International Journal of Corporate Governance Volume1 - Issue 1 - 2008

International Journal of Corporate Governance

Volume 1 - Issue 1 - 2008

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Int. J. Corporate Governance, Vol. 1, No. 1, 2008

Corporate boards and the leverage and debt maturity choices Jarrad Harford Foster School of Business, University of Washington, Box 353200, Seattle, WA 98195-3200, USA E-mail: [email protected]

Kai Li* Sauder School of Business, University of British Columbia, 2053 Main Mall, Vancouver, BC V6T 1Z2, Canada E-mail: [email protected] *Corresponding author

Xinlei Zhao Department of Finance, Kent State University Kent, OH 44242, USA E-mail: [email protected] Abstract: Debt, and in particular, short-term debt have the potential to discipline managers. We examine the role of the board in making financing decisions that provide this discipline. Specifically, given a firm’s characteristics, we predict that stronger boards will force the firm to hold more debt and more short-term debt. Employing a rich dataset of board characteristics and controlling for other aspects of a firm’s corporate governance, we find support for these hypotheses. Our simple measure of director power is a robust and promising measure of internal governance. Keywords: leverage; debt maturity; board effectiveness; incentive alignment; director power; governance. Reference to this paper should be made as follows: Harford, J., Li, K. and Zhao, X. (2008) ‘Corporate boards and the leverage and debt maturity choices’, Int. J. Corporate Governance, Vol. 1, No. 1, pp.3–27. Biographical notes: Jarrad Harford is the Marion Ingersoll Endowed Professor of Finance at the Foster School of Business, University of Washington. His main research interests are corporate finance, mergers and acquisitions, payout policy, corporate governance. Kai Li is the W.M. Young Professor of Finance at the Sauder School of Business, University of British Columbia in Vancouver, Canada. Her main interests include corporate finance and corporate governance.

Copyright © 2008 Inderscience Enterprises Ltd.

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J. Harford et al. Xinlei Zhao is currently an Assistant Professor of Finance at Kent State University. Her primary teaching and research interests are in the fields of empirical corporate finance and investments.

1

Introduction

The separation of ownership and control in modern corporations leads to conflicts of interest between managers and shareholders (Jensen and Meckling, 1976). Past research, including Grossman and Hart (1982), Jensen (1986), Stulz (1990), Hart and Moore (1995), Rajan and Winton (1995) and Stulz (2000), has suggested leverage and debt maturity structure as effective ways to mitigate this agency problem. The intuition is that leverage, and particularly short-term debt, can reduce discretionary funds and subject managers to the scrutiny of the financial market and the threat of default, effectively curbing self-serving behaviour by managers. However, both leverage and debt maturity structure choices are influenced by managers, and they are not expected to voluntarily make the shareholders’ preferred leverage and debt maturity choices to constrain themselves.1 Out of self-interest, managers would prefer less debt and/or debt with longer maturity. Consistent with that hypothesis, Berger et al. (1997) provide evidence that entrenched managers prefer equity to debt. Datta et al. (2005) show that managers with fewer equity-based incentives tend to employ more long-term debt, and Benmelech (2006) find that entrenched managers are less likely to finance with short-term debt. Further, Denis and Mihov (2003) show that managers with low ownership prefer diffuse public debtholders instead of concentrated private lenders. Empirical evidence has demonstrated that the board has the power to set financing policy and that the board uses it. Both Klein (1998) and Güner et al. (2006) find evidence that the composition of the board or finance committee impacts the firm’s financing choices.2 While we do not expect the control of agency conflicts to be the primary consideration in setting the level and maturity of debt, we would expect that, on the margin, boards do not overlook this tool available to them. The hypothesis we test in this paper is that a strong board is associated with more debt and shorter debt maturity. Boards are multi-faceted. It is a challenging task to characterise boards’ potential for effectiveness in monitoring. The different aspects of a board may contribute to a firm’s corporate governance environment differently, with some aspects providing more effective monitoring than others. Further, some board aspects may be complementary to leverage, while others may be substitutes. In order to have a thorough understanding of the effect of the board, as part of the firm’s internal corporate governance, on capital structure and debt maturity choices, we first construct a broad index of board characteristics. We then further refine our aggregate index into four subindices to capture distinct aspects of board functionality: monitoring effectiveness, incentive alignment, director power, and shareholder power.3 Using a sample of S&P 1500 firms over the period 1997–2004 and the panel data fixed-effects estimation, we show that our board index is not significantly related to leverage but is negatively associated with debt maturity. Among the four subindices, greater director power is the only subindex that is positively related to leverage and negatively related to debt maturity. The positive relation between director power and

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leverage is offset by the negative relation between incentive alignment and leverage, leading to a lack of relation between the board index and leverage. Although director incentive alignment is negatively related to leverage, suggesting a possible substitute effect, this effect is not robust because of a lack of relation between incentive alignment and debt maturity. These results are obtained after controlling for an extensive list of other governance mechanisms in a firm. This finding suggests that director power is the most important characteristic for a board to have in order to be effective in implementing capital structure decisions that discipline managers. This paper contributes to the existing literature along the following dimensions. First, to the best of our knowledge, this study is the first in the literature to examine the role of corporate boards in debt maturity choices. Further, we control for a rich set of corporate governance mechanisms, both internal and external, to isolate the effect of the board on capital structure decisions. We also make a methodological contribution by constructing a broad board index to explore the role of corporate boards in firms’ financing decisions. Prior studies of corporate boards focus on at most a few aspects of the board, without being able to consider all of the dimensions of the board and the channels through which it becomes effective. The new dataset used here allows us to simultaneously examine a broad list of board attributes and assess which of them has the largest impact on the board’s ability to influence financing decisions. The plan of the paper is as follows. We review the literature and develop our hypotheses in the next section. Section 3 describes our sample and variables and provides descriptive statistics. Section 4 presents the empirical results on the role of corporate boards in leverage and debt maturity structure choices and offers interpretations. Section 5 implements some additional investigation and Section 6 concludes.

2

Literature review and hypothesis development

2.1 Literature review The recent corporate scandals and the subsequent changes in securities laws and exchange rules highlight the importance of corporate boards in the mindset of regulators and the general public. Nonetheless, empirical evidence on the effectiveness of boards in corporate decisions and performance has been mixed. On the one hand, Baysinger and Butler (1985) find a positive relationship between board composition and performance, but there is no relation between changes in composition and changes in performance. Yermack (1996) shows a significant negative association between board size and firm value. Bhagat et al. (1999) show that higher dollar value of equity holdings by directors is associated with better corporate performance and a higher likelihood of managerial replacement after poor results. Adams and Ferreira (2004) show that board attendance is higher in the presence of higher meeting fees and that firms paying mostly a flat retainer overpay their directors on average. Adams et al. (2005) show that firms with powerful CEOs experience more variability in performance. Their measures of CEO power include: whether the CEO is also a founder, or the only insider on board, or also the chairman of the board. On the other hand, Hermalin and Weisbach (1991) show that there is no strong relationship between the fraction of outsiders on the board and firm performance. Brickley et al. (1997) do not find evidence that separation of CEO and chairman is

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associated with higher market or operational performance. Core et al. (1999) find that outside directors are not more effective than inside directors in setting CEO compensation and conclude that the emphasis on directors and institutional ownership has been misplaced. Bhagat and Black (2002) show that low-profitability firms increase the independence of their boards, but firms with more independent boards do not perform better than other firms. Fich and Shivdasani (2006) show that firms in which a majority of outside directors hold three or more board seats have significantly lower valuation than firms in which a majority of outside directors hold fewer than three board seats. In summary, the empirical literature examining whether board size, composition, leadership, and incentives have real effects on firm performance and managerial incentives shows mixed results, and these studies motivate our adoption of ten board characteristics to broadly measure the effectiveness of the board. Given that boards meet infrequently, the monitoring role of the board is most likely to be detectable in specific, discrete corporate decisions, rather than in the day-to-day operations that contribute to long-run stock and operating performance. Indeed, the existing literature does deliver a much clearer message when examining the effect of the boards on top management turnover and mergers and acquisitions. Starting with Weisbach (1988), many papers have found boards dominated by independent directors to be more likely to make decisions that are in the interest of shareholders.4 Our paper is most closely related to the literature examining the relation between corporate governance and firm capital structure decisions. Berger et al. (1997) study associations between managerial entrenchment and firms’ capital structures, and their results suggest that entrenched CEOs seek to avoid debt. Garvey and Hanka (1999) find that firms protected by second generation state antitakeover laws substantially reduce their use of debt, and that unprotected firms do the reverse. Datta et al. (2005) conclude that managerial ownership is effective in forcing firms to have shorter debt maturity. Benmelech (2006) finds that entrenched managers prefer long-term debt.

