3.1376 3.1789 1.6299 0.4402

0.5873 0.3678 0.6495 0.5893 0.5418 0.1517 0.2387 0.4751 0.6459 0.5178 0.2876 0.4544 0.7656 0.3827 0.0373 0.0163 0.4941 0.4454 0.5421 0.3622 0.1822 0.3835 0.5134 0.5573 0.7533 0.0812 0.4968 0.2995 0.4959 0.1599 0.0000 0.0000 0.0010 0.0009 0.0524 0.3301

-0.0103% 0.0055% -0.0125% -0.0231% -0.0280% 0.0203% 0.0535% 0.0564% 0.0389% 0.0368% 0.0631% 0.0684% 0.0345% 0.0485% 0.1322% 0.2328% 0.2334% 0.2399% 0.2349% 0.2514% 0.2939% 0.3078% 0.3062% 0.2995% 0.2674% 0.3329% 0.3333% 0.3579% 0.3584% 0.4050% 0.6283% 1.1175% 1.2641% 1.4127% 1.4888% 1.5094%

0.1312%

SAAVOL

** **

*

*** *** *** *** *

0.0005

Panel B: Cumulative Average Abnormal Volume over Multiple Event Days

Note:

Event

AAVOL(%) or

Window

CAAVOL(%)

t-statistic

[-30, -1]

0.405%

1.5823

0.0577

*

[-20, -1]

0.368%

1.7616

0.0399

**

[-10, -1]

0.154%

1.0392

0.1500

[-5, -1]

0.138%

1.3168

0.0947

*

[0]

0.223%

4.7791

0.0000

***

[1, 5]

0.881%

8.4316

0.0000

***

Upper Tail p-Value


159

Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 7. Independent Variables Statistics This table presents the independent variables descriptive statistics (Panel A) and correlation (Panel B). The independent variables are: SIZE - natural log of firm market capitalisation, GRWTH - natural log return of firm trading revenue, and DBTEQU - debt to equity ratio of firm. Panel A: Descriptive Statistics SIZE

GRWTH

DBTEQU

Minimum

0.47

-3.0330

-9.53

Maximum

10.75

6.9925

11.69

Range

10.28

10.0255

21.22

Mean

4.70

0.3174

0.53

Median

4.45

0.1563

0.30

Standard Deviation

1.920

1.053

1.521

Panel B: Correlation SIZE

1

0.080

0.132

GRTH

0.080

1

-0.013

DBTEQU

0.132

-0.013

1

Table 8. Results of Cross Sectional Analysis for Upgrades and Warnings This table presents the regression tests of information content prior to profit adjustments (upgrades/downgrades) made by ASX-listed firms, over the sample period of January 1, 2004 to December 1, 2004. The dependant variable is the absolute CAR for each event window. The independent variables are: SIZE - natural log of firm market capitalisation, GRWTH natural log return of firm trading revenue, DBTEQU - debt to equity ratio of firm, and NEG - dummy variable assigned a value of one for profit warnings and zero otherwise. T-statistics are in parentheses.

CARt = δ 0 + δ 1SIZE + δ 2GRWTH + δ 3 DBTEQU + δ 4 NEG + µ t Event Window [-1]

[-5, -1]

[-10, -1]

[-20, -1]

[-30, -1]

0.0095

0.0124

0.0138

0.0283

0.0548

(1.214)

(0.942)

(0.678)

(0.896)

(1.318)

SIZE

-0.0007 (-0.575)

0.0001 (0.062)

0.0001 (0.036)

-0.0023 (-0.404)

-0.0054 (-0.732)

GRWTH

-0.0018 (-0.945)

-0.0036 (-0.868)

-0.0125 (-1.979)

C

DBTEQU

-0.0026

R2

Note:

160

-0.0171 (-1.736) -0.0093

-0.0054

*

(-1.358)

(-0.596)

*

-0.0212 (-1.637)

-0.0042

-0.0075

(-1.472)

(-1.696)

-0.0011 (-0.173)

-0.0062 (-0.667)

0.0098 (0.688)

0.0308 (1.393)

0.0311 (1.068)

0.017

0.018

0.042

0.031

0.033

(-1.889) NEG

**

*


Corporate Ownership & Control / Volume 6, Issue 2, Winter 2008 Table 9. Results of Cross Sectional Analysis by Industry This table presents the regression tests of information content prior to profit adjustments (upgrades/downgrades) made by ASX-listed firms, over the sample period of January 1, 2004 to December 1, 2004. The dependant variable is the absolute CAR for each event window. The independent variables are: SIZE - natural log of firm market capitalisation, GRWTH natural log return of firm trading revenue, DBTEQU - debt to equity ratio of firm, and IND – dummy variable assigned a value of one for profit warnings issued by firms in a given GICS industry group and zero otherwise. T-statistics are in parentheses.