2.2 Our hypotheses The literature has suggested the following channels through which debt exerts its disciplinary role on managers. Grossman and Hart (1982) point out that since higher levels of debt increase the threat of bankruptcy which put managers under pressure due to the potential loss of control of their firms, higher levels of debt induce managers to avoid value-decreasing corporate decisions. Jensen (1986) further suggests that the fixed payments associated with debt reduce a firm’s free cash flow, and effectively limit management’s ability to waste corporate resources to benefit themselves. Moreover, the issuance of external debt also results in monitoring by bondholders, other lenders, investment bankers, and bond rating agencies. Other work has focused on the maturity structure of debt in addition to the level of debt to discipline managers. Easterbrook (1984), while primarily writing about dividends, notes that when a firm has to frequently issue new debt, its managers are reevaluated by capital providers at each issuance, increasing monitoring. Rajan and Winton (1995) point out that short-term loans give the bank unlimited power to act, while long-term loans with covenants only allow the bank to act if a covenant has been violated (based on verifiable information). They conclude that loans that are payable on demand or have short fixed maturities give lending institutions greater flexibility and control. Benmelech (2006) develops a model that endogenises debt maturity choice by self-interested

Corporate boards and the leverage and debt maturity choices

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managers and predicts that entrenched managers will finance with long-term debt to avoid liquidation. Finally, DeAngelo et al. (2002) provide a case study illustrating the importance of short-term debt in properly constraining managers. A priori, capital structure and board strength could be substitutes or complements in controlling agency costs. They would be substitutes if managers choose a restrictive capital structure (higher leverage and shorter maturity) to bond themselves and establish a reputation with the capital markets in the absence of strong internal governance. Conversely, if restrictive capital structures are the outcome of strong boards imposing constraints on managers, then capital structure and board strength would be found to be complements. Previous work on the amount of leverage, by Berger et al. (1997) casts doubt on the substitutes view. Further, more restrictive capital structure has the advantage of utilising scrutiny by the capital markets to help the board (with limited time and resources) monitor managers. Thus, we reason that strong boards force managers to choose a level and maturity structure of debt that facilitates more (frequent) monitoring. Hence, we test the following hypotheses: H1: There is a positive relation between strong boards and the level of leverage H2: There is an inverse relation between strong boards and debt maturity. Specifically, these hypotheses predict that, ceteris paribus, our empirical measures of the strength, incentives, and effectiveness of the board will be positively related to the level of debt and negatively related to the maturity of debt in a firm. We predict that strong boards will be overall complements of restrictive debt policy. However, we admit the possibility that some components of board strength could be substitutes with debt policy and others could be complements, such that when we examine the individual subindices, the relation could go either way. Whether a specific board component is a complement or substitute of debt policy is an empirical issue. In addition to the agency conflict between managers and shareholders (represented by the board), a conflict of interest exists between shareholders and bondholders. Bondholders would prefer managers to undertake low-risk projects. Managers, due to their overexposure to firm-specific risk, would also prefer a more conservative investment profile and capital structure than would shareholders. Thus, when shareholders take actions to better control managers, bringing the firm’s risk profile into line with shareholders’ preferences, the conflict between shareholders and bondholders is greater than in the case where managers are unconstrained. Klock et al. (2005) and Cremers et al. (2007) provide a similar argument that weaker shareholder control of managers can actually be preferred by bondholders and provide evidence from bond yields consistent with this argument. Bondholders’ concern about risk-shifting is largest for long-term debt because it limits their ability to reevaluate management. Thus, they are more likely to offer short-term debt to firms whose managers are closely monitored by a strong board. This effect reinforces the prediction in H2.

3

Sample formation and variable construction

Our empirical design is to relate measures of corporate boards to leverage and debt maturity structure choices. We obtain detailed board information for S&P 1500 firms (including S&P 500, S&P Midcap 400, and S&P Small Cap 600) from the Investor

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Responsibility Research Centre (IRRC), now part of Institutional Shareholder Services. The ISS/IRRC board data, our initial sample, covers the S&P 1500 firms for the 1997–2004 proxy season, and thus our final sample will more likely be large firms. Following the prior literature, we restrict our sample to industrial firms excluding utilities and financials. Our initial sample is an intersection of the ISS/IRRC board data, ExecuComp for managerial ownership, Compustat for accounting information, and CRSP for stock prices for the period 1997–2004. This leads to an initial sample of 6,145 observations. In order to isolate the effect of the board, we need to control for other governance mechanisms in addition to managerial ownership. Gompers et al. (2003) construct an external governance measure Gindex that proxies for the level of shareholder rights. Litov (2005) shows that firms with weak shareholder rights actually use more debt financing and have higher leverage ratios, and Benmelech (2006) finds that more entrenched managers tend to employ long-term debt. To make sure that our results will not be affected by the extent of managerial entrenchment in the corporate control market, we control for a modification to the Gindex – the Eindex in our main analysis. Bebchuk et al. (2005) show that only six of the 24 provisions in the Gindex are significantly associated with firm value. The Eindex is not available on a continuous basis. For years where the Eindex data is not available, we follow the common practice of filling in the missing years with the prior data (e.g., assuming that 1999 has 1998 values, 2001 has 2000 values, and 2003 has 2002 values). Another important corporate governance measure is the presence of institutional investors. We obtain institutional shareholding information from Thompson Financial’s 13F filings. We merge our initial sample with the data on the Eindex and the institutional shareholding. We employ two leverage measures. The book leverage ratio is defined as the ratio of total debt to total assets, and the market leverage ratio is the ratio of total debt to the market value of total assets, obtained as total assets minus book equity plus market value of equity. Following Barclay and Smith (1995), we measure debt maturity as the proportion of total debt maturing in more than T years, where T ranges from 1 (debt1) to 5 (debt5). We discard any firm-year observation where the book leverage and debt maturity ratio variables are less than 0% or more than 100%. And our final sample has 5,825 firm-year observations representing 1,130 unique firms with no missing data on all variables used in our multivariate analysis. Panel A of Table 1 provides descriptive statistics on leverage and debt maturity structure for our sample of firms. We note a large variation in leverage among our sample firms, with average at 17% (23%) and corresponding standard deviation at 15% (16%) for the market (book) leverage measure. Our market leverage measure is of similar magnitude as the one in Datta et al. (2005), and our book leverage measure is quite close to the leverage number in Berger et al. (1997) even though our sample and sample period do not overlap with Berger et al. (1997) and only overlap with the Datta et al. sample by a few years. This suggests that among large US firms, leverage ratios on average have been quite stable over the past 20 years, consistent with the conclusions of Lemmon et al. (2007).5 Over 90% of the debt of a median firm in our sample matures in more than one year. The median proportion of debt maturing in more than three and five years is 70% and 47%, respectively. These numbers are much higher than similar numbers reported in Barclay and Smith (1995), but not much higher than those in Datta et al. (2005), suggesting that firms have lengthened their debt maturity in the late 1990s.

Corporate boards and the leverage and debt maturity choices Table 1

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Sample characteristics

Panel A: Leverage and debt maturity Mean

StdDev

25th percentile Median 75th percentile

Market leverage

0.165

0.145

0.041

0.137

0.252

Book leverage

0.231

0.164

0.096

0.232

0.342

Debt1

0.800

0.263

0.730

0.909

0.982

Debt2

0.719

0.290

0.590

0.818

0.948

Debt3

0.632

0.313

0.440

0.703

0.894

Debt4

0.549

0.324

0.297

0.591

0.826

Debt5

0.467

0.331

0.159

0.473

0.733

Panel B: Firm characteristics Mean

StdDev

25th percentile Median 75th percentile

Firm size

6218

17176

641

1613

4872

Tangibility

0.302

0.187

0.162

0.259

0.406

M/B ratio

2.025

1.429

1.187

1.552

2.285

Profitability

0.142

0.095

0.098

0.143

0.193

Asset maturity

8.990

8.426

3.973

6.640

11.679

Term structure

1.717

1.075

0.998

1.629

3.004

Asset return StdDev

0.275

0.199

0.155

0.225

0.334

Proportion of firms paying dividend

60.01%

–

–

–

–

Proportion of firms with rating

54.06%

–

–

–

–

Proportion of firms with investment grade rating

34.99%

–

–

–

–

This table presents summary statistics of leverage, debt maturity, and firm characteristics for our sample firms. Our sample is an intersection of the ISS/IRRC board data, Gindex data, ExecuComp, Compustat, and CRSP for the period 1997–2004. Our sample has 5,825 firm-year observations representing 1,130 unique firms. Market leverage is the ratio of total debt (data34 + data9) to market value of total assets which is computed as the sum of market value of equity (data199 × data54) and book value of debt minus book value of equity. Book leverage is the ratio of total debt to total assets (data6). Debt1-Debt5 are the proportion of total debt maturing in one to five years, respectively. We drop observations where the leverage ratio and debt maturity ratio variables are outside the (0, 1) range. Firm size is sales (data12) in millions of 2004 dollars. Asset tangibility is the ratio of net property, plant, and equipment (data8) to total assets. M/B ratio is the ratio of market value of total assets to book value of total assets. Profitability is operating income before depreciation (data13) normalised by the lagged value of total assets. Asset maturity is the weighted average of current assets (data4) divided by the cost of good sold (data41), and net property, plant, and equipment divided by depreciation and amortisation (data14), following Datta et al. (2005). Term structure is the yield difference between 10-year T-bond and 3-month T-bill. Asset return StdDev is stock return standard deviation times the equity-to-firm value ratio following Barclay and Smith (1995). Panel A presents summary statistics of capital structure choices, and Panel B presents firm characteristics.

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J. Harford et al.

Panel B of Table 1 documents sample firm characteristics. Our sample firms are quite large, with median sales (in 2004 $) at 1.6 billion. A median firm in our sample has 26% of their assets in tangible assets, and an M/B ratio of 1.6. We see substantial variations across our sample firms in terms of operating income, asset maturity, and asset return standard deviation. Sixty percent of our sample firms pay dividends, and over half of them have bond ratings, with most of them obtaining an investment grade rating. Dividend payers have greater representation in our sample than as reported for all public firms in Fama and French (2001), due to the fact that our sample is skewed toward large firms.

3.1 The board index In this paper, we ask whether and how boards affect corporate financing decisions. Departing from existing work, we first construct an aggregate board index that captures different facets of the board, and then study the empirical relationship between this index and firms’ financing choices. The ISS/IRRC board data covers director identity and affiliation, director compensation and equity ownership, director tenure, committee membership, whether the CEO is the chairperson of the board, whether cumulative voting is allowed, and whether there is a provision that staggers the terms and elections of directors. The unique director identifier within the dataset allows us to compute board size, director/board independence, and how many board seats are held by a specific director. Based on the prior theoretical and empirical work summarised in the previous section, we single out ten board characteristics to be included in our board index construction (see detailed definitions in the Appendix). They are small board, not busy (board), board independence, no interlock, (board) equity ownership, (board) meeting fee, CEO not Chairperson of the Board (COB), blockholder on board, cumulative voting, and no classified board. Among the ISS/IRRC sample of firms, the median board size is nine, the median director equity ownership is $ 0.54 millions, the median board meeting fee is $ 1134, and the median number of board meetings per year is seven. Our board index is constructed to proxy for the balance of power between the board of directors and managers. We calculate our index for each firm-year in a straightforward manner: we add one point for every board measure that increases the likelihood that the board will be an effective monitor of managers in shareholders’ interests. Thus, the board index (‘Bindex’) is just the sum of the points awarded for the existence of each board characteristic.6 We also construct subindices for characteristics in each of the following four categories: Board Effectiveness (BEindex), Incentive Alignment (IAindex), Director Power (DPindex), and Shareholder Power (SPindex). By construction, the four subindices sum to the board index (see our Appendix for board characteristics included in the subindices). The maximum possible number for the Bindex is 10, and the maximum possible values for the BEindex, IAindex, DPindex, and SPindex are 2, 4, 2, and 2, respectively. The higher the values for the Bindex and the four subindices, the better is the quality of a firm’s corporate governance.

Corporate boards and the leverage and debt maturity choices

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In Table 2, Panel A presents the summary statistics of our Bindex and the four subindices, and Panel B presents the descriptive statistics for each of the ten board characteristics included in the Bindex. The median firm in our sample scores 5 out of 10 in the Bindex, with the mean score at 5.2. One focus of governance reform in the last decade has been the independence and incentives of the directors. Our sample firms score quite well on the dimension of incentive alignment of the board, with the majority of firms in our sample scoring 3 out of a possible maximum value of 4 in the IAindex. In particular, as shown in Panel B, 76% of the sample firms have a board with the majority of the directors being independent, and over 90% of our sample firms have a board free of directors with interlocking relationships. By contrast, most of our sample firms do not score well in terms of board effectiveness, director power, and shareholder power in particular. For instance, the majority of sample firms only score 1 out of 2 in the DPindex. The data as shown in Panel B confirms that in most firms, CEOs are also COBs. Only about half of the sample firms have blockholders sitting on the board. Table 2

Corporate governance characteristics

Panel A: Our board indices Mean

StdDev

25th percentile

Median

75th percentile

Bindex

5.244

1.570

4

5

6

BEindex

1.293

0.603

1

1

2

IAindex

2.649

0.795

2

3

3

DPindex

0.811

0.698

1

1

2

SPindex

0.491

0.586

0

0

1

Panel B: Board characteristics Percent of firms with that feature Board effectiveness (BEindex) Small board

38.1

Not busy

91.2

Incentive alignment (IAindex) Board independence

76.3

No interlock

91.4

Equity ownership

49.1

Meeting fee

48.2

Director power (DPindex) CEO not COB

27.7

Blockholder on board

53.4

Shareholder power (SPindex) Cumulative voting

10.4

No classified board

38.6

12 Table 2

J. Harford et al. Corporate governance characteristics (continued)

Panel C: Other governance mechanisms Eindex Public pension holding Executive ownership

Mean

StdDev

25th percentile

Median

75th percentile

2.214

1.299

1.000

2.000

3.000

0.031 23.84

0.018 94.54

0.022

0.029

1.55

4.89

0.036 14.47

This table presents summary statistics of corporate governance characteristics for our sample firms. Please refer to our Appendix for the definitions of the Bindex, BEindex, IAindex, DPindex, SPindex, and their corresponding constituents. The Eindex is defined based on Bebchuk et al. (2005) covering staggered boards, limits to shareholder bylaw amendments, supermajority requirements for mergers, supermajority requirement for charter amendments, poison pills, and golden parachutes. Public pension holding is defined as aggregate holdings by active public pensions as identified in Cremers and Nair (2005), normalised by the number of shares outstanding. Executive ownership is dollar value of common stock and restricted shares held by the top five executives in millions of 2004 dollars. Panel A presents summary statistics of our board indices, Panel B presents summary statistics of our ten board characteristics, and Panel C presents summary statistics of other governance mechanisms.