CARt = δ 0 + δ1 SIZE + δ 2 GRWTH + δ 3 DBTEQU + δ j IND j + µ t

Event Window

C SIZE GRWTH DBTEQU

[-1]

[-5, -1]

[-10, -1]

[-20, -1]

[-30, -1]

0.0082 (0.990) -0.0007 (-0.440) 0.0000 (-0.011) -0.0020 (-1.178)

0.0068 (0.473) 0.0011 (0.403) -0.0035 (-0.865) -0.0028 (-0.933)

0.0065 (0.297) 0.0016 (0.398) -0.0121 (-1.960) -0.0081 (-1.779)

0.0202 (0.567) -0.0005 (-0.079) -0.0178 (-1.783) -0.0104 (-1.410)

0.0486 (1.039) -0.0044 (-0.515) -0.0240 (-1.826) -0.0026 (-0.264)

* *

*

*

IND: 1510 2010 2020 2030 2510 2520 2530 2540 2550 3020 3510 4010 4020 4040 4510 4520 5010 5510

R2

Note:

0.0043 (0.447) -0.0134 (-0.965) -0.0150 (-1.018) -0.0132 (-0.795) -0.0060 (-0.263) 0.0293 (1.543) -0.0256 (-1.542) -0.0288 (-1.260) 0.0486 (2.576) -0.0210 (-1.885) 0.0467 (2.488) -0.0023 (-0.094) 0.0049 (0.199) -0.0413 (-1.283) -0.0368 (-2.439) 0.1054 (5.556) -0.0079 (-0.244) 0.0095 (0.296) 0.313

*

***

***

***

-0.0097 (-0.574) -0.0176 (-0.727) -0.0153 (-0.598) -0.0089 (-0.306) 0.0038 (0.096) 0.0140 (0.424) -0.0786 (-2.720) 0.0178 (0.446) -0.0262 (-0.798) -0.0210 (-1.082) 0.0307 (0.938) -0.0262 (-0.619) 0.0445 (1.038) -0.0376 (-0.669) 0.0174 (0.664) 0.1209 (3.656) -0.0152 (-0.269) -0.0197 (-0.351) 0.170

***

-0.0035 (-0.136) -0.0037 (-0.100) -0.0071 (-0.183) 0.0403 (0.913) 0.0171 (0.283) -0.0200 (-0.397) -0.0451 (-1.026) 0.0193 (0.319) 0.0023 (0.046) -0.0033 (-0.113) 0.1249 (2.512) -0.0230 (-0.357) -0.0237 (-0.364) -0.2859 (-3.348) 0.0484 (1.212) 0.1188 (2.363) 0.2008 (2.341) 0.1026 (1.206) 0.212

***

*** ***

-0.0235 (-0.562) 0.0204 (0.340) 0.0761 (1.205) 0.0598 (0.836) -0.0382 (-0.390) 0.0120 (0.148) -0.0311 (-0.436) 0.0784 (0.799) 0.0285 (0.351) 0.0411 (0.860) 0.2221 (2.754) 0.0034 (0.033) -0.0299 (-0.282) -0.2759 (-1.992) 0.0820 (1.266) 0.0732 (0.898) 0.1796 (1.291) 0.1509 (1.093) 0.146

***

*

-0.0094 (-0.171) -0.0818 (-1.038) 0.1538 (1.852) 0.0160 (0.170) -0.0845 (-0.656) 0.0493 (0.460) -0.0787 (-0.840) 0.1309 (1.013) 0.0766 (0.719) 0.0309 (0.491) 0.1756 (1.655) -0.0130 (-0.094) 0.0853 (0.613) -0.2330 (-1.278) 0.1894 (2.222) -0.0544 (-0.507) 0.1471 (0.804) 0.1909 (1.051)