3.2 Other governance mechanisms A variety of firm-level mechanisms are associated with the governance of the public corporations. Other than the board measures we have constructed earlier, we also control for other governance mechanisms in order to isolate the effect of boards on corporate financing decisions. These firm-level mechanisms can be broadly grouped into two categories – external and internal governance mechanisms. Takeovers and large shareholders are often seen as the primary external governance mechanisms, while incentive pay and the board of directors are the main internal mechanisms. To measure managerial entrenchment from an external governance point of view, we use the Eindex recently proposed by Bebchuk et al. (2005), which is based on a count of six provisions that reduce shareholder rights. They are staggered boards, limits to shareholder bylaw amendments, supermajority requirements for mergers, supermajority requirement for charter amendments, poison pills, and golden parachutes. We expect that firms with strong shareholder rights (lower value of the Eindex) are more likely to employ debt and ceteris paribus, more short-term debt.7 Shleifer and Vishny (1986) suggest that large shareholders have incentive to monitor the management. Research by Del Guercio and Hawkins (1999) and Cremers and Nair (2005) show that public pension funds generally have fewer conflicts of interest and less corporate pressure than other institutional shareholders do. To measure this aspect of the governance of a firm, we construct the aggregate holdings by active public pensions as identified in Cremers and Nair (2005), normalised by the number of shares outstanding, Since Jensen and Meckling (1976), many studies have shown that managers will have more powerful incentives to make value-maximising corporate decisions when their stock ownership is high. Berger et al. (1997) show that firms whose CEOs have greater equity ownership are associated with the use of higher leverage. Denis and Mihov (2003) find that higher managerial ownership is associated with the use of more scrutinising private debt, and Datta et al. (2005) conclude that managerial ownership is negatively related to

Corporate boards and the leverage and debt maturity choices

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debt maturity. We use the dollar value of stock ownership for the top five executives (inferences are unchanged if we focus on the CEO) as a measure of their cumulative equity-based compensation to capture the degree of incentive alignment between managers and shareholders. Note that our dollar value measure of managerial equity incentives is different from past work and is motivated by the following considerations. As Hall and Liebman (1998) argue, for large and diversely-held companies, a top executive might only hold a very small fraction of the firm’s shares while those shares, in terms of dollar values, could be a significant portion of the executive’s personal wealth, and hence leading to an alignment of interests between the executive and the shareholders. Measuring fractional ownership is best-suited for capturing incentives to over-consume on perquisites because the manager only bares a fraction of the costs. Using a dollar value measure captures the amount of wealth she has at risk in the firm and is an appropriate measure of incentive alignment on major corporate decisions such as financing policies.8 Our definition of managerial stock ownership includes common stock and restricted shares and is scaled by the total number of shares outstanding. And our dollar value equity incentive is the product of managerial equity ownership and market capitalisation, measured in millions of 2004 dollars. Panel C of Table 2 presents the summary statistics of other corporate governance measures. The median sample firm scores 2 out of 6 in the Eindex. The median level of public pension fund holding in our sample firms is about 3%, similar to the number reported in Cremers and Nair (2005). The median (mean) dollar value of executive ownership of company shares is about $5 ($24) millions in 2004 $, while the median fractional executive ownership is about 1% among our sample firms (unreported), similar to the number reported in Datta et al. (2005) even though our sample periods only overlap by a few years. The low equity ownership by top executives in our sample is due to the fact that our sample includes the largest companies in the USA. Table 3 presents measures of the time-series variation in the main board index, its four subindices, and its ten board characteristic constituents. We first compute the average of year-to-year changes in the specific board index or characteristic for each firm. We then calculate the summary statistics for the cross-sectional sample of average annual changes for that specific measure. Panel A shows that there are minimal changes in the BEindex and SPindex, with the majority of firms experiencing no changes from year to year. There is relatively more temporal variation in the IAindex and DPindex. As a result, there is moderate temporal variation in the Bindex. Even though for each individual characteristic, there is a low probability of change in any particular year, that does not mean that the board characteristics are static. We construct another measure, change frequency, capturing the frequency with which any one or more of the board characteristics changes from year to year. For example, in each of the seven years, a different board characteristic could change. This is clearly a board in flux, but each individual characteristic would show a median change of zero from year to year. Our new measure would capture it as a median change of one, normalising the seven individual yearly changes by the maximum number of possible changes (7). The last row in Panel B presents the summary statistics of this new measure. It shows that on average, about half of the boards experience at least one change in their characteristics per year. Our evidence is consistent with Denis and Sarin (1999) who show that 65% of their sample firms exhibit large changes in ownership and board structure in any given year over the ten-year period they examined.

14 Table 3

J. Harford et al. Temporal variation in board indices and board characteristics

Panel A: Time variation in our board indices Bindex BEindex IAindex DPindex SPindex

Mean

StdDev

0.078 –0.015 0.050 0.045 –0.002

0.457 0.207 0.317 0.241 0.062

25th percentile Median 75th percentile 0.000 0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000 0.000

0.286 0.000 0.143 0.143 0.000

Panel B: Time variation in board characteristics Board effectiveness (BEindex) Small board Not busy Incentive alignment (IAindex) Board independence No interlock Equity ownership Meeting fee Director power (DPindex) CEO not COB Blockholder on board Shareholder power (SPindex) Cumulative voting No classified board Change frequency

Mean

StdDev

25th percentile Median 75th percentile

–0.018 0.003

0.189 0.084

0.000 0.000

0.000 0.000

0.000 0.000

0.038 0.007 0.028 –0.024

0.195 0.104 0.173 0.195

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

0.018 0.027

0.187 0.156

0.000 0.000

0.000 0.000

0.000 0.000

0.000 –0.002 0.485

0.055 0.042 0.311

0.000 0.000 0.286

0.000 0.000 0.500

0.000 0.000 0.714

This table presents the temporal variations in board indices and board characteristics. Please refer to our Appendix for the definitions of the Bindex, BEindex, IAindex, DPindex, SPindex, and their corresponding constituents. We first compute the average of year-to-year change in board indices and board characteristics for each firm. We then calculate the summary statistics for the cross-sectional sample of average annual changes. Change frequency refers to the frequency with which any board characteristic changes from year to year. This captures the probability that in any given year, some aspect of the board will change. Panel A presents the summary statistics of year-to-year changes in our board indices, and Panel B presents the summary statistics of year-to-year changes in board characteristics.

Table 4, Panel A presents the correlation between leverage, debt maturity, and all our governance measures. Contrary to our hypothesis for debt levels and to prior literature, the results indicate significantly negative correlations between measures of leverage and strong governance measured by our board index. Nonetheless, the correlations between measures of debt maturity and our board index are significantly negative as predicted. However, omitted variable bias in univariate correlations can mask the true relationships between the variables. As a result, we later employ multiple regressions in order to detect causal relationships between leverage, maturity structure, and board measures after controlling for an extensive list of potential determinants of leverage and maturity structure choices.

Corporate boards and the leverage and debt maturity choices Table 4

Simple correlation between corporate governance measures

15

16 Table 4

J. Harford et al. Simple correlation between corporate governance measures (continued)

Corporate boards and the leverage and debt maturity choices

17

Panel A also shows that correlations among the governance measures are mixed. The board subindices are, in general, positively, but weakly correlated. Our Bindex and subindex SPindex are strongly and negatively correlated with the Eindex. While both the BEindex and DPindex are significantly negatively correlated with Eindex, the correlations are 10% or lower. Executive ownership is negatively correlated with the Eindex and public pension holding. Table 4, Panel B presents the correlation between the ten board characteristics that we examine. Many of the correlations are sensible. A small board is more likely to have directors that do not sit on multiple boards, and less likely to be an independent board. Non-busy directors are more likely to have high equity ownership and are positively associated with the presence of blockholders on the board. In contrast, independent boards are associated with low equity ownership and the absence of blockholders on the board. The median director equity ownership is strongly and positively correlated with the presence of blockholders on the board.

4

Results on board monitoring

4.1 Model specification To test our hypotheses that there is a positive relation between our board constructs and the level of leverage, and a negative relation between our board constructs and debt maturity in a multivariate framework, we use two-stage least squares regression analysis as in Barclay et al. (2003) and Datta et al. (2005). We model total leverage in the first stage and then model the maturity structure in the second stage including our fitted leverage estimate as an explanatory variable. The first-stage regression model is Leverageit = α 0 + β1Board Measureit + β 2 Gindex it + β 3 Public Pension Holdingit + β 4 Executive Ownershipit + β 5 Firm Sizeit + β 6 Asset Tangibilityit

(1)

+ β 7 M / B Ratioit + β 8 Profitabilityit + β 9 Dividend Paying Dummyit + eit ,

where the market leverage ratio is the dependent variable, and ‘Board Measure’ is one or more of our board indices. Motivated by prior findings in Litov (2005), Cremers and Nair (2005) and Datta et al. (2005), we also include alternative governance mechanisms in the above regression. Firm characteristics used to determine leverage in the first stage are firm size, asset tangibility, M/B asset ratio, profitability, and the dividend-paying dummy. These variables are defined in Table 1 and are motivated by the empirical findings in Berger et al. (1997), Barclay et al. (2003) and Frank and Goyal (2007), among others. We employ two different sets of board measures when reporting our estimation results. In Model 1, we use the overall board index, namely, Bindex. In Model 2, we replace the Bindex with our four board subindices. In the second-stage regression, we control for leverage using the predicted leverage from the first-stage regression.9 To properly identify the system of equations, in the second-stage regression, we exclude asset tangibility, profitability, and dividend-paying dummy,10 and add asset maturity, a term structure measure, asset return volatility, a rating dummy, and an investment grade dummy following Barclay and Smith (1995),

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Guedes and Opler (1996) and Stohs and Mauer (1996). Specifically, we estimate the following model for debt maturity in the second stage: Debt Maturityit = α 0 + β1Board Measureit + β 2 Gindex it + β 3 Public Pension Holding it + β 4 Executive Ownershipit + β 5 Fitted Leverageit + β 6 Firm Sizeit + β 7 M / B Ratioit + β 8 Asset Maturityit + β 9 Term Structuret

(2)

+ β10 Asset Return StdDevit + β11Bond Rating Dummyit + β12 Investment Grade Dummyit + eit .

Again, we employ two different sets of board measures when reporting our estimation results. Given that the data is an unbalanced panel, we employ the panel data estimator with fixed effects. The fixed-effects model relies on time series variation to identify the relation between board measures and financing choices. Hence it captures the dynamic and causal effect of boards on capital structure. In contrast, the commonly used cross-sectional regression is only able to identify (static) correlation but fails to establish (inter-temporal) causality. Moreover, the fixed-effects approach is robust to the presence of omitted time-invariant firm-specific variables (including the industry effect) that would lead to biased estimates in an ordinary least squares framework. Finally, Lemmon et al. (2007) present evidence of the persistence in capital structures and recommend the use of fixed-effects estimation in capital structure studies. The reported P-values are based on White heteroscedasticity-consistent standard errors adjusted to account for possible correlation within a (firm) cluster. We report results from the first-stage leverage regression in the first two columns of Table 5. Under Model 1, we find that the Bindex is not significantly related to the level of leverage. Under Model 2, we find that the DPindex is significantly and positively related to the level of leverage. The economic implication of this result is that an increase in the DPindex from the 25th percentile to the 75th percentile is expected to increase leverage by 0.6%. On the other hand, the IAindex is significantly and negatively related to leverage, suggesting a possible substitute effect between incentive alignment and leverage.11 In addition, there are no significant associations between leverage and the other two subindices: the BEindex and SPindex. Columns 3 and 4 report the second-stage maturity regression results. The dependent variable here is the proportion of total debt maturing in more than three years (debt3).12 Under Model 1, we find that the overall board index, Bindex, is significantly negatively related to debt maturity. The economic implication of this result is that an increase in the Bindex from the 25th percentile to the 75th percentile is expected to reduce the percentage of total debt maturing in three years or more by 1.6%, relative to an unconditional average of 63%. This finding lends support to our second hypothesis that a strong board is associated with the use of more short-term debt. Under Model 2, among our four board subindices, only the DPindex is found to be significantly negatively associated with debt maturity. The economic implication of this result is that an increase in the DPindex from the 25th percentile to the 75th percentile is expected to reduce the percentage of total debt maturing in three years or more by 1.9%. The IAindex is not significantly related to debt maturity, inconsistent with the substitute argument, even though it is significantly negatively associated with leverage. Therefore, we conclude that there is no strong evidence in support of the substitute effect.

Corporate boards and the leverage and debt maturity choices

19

In other words, the DPindex is the only board subindex that shows a consistent relation with leverage and debt maturity, suggesting that director power relative to the CEO is the most important characteristic of the board in exerting their monitoring influence. Table 5

Leverage and maturity regressions

Bindex

Leverage regressions

Debt maturity regressions

Model 1

Model 1

Model 2

–0.001

–0.008*

(0.304)

(0.089)

BEindex

IAindex

0.002

–0.010

(0.482)

(0.344)

–0.007***

0.002

(0.000) DPindex

(0.799)

0.006**

SPindex

Model 2

–0.019**

(0.015)

(0.040)

0.006

–0.036

(0.419) –0.002 (0.434)

(0.486)

(0.989)

(0.925)

Public pension holding

–0.177

–0.180

–0.574

–0.573

(0.137)

(0.131)

(0.153)

(0.154)

Executive ownership

0.008*** (0.000)

–0.001

(0.286)

Eindex

0.008*** (0.000)

Fitted leverage Firm size Asset tangibility

M/B ratio Profitability Dividend-paying dummy Asset maturity

0.034***

0.036***

(0.000)

(0.000)

0.023

0.024

(0.378)

(0.365)

–0.017***

–0.017***

(0.000)

(0.000)

–0.338***

–0.343***

(0.000)

(0.000)

–0.019***

–0.018***

(0.001)

(0.002)

0.000

0.014**

–0.001

0.015***

(0.011)

(0.010)

0.244

0.222

(0.394)

(0.434)

–0.013

–0.015

(0.451)

(0.385)

0.010

0.009

(0.262)

(0.302)

–0.003*

–0.003*

(0.075)

(0.072)

20

J. Harford et al.

Table 5

Leverage and maturity regressions (continued) Leverage regressions

Debt maturity regressions

Model 1

Model 1

Model 2

Term structure

0.013***

Asset return StdDev Bond rating dummy Investment grade dummy Intercept Number of observations

Model 2 0.013***

[0.001]

[0.001]

–0.047

–0.045

(0.110)

(0.123)

–0.109***

–0.110***

(0.003)

(0.003)

–0.014

–0.013

(0.589)

(0.598)

–0.006

–0.015

(0.884)

(0.721)

(0.000)

0.795***

(0.000)