**

**

**

0.134


161


While this variable has not been considered in the supporting literature, this relationship would indicate that firms with increasing levels of debt finance in relation to equity, have decreasing propensity to predisclose price sensitive information prior to the official announcement release. This finding is especially noteworthy when considering firms issuing profit warnings, as a profit warning would generally indicate decreased revenue and a parallel reduced ability to service debt requirements. Finally, a firm’s propensity to pre-disclose information contained in profit warnings, as segmented by industry group, is considered. The results of the primary model were inconsistent with this study’s previously reported findings, which suggested significant information leakage and informed trading activity prior to the release of profit warnings by ASX-listed firms. As the primary model indicated this relationship was not significant across all event windows, the extended model stratifies firms by their GICS industry group to enhance our ability to observe associations that are more marginal. As indicated in Table 9, seven of the eighteen industries represented in the sample exhibit significant coefficients for at least one event window observed. The most substantial findings were for Health Care Equipment & Services (IND 3510), which reported highly significant coefficients for all windows except [-5, -1], and Technology Hardware & Equipment (IND 4520), which reported highly significant coefficients for window [-10, -1] and shorter time-periods. Other industries exhibiting significant coefficients were Commercial Services & Supplies (IND 2020), Consumer Durables and Apparel (IND 2520), Retailing (IND 2550), Software & Services (IND 4510) and Telecommunication Services (IND 5010). In contrast, the model constant term (C), which illustrates the intercept term for positive announcements, is highly insignificant across all event windows. This finding indicates that firms within particular industry groups have an apparent increased propensity to pre-disclose information contained in profit warnings prior to the official information release via the Company Announcements Platform. V. Conclusion

This paper presents an empirical study of information content and trading behaviour around unscheduled earnings announcements – consisting of profit upgrades, profit warnings and neutral trading statements – made by ASX-listed companies during 2004. The contention is that informed trading impacts on the stock returns and trading volumes of listed entities, and hence abnormal returns or trading volumes observed prior to an announcement provide evidence of information leakage. The signal conveyed in profit adjustments may be uncertain where the market has anticipated the information from other news disseminated about a

162

firm, an industry, or the general economy (Jackson and Madura, 2003). The valuation and volume effects during the post-announcement period are examined to determine whether management of disclosing firms hold private, price sensitive information, which the market was previously unaware. In an efficient market, a positive (negative) abnormal return on the announcement day implies that the market reacted to unanticipated good (bad) news that day (Mac, 2002). We observe highly significant levels of average abnormal revenue and proportional abnormal trading volume for both profit upgrades and profit warnings on the announcement day. Accordingly, we can confidently reject the null hypothesis of nil information content for profit upgrades and profit warnings. Further, we may conclude that these announcements contain private information, and are made to fulfil obligations imposed by the ASX Listing Rules. These findings do not hold for neutral trading statements. We report that average abnormal revenue and trading volume on the announcement day of neutral trading statements were not significantly different from zero, and are unable to reject the null hypotheses of nil information content. It is posited that managers of firms making neutral trading statements do so to improve transparency and marketability, and further to prevent a false market in their securities. The study then examines the preannouncement period to test for information asymmetry and informed trading prior to the official release of the earnings information through the ASX Company Announcements Platform. To the extent that information is leaked to the media, analysts or favoured shareholders, the market’s revaluation of a firm may begin before the unscheduled earnings announcement is made. If there were such activity prior to the announcement, we would expect to see abnormal trading volumes and security prices, and hence returns, creep up (down) as informed traders revise their positions. The examination of pre-announcement trading activity for profit upgrades indicates abnormal returns and abnormal volume at insignificant levels. These findings are consistent with Collett (2004) in a comparative study of UK firms, and we are unable to reject the null hypothesis that firms do not experience significant positive valuation effects prior to the release of profit upgrades. The study does find evidence of information leakage and informed trading prior to the release of profit warnings by ASX-listed firms during the sample period. While these findings largely contradict the UK literature, which indicates continuous disclosure regulations effectively reduced information leakage and informed trading to insignificant levels (Collett, 2004, Helbok and Walker, 2003), they are consistent with the findings of Mac (2002) who reports comparatively less information leakage for positive surprises than negative surprises around US earnings announcements.


Specifically, we find evidence of significant abnormal volumes caused by heterogenous investor expectations during the period 2-3 weeks prior to announcement, and significant abnormal revenues reflecting a shift in market consensus expectations during the period 1-2 weeks prior to announcement. The finding that individual trading activity precedes broader market revaluation is in line with Meulbroek (1992) who, in an empirical analysis of illegal insider trading, reports that both the amount traded by an informed trader and trade specific characteristics, such as trade size, direction, and frequency, signal the presence of an informed trader to the market. To conclude, the study considers a range of firm characteristics that may potentially influence firm disclosure practices and contribute to the level information asymmetry in the market during the preannouncement period. Previous research has investigated the influence of firm size and information content in contributing to information leakage. This study further considers the variables of firm growth, capital structure and industry group. The cross-sectional analysis indicates a decreasing propensity to selectively disclose information contained in unscheduled earnings announcements for those firms experiencing an increase in growth, and for those with high levels of debt financing. The relationship between firm size and the magnitude of pre-announcements CARs is inconclusive and negligible. While the firm-size differential information hypothesis contends that preannouncement information production and dissemination is an increasing function of firm size (Atiase, 1980), our findings support an ancillary line of reasoning that unscheduled announcements occur randomly and hence cannot be predicted in the same way as anticipated periodic accounting reports (Ryan and Taffler, 2004). Analyses of the announcement information content support the event study conclusions indicating insignificant levels of information leakage and informed trading prior to the release of profit upgrades. While the primary model produced inconclusive correlation between negative announcements and the magnitude of preannouncement CARs, the enlarged model demonstrates that information leakage and informed trading prior to the release of profit warnings is highly clustered by industry group for the given sample.