0.818***

5825

5825

5138

5138

R-squared Within

0.166

0.169

0.013

0.014

Between

0.196

0.190

0.046

0.036

Overall

0.188

0.181

0.024

0.018

*, **,*** denote significance at the 10%, 5% and 1% levels, respectively. This table presents fixed-effects regression results of leverage and Debt3, which is the proportion of total debt maturing in more than three years. We use the market leverage as the dependent variable and it is the ratio of total debt (data34 + data9) to market value of total assets which is computed as the sum of market value of equity (data199 × data54) and book value of debt minus book value of equity. Please refer to our Appendix for the definitions of the Bindex, BEindex, IAindex, DPindex, and SPindex. The Eindex is defined based on Bebchuk et al. (2005). Public pension holding is defined as aggregate holdings by active public pensions as identified in Cremers and Nair (2005), normalised by the number of shares outstanding. Executive ownership is dollar value of common stock and restricted shares held by the top five executives in millions of 2004 dollars. Fitted leverage is the fitted market total leverage from the first-stage leverage regression in the table. Firm size is the natural logarithm of sales (data 12) in millions of 2004 dollars. Asset tangibility is the ratio of net property, plant, and equipment (data8) to total assets. M/B ratio is the ratio of market value of total assets to book value of total assets. Profitability is operating income before depreciation (data13) normalised by the lagged value of total assets. Dividend-paying dummy equals one for firms paying dividends, and zero otherwise. Asset maturity is the weighted average of current assets (data4) divided by the cost of good sold (data41), and net property, plant, and equipment divided by depreciation and amortisation (data14), following Datta et al. (2005). Term structure is the yield difference between 10-year T-bond and 3-month T-bill. Asset return StdDev is stock return standard deviation times the equity-to-firm value ratio following Barclay and Smith (1995). Bond rating dummy equals one for firms with long-term bond rating available, and zero otherwise. Investment grade dummy equals one for firms with investment grade bond rating, and zero otherwise.

Table 5 also presents the estimation results on the relationship between other corporate governance measures and leverage and debt maturity choices. We find that the Eindex is not significantly related to leverage once we account for the role of corporate boards in firm financing decisions.13 Public pension holding is not significantly positively

Corporate boards and the leverage and debt maturity choices

21

associated with leverage, contradicting the prevailing view that these institutional investors are active monitors (Cremers and Nair, 2005). On the other hand, the negative relation between pension fund presence and leverage seems to suggest that due to their fiduciary duties, public pension funds tend to invest in firms with lower financial risk. Executive ownership is positively associated with the level of leverage, consistent with the findings in Berger et al. (1997); however, it is significantly and positively associated with debt maturity, in contrast to Datta et al.’s (2005) findings without including board characteristics.14 Further, neither the Eindex nor public pension holding is significantly associated with debt maturity. Finally, Table 5 shows the relation between other firm characteristics and leverage or debt maturity choices. There results are quite consistent with those from earlier studies. In particular, large less profitable non-dividend paying firms with lower growth opportunities are more likely to have higher leverage. Further, firms with shorter asset maturity are more likely to use short-term debt. The term structure is significantly positively related to the use of long-term debt, consistent with the tax hypothesis put forward by Brick and Ravid (1985): when the yield curve is upward sloping, issuing long-term debt reduces firms’ expected tax liability and consequently increases their current market value. Firms with a bond rating use more short-term debt, suggesting that firms with lower liquidation risk tend to shorten their debt maturity. This finding is different from Barclay and Smith (1995), but is consistent with the nonmonotonic relation between debt maturity and bond rating predicted by Diamond (1991) and confirmed by Guedes and Opler (1996), and Stohs and Mauer (1996). One caveat to our estimation results regarding the firm specific control variables is that several of these firm characteristics, such as the presence of bond rating, or asset maturity, do not change much from year to year, while our estimation technique – the panel data fixed-effects estimator – relies heavily on the time series variations in these control variables.

5

Additional investigation

We discuss additional investigation we have done in this section.

5.1 Alternative samples So far, our sample excludes financial firms and utilities as is standard in the literature. We also conduct our main analysis using two other different samples. Our second sample follows: Barclay and Smith (1995) and Datta et al. (2005) to focus on industrial firms only (SIC 2000–5999), leaving 6,445 firm-year observations. Our final sample does not impose any industry restrictions, yielding 9,086 firm-year observations. We find that these samples give very similar results as our main sample. We conclude that the effect of boards on capital structure choice is robust among firms of both unregulated and regulated industries.

5.2 CEO age It is possible that older CEOs will have risk preferences that lead them to choose more conservative capital structures. We add the CEO age variable to our main specifications and find that CEO age is only weakly associated with short debt maturity, and has no

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effect on the amount of leverage. Our main results on the role of boards in capital structure decisions remain unchanged. This variable is inconsistently reported in our data, cutting our sample considerably, so we exclude it from our main analysis.

5.3 Sarbanes-Oxley Our sample period includes the passage of the Sarbanes-Oxley Act and the subsequent governance changes. Therefore, for robustness, we re-estimate our leverage and maturity equations including a dummy variable for post-2002. We find that our inferences are unchanged.

6

Summary and conclusions

This paper investigates the relation between the board and firms’ leverage decisions. We hypothesise that strong boards will use financing decisions to help monitor managers. Specifically, we predict that firms with strong boards will have more leverage and will make greater use of short-term debt. We construct a board index based on ten board characteristics and identify four board subindices. We find that strong boards, in particular director power, are positively associated with leverage and negatively associated with the use of long-term debt. These findings suggest that director power vis-à-vis the CEO is more important than measures of board effectiveness and incentive alignment. This study improves our understanding of the role of boards in monitoring corporate decisions. Additionally, it contributes to the recent empirical literature examining the influence of corporate governance on firms’ financing decisions by examining the role of the board controlling for other aspects of corporate governance and by considering the maturity structure of the firm’s debt. Finally, the data allow us to simultaneously examine many aspects of the board and identify those that are most important.

Acknowledgement We thank Allen Ferrell and Lubo Litov for providing the entrenchment index, and Carol Bowie of the ISS/IRRC for her help on the board data. We also thank David Denis, Adlai Fisher, Ron Giammarino, Rob Heinkel, Jon Karpoff, Adam Kolasinski, Alfred Lehar, Wayne Mikkelson, Hernan Ortiz-Molina, Ed Rice, Josef Zechner, seminar participants at K.U. Leuven, Kent State University, University of British Columbia, University of Calgary, University of Vienna, and University of Washington finance brown bag, and conference participants at the 2006 UBC Finance Summer Conference (Whistler), and the University of Oregon Conference on Research in Corporate Finance (Eugene) for their helpful comments. Huasheng Gao provided excellent research assistance. We acknowledge the financial support from the Social Sciences and Humanities Research Council of Canada and the Certified Management Accounting Society of British Columbia. All errors are ours.

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Novaes, W. (2003) ‘Capital structure choice when managers are in control: Entrenchment versus efficiency’, Journal of Business, Vol. 76, pp.49–81. Paul, D.L. (2007) ‘Board composition and corrective action: evidence from corporate responses to bad acquisition bids’, Journal of Financial and Quantitative Analysis, Vol. 42, pp.759–783. Rajan, R. and Winton, A. (1995) ‘Covenants and collateral as incentives to monitor’, Journal of Finance, Vol. 50, pp.1113–1146. Shivdasani, A. (1993) ‘Board composition, ownership structure, and hostile takeovers’, Journal of Accounting and Economics, Vol. 16, pp.167–198. Shleifer, A. and Vishny, R. (1986) ‘Large shareholders and corporate control’, Journal of Political Economy, Vol. 94, pp.461–488. Stohs, M.H. and Mauer, D.C. (1996) ‘The determinants of corporate debt maturity structure’, Journal of Business, Vol. 69, pp.279–312. Stulz, R. (1990) ‘Managerial discretion and optimal financing policies’, Journal of Financial Economics, Vol. 26, pp.3–28. Stulz, R. (2000) Does Financial Structure Matter for Economic Growth? A Corporate Finance Perspective, Ohio State University Working Paper. Weisbach, M.S. (1988) ‘Outside directors and CEO turnover’, Journal of Financial Economics, Vol. 20, pp.431–460. Yermack, D. (1996) ‘Higher market valuation of companies with a small board of directors’, Journal of Financial Economics, Vol. 40, pp.185–211. Zwiebel, J. (1996) ‘Dynamic capital structure under managerial entrenchment’, American Economic Review, Vol. 86, pp.1197–1215.

Notes 1

The exceptions are Zwiebel (1996), Novaes (2003) and Benmelech (2006) where entrenched managers voluntarily choose debt and debt maturity to credibly constrain their empire-building incentives due to the trade-off between private benefits of control and the loss of job due to control challenges. 2 One possible channel that boards could exert influences on debt maturity is through their sophistication that counters the miscalibration of corporate managers, as Ben-David et al. (2006) show overconfident managers prefer the use of long-term debt. 3 There are two distinct approaches in the literature to capture corporate governance in general, and boards in particular at the firm level. On the one hand, Larcker et al. (2005) employ the principal component approach to distill 39 structural measures of corporate governance and end up with 14 governance factors. On the other hand, Brown and Caylor (2004) take a more agnostic approach by summing up 51 corporate governance provisions to form a grand governance score. We view our approach in this paper more of a guided principal component approach where we specify the factors and their constituents based on economic theory. 4 See, for example, Byrd and Hickman (1992), Shivdasani (1993), Cotter et al. (1997), Bange and Mazzeo (2004) and Paul (2007). 5 We use market leverage throughout this paper. Results using book leverage are quite similar. 6 Although many of the underlying characteristics in our board index are continuous, we convert them to binary variables for several reasons. First, a priori, there is reason to believe in some cases that the relation between the variable of interest, and board incentives, power, etc., is nonlinear. For example, in a voting model, having a majority of independent or long-serving directors is important, but having a majority +1 of such directors is not incrementally more important. For others, theory does not strongly motivate a linear relation, so we do not impose a linear relation on the data. As a practical matter, the binary transformation facilitates the construction of the overall index and corresponding board subindices.

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7

We note that using the broader Gindex instead does not change our main inferences. We note, however, that using percentage ownership instead of dollar ownership does not change our inferences. 9 We note that using different specifications in the first stage does not affect our main inference in the second stage, so as using the raw leverage measure instead of the fitted leverage from the first stage. 10 Most tax and agency models of capital structure predict that leverage will be increasing in profitability (Jensen (1986) for example), while empirically, the opposite relation often has been found. Prior studies have also shown that tangible assets provide better collateral for loans, and thus are associated with higher leverage; while dividends require funds and hence dividend-paying firms are associated with lower leverage (see Frank and Goyal, 2007). 11 In untabulated tests, we find that the key driver of the IAindex result is the board independence variable. 12 The sample size decreases because in the debt maturity regressions, we require the firm to have positive debt. 13 This insignificant result may be due to the fact that there is limited variation in the Eindex from year to year. So the fixed-effects approach is not able to detect the significant relation between the Eindex and leverage or debt maturity. 14 Following Güner et al. (2006), we also introduce a measure ‘bankers on board’ to capture the financial expertise and/or conflicts of interests exhibited in the boardroom. This variable takes the value of one if there is any director affiliated with a commercial bank sitting on the board, and zero otherwise. The sample mean for this measure is around 2%. We find that bankers on board are significantly negatively associated with leverage and have no significant role in debt maturity decisions. 8

Appendix

Definitions of the ten board characteristics

This appendix describes the board characteristics listed in Table 2, Panel A and used as components of the Board Index (Bindex). The shorthand title of each board measure, as used in the text and tables of the paper, is explained here. The descriptions are given in the order of different board roles. ‘BE’ stands for the board effectiveness subindex, ‘IA’ for the incentive alignment subindex, ‘DP’ for the director power subindex, and ‘SP’ for the shareholder power subindex. Our Bindex is a simple sum of the above four subindices.15 Subindex Variable definition BE

Small board equals one if the board size is less than the sample median, and zero otherwise

BE

Not busy equals one if the fraction of outside directors with three or more board positions (including the current board position) is no more than 50%, and zero otherwise

IA

Board independence equals one if the fraction of independent directors on the board exceeds 50%, and zero otherwise. According to the ISS/IRRC, independent directors include retired executives of other firms, academics, private investors, executives of unaffiliated firms, and others. The corporate governance literature has typically used independent directors to measure the board’s alignment with shareholder interests

Corporate boards and the leverage and debt maturity choices

27

Subindex Variable definition IA

No interlock equals one if the number of interlocking directors is zero, and zero otherwise. According to the ISS/IRRC, directors have interlocking relationship in a situation where a director and executive of company ABC sits on a board of company XYZ and a director and executive of company XYZ sits on the board of company ABC

IA

Equity ownership equals one if the median dollar value of director equity ownership is greater than the sample median, and zero otherwise

IA

Meeting fee equals one if the board meeting fee exceeds the sample median, and zero otherwise

DP

CEO not COB equals one if the CEO is not the chairman of the board (COB), and zero otherwise

DP

Blockholder on board equals one if the number of blockholders (with holdings more than 5%) is greater than zero, and zero otherwise

SP

Cumulative voting equals one if cumulative voting is allowed for the election of directors, and zero otherwise

SP

No classified board equals one if a provision that staggers the terms and elections of directors is absent, and zero otherwise

28

Int. J. Corporate Governance, Vol. 1, No. 1, 2008

Evolving ‘rules of the game’ in corporate governance reform Jennifer Hill Sydney Law School, Australia E-mail: [email protected] Abstract: While post-scandal reforms in the USA, UK and Australia were prompted by similar motivations, interesting differences in terms of their focus and structure still resonate in current corporate governance debate. The unique contours of the various regulatory responses challenge not only the traditional convergence hypothesis, but also the idea that a unified common law corporate governance model exists. Rather, a fluid, dynamic and increasingly fragmented picture of corporate governance has emerged. Within this developing corporate governance framework, various jurisdictions are able to test regulatory techniques and learn by their own trial and error, and that of other jurisdictions. Keywords: Sarbanes-Oxley Act; capital market regulations; corporate social responsibility. Reference to this paper should be made as follows: Hill, J. (2008) ‘Evolving ‘rules of the game’ in corporate governance reform’, Int. J. Corporate Governance, Vol. 1, No. 1, pp.28–48. Biographical notes: Jennifer Hill is Professor of Corporate Law at Sydney Law School, a Visiting Professor at Vanderbilt Law School and a Research Associate of the European Corporate Governance Institute (ECGI). Her areas of interest are: corporate law, corporate theory, corporate governance, comparative corporate governance, executive remuneration, corporate crime and US corporate law.

1

Introduction

Parallels between Jean Renoir’s classic film, ‘La Règle du Jeu’ (“The Rules of the Game”) and contemporary corporate governance might not be readily discernible. Renoir’s film, a box office flop at the time of its release in 1939, was notable for displaying a set of strictly ordered social rules and mores of the French haute bourgeoisie, which the audience witnesses dissolve as the film progresses. Renoir himself said that his aim in making the film was to show “a rich, complex society where … we are dancing on a volcano” (Sesonske, 1980).1 Contemporary corporate governance has had its own seismic shift in the form of the international corporate collapses, epitomised by Enron and WorldCom in the USA, and HIH and One.Tel in Australia. In the pre-scandal era at the beginning of this decade, the convergence/divergence debate in comparative corporate governance was at its height, with some scholars claiming that orderly convergence of corporate governance

Copyright © 2008 Inderscience Enterprises Ltd.