4. 5.

6.

7. 8.

9.

10. 11.

12.

13.

14.

15.

16. 17. 18.

19. 20. 21. 22.

23.

References 24. 1.

2.

3.

Aitken, M. and Czernkowski, R. (1992) 'Information Leakage Prior to Takeover Annoncements: The Effect of Media Reports' Accounting and Business Research 23, 320. Ajinkya, B. and Gift, M. (1984) 'Corporate Managers Earnings Forecasts and Symmetrical Adjustments of Market Expectations' Journal of Accounting Research 22, 425-44. ASIC Media Release 00/365, (2000) 'How do Australian Regulatory Standards on Disclosure by Listed Companies Compare to those in the United States?'

25. 26.

Australian Stock Exchange, (2003) 'Guidance Note 8: Continuous Disclosure'. Atiase, R. (1980) 'Predisclosure Informational Asymmetries, Firm Capitalization, Earnings Reports, and Security Price Behavior around Earnings Announcement'. Bamber, L. (1986) 'The Information Content of Annual Earnings Releases: A Trading Volume Approach' Journal of Accounting Research 24, 40-56. Beaver, W. (1968) 'The Information Content of Annual Earnings Announcements' Journal of Accounting Research 6, 67-92. Brailsford, T., Faff, R. and Oliver, B. (1997) Research Design Issues in the Estimation of Beta, McGraw-Hill, Sydney. Brown, P., Taylor, S. and Walter, T. (1996a) 'The Effect of the Enhanced Disclosure Regime on the Efficiency of the Australian Share Market' SIRCA Working Paper. Brown, P., Taylor, S. and Walter, T. (1996b) 'The Impact of the Enhanced Disclosure Regime on Corporate Disclosure Policies' SIRCA Working Paper. Brown, P., Taylor, S. and Walter, T. (1996c) 'Enhanced Statutory Disclosure: Problems and Prospects' SIRCA Working Paper. Brown, P., Taylor, S. and Walter, T. (1999) 'The Impact of Statutory Sanctions on the Level and Information Content of Voluntary Corporate Disclosures' Abacus 35, 138-62. Collett, N. (2004) 'Reactions of the London Stock Exchange to Company Trading Statement Announcements' Journal of Business Finance & Accounting 31, 3-35. Dedman, E. (2004) 'Discussion of Reactions of the London Stock Exchange to Company Trading Statement Announcements.' Journal of Business Finance & Accounting 31, 37-47. Helbok, G. and Walker, M. (2003) 'On the Willingness of UK Companies to Issue Profit Warnings: Regulatory, Earnings Surprise Permanence, and Agency Cost Effects' Working Paper (SSRN). Jackson, D. and Madura, J. (2003) 'Profit Warnings and Timing.' Financial Review 38, 497-513. Kasznik, R. and Lev, B. (1995) 'To Warn or Not To Warn: Management Disclosures in the Face of an Earnings Surprise.' Accounting Review 70, 113-34. Kim, O. and Verrecchia, R. (1991) 'Trading Volume and Price Reactions to Public Announcements' Journal of Accounting Research 29, 302-21. Mac, C. (2002) 'The Effects of Regulation Fair Disclosure on Information Leakage' Working Paper (SSRN). Meulbroek, L. (1992) 'An Empirical Analysis of Illegal Insider Trading' The Journal of Finance 47, 1661-99. Organisation for Economic Cooperation and Development. (2003a) 'White Paper on Corporate Governance in Asia' 113. Organisation for Economic Cooperation and Development (2003b) 'White Paper on Corporate Governance in South East Europe' 104. Ryan, P. and Taffler, R. (2004) 'Do Firm-specific News Releases Drive Economically Significant Stock Returns and Trading Volumes' Journal of Business Finance & Accounting 31. Scholes, M. and Williams, J. (1977) 'Estimating Betas from Non-synchronous Data', Journal of Financial Economics, Vol 5, 309-27. Skinner, D. (1994) 'Why Firms Voluntarily Disclose Bad News' Journal of Accounting Research 32, 38-60. Verrecchia, R. (2001) 'Essays on disclosure.' Journal of Accounting & Economics 32, 97-180.

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