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regimes was both inevitable and imminent (Hansmann and Kraakman, 2001, p.468). A background assumption to this argument was that a cohesive Anglo-American governance model already existed and would form the point of convergence. Even scholars on the opposite side of this debate (Roe, 1997, p.165) at times seemed to share the assumption of a unified common law governance model (Gordon and Roe, 2004),2 while disputing the view that civil law jurisdictions would inevitably adopt these rules. The international corporate collapses complicated this debate. Common law jurisdictions, such as the USA, UK, Australia and Canada introduced a variety of regulatory responses to the corporate scandals (Hill, 2005a). Similar motivations underpinned these reforms, potentially providing evidence of the convergence hypothesis at work. Nonetheless, there are several factors which challenge such a straight-forward regulatory picture. In spite of the existence of common themes in the international post-scandal reforms, significant differences emerged in terms of focus, structure and regulatory detail. Some of the common law post-Enron reforms are interesting from the perspective of what they did not, rather than what they did, address. Thus, for example, there is an interesting dichotomy between strengthening of shareholder participatory rights vs. protection of shareholder interests evident in the reforms. Strengthening of shareholder participatory rights was a significant theme in the Australian and the UK reforms, but not in the US reforms. The shape of these reforms has also affected subsequent corporate law debates in the USA, UK and Australia which address quite different policy concerns. Scholars have noted that, even where similar motivations underpin various reforms, it is unlikely that their long-term effects will coincide (Langevoort, 2007). Another aspect of this long-term regulatory unpredictability is the impact of backlash, recently exemplified by the Report of the Committee on Capital Markets Regulation (Paulson Committee, 2006) (“The Paulson Committee Report”). One criticism of convergence theory is that it engaged in overgeneralisation, which could obscure significant differences within the common law world (Toms and Wright, 2005, p.267). The post-scandal developments discussed in this paper support the view that interesting differences in regulatory approach exist within the common law world itself, and challenge any assumption of an orderly, seamless progression towards a uniform model of good corporate governance. As in Renoir’s famous film, the regulatory picture they present is a more complex, dynamic and unpredictable one.

2

Background issues in comparative corporate governance

Although in the early 1990s, a central issue in comparative corporate governance was whether the US should adopt governance mechanisms from other jurisdictions, such as Germany and Japan, (Roe, 1993; Romano, 1993)3 the comparative corporate governance debate did a u-turn later in the decade. With interest in globalisation then at its peak, the new focus of debate became the export of US style corporate governance principles internationally (Pinto, 2005; Hill, 2005b). Comparative corporate governance literature posits a divide between jurisdictions with dispersed ownership structures, such as the USA, and those with concentrated ownership structures, traditionally found in continental Europe and Asia (Bratton and McCahery, 1999; Cheffins, 2001; Coffee, 1999, p.707; Visentini, 1998). This formed the

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backdrop to the convergence-divergence debate, in which the scholarship of La Porta et al. (1998, 1999), proved so influential. La Porta et al. argued that jurisdictions with a high level of minority shareholder protection would develop dispersed ownership structures, such as those existing in the USA and UK. According to the study, law, and indeed legal origins, matter. The normative subtext was that common law legal protections were superior to those found in civil law legal systems (Skeel, 2004, pp.1544, 1545). This message provided strong support for a convergence theory of corporate governance, via a quasi-evolutionary progression towards the superior legal rules, presumed to exist in the common law world (Jordan, 2005, pp.985–990). Not all commentators were convinced of La Porta et al.’s hypothesis. Comparative law scholarship contains a long tradition of scepticism about the feasibility of transplanting elements of one legal system to another (Kahn-Freund, 1974; Licht, 2004; Paredes, 2004; Teubner, 1998). Within this general theoretical tradition, contemporary scholars such as Roe have identified historical, political and social ‘path dependence’ factors, which may create, or perpetuate, differences in legal regimes (Roe, 1997). The convergence and ‘law matters’ hypotheses have been challenged from a range of perspectives. Some commentators, while accepting the strong homogenising influences of globalisation, challenged the view that convergence would be a continuous and steady process (Milhaupt, 2004, p.213). Indeed, it has been argued that the very concept of ‘convergence’ is ambiguous, in that it is sometimes unclear whether it relates to form or substance (Gilson, 2004, p.158). Other commentators disputed the presumed link between transplantation and efficiency gains, warning that transplantation may disrupt the internal balance and consistency of a regulatory system, creating a newly minted, but now dysfunctional, governance system (Bratton and McCahery, 1999, p.219; Schmidt and Spindler, 2004, pp.119, 122). Also, the intended consequences of regulation are often subverted by the underlying social environment (Langevoort, 2007; Parker et al., 2004, p.7). Finally, the methodology and background assumptions in the ‘law matters’ study have been criticised. One strand of criticism focuses on the broad generalisations underlying the ‘law matters’ hypothesis, some scholars arguing that the presumed differences between civil law and common law systems adopted by many convergence theorists are too sharply defined and often inaccurate (Jordan, 2005, p.1005; Pistor et al., 2002, p.799; Skeel, 2004, p.1546). On the other hand, regulatory differences which sometimes exist between common law countries are simply obscured or ignored (Aguilera et al., 2006, pp.147, 148; Davies and Hopt, 2004, p.172; Toms and Wright, 2005). Takeover law, where fundamental differences exist between, for example, USA, UK and Australian law, is a good example of this problem (Armour and Skeel, 2007; Davies and Hopt, 2004, p.172). It has also been argued that the primary focus in La Porta et al.’s study on ‘law on the books’ (Pistor and Xu, 2003; Skeel, 2004, p.1543) was misguided, since it ignored or concealed important dynamic features of legal systems, such as the operation of social norms (Coffee, 2001) and enforcement intensity (Hertig, 2004, p.328; Coffee, 2007). Alternative, and arguably more nuanced, approaches to regulatory difference than the convergence and ‘law matters’ hypotheses have emerged in recent times. Thus, for example, the 2004 book, The Anatomy of Corporate Law (Kraakman et al., 2004), identifies a wide range of regulatory and governance strategies used to control opportunism and conflicts of interest between corporate participants (Skeel, 2004). In contrast to the approach of La Porta et al., the methodology adopted in The Anatomy of

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Corporate Law focuses on “substantive results rather than on mere legal origin” (Kraakman et al., 2004, p.221), avoiding the normative subtext of the convergence debate. The vision of comparative corporate governance adopted in this book is, therefore, one in which different jurisdictions address common corporate governance problems with the aid of a diverse range of regulatory tools. It is a picture that allows us to see regulatory paradigm shifts both within, and between, common law and civil law jurisdictions.

3

The post-scandal regulatory responses: laws, principles and politics

The international corporate scandals elicited a range of regulatory responses in common law jurisdictions, such as the USA, UK, Australia and Canada. These included legislative reforms4 and governance changes by self-regulatory organisations.5 At one level, the corporate law reforms addressed similar governance concerns, particularly with respect to gatekeeper conflicts of interest (Coffee, 2002a, 2004a; Gordon, 2002), and potentially provided more evidence of the convergence hypothesis at work (von Nessen, 2003). Although similar concerns and motivations prompted the reforms, there are several matters that challenge such an ordered regulatory picture and highlight significant differences between the various regulatory responses. First, in spite of globalising influences, many of the reforms responded specifically to local issues. In the USA, the Sarbanes-Oxley Act 2002 (‘Sarbanes-Oxley Act’) closely tracked the contours of Enron (Ribstein, 2002, pp.4–18). Local issues were also prominent in UK reforms (Ferran, 2005, p.25) and, in Australia, aspects of the CLERP 9 Act 2004 were directly linked to the failure of HIH Insurance, which was the largest collapse in Australian corporate history (HIH Royal Commission, 2003). Convergence sceptics have highlighted the importance of politics and the fact that “corporate law rules are the products of collective action”, in support of the proposition that convergence is highly unlikely (Charny, 2004, p.296). Localised political pressures are revealed in several aspects of the post-scandal reforms, including their timing and evolution. The most immediate legislative response to the corporate scandals occurred in the USA, where a full-scale regulatory overhaul was achieved in 2002.6 The speed with which the reforms were introduced became a focal point in subsequent academic discussion. It has been argued that the real impetus for reforms emanated not from Enron, but from the US political climate which developed after the WorldCom scandal, when investor protection became a major issue in looming elections (Langevoort, 2007, p.1821). Unusual bipartisan cooperation enabled the swift passage of reforms that effectively reshaped the allocation of regulatory power between the states and federal law in the USA (Chandler and Strine, 2003, p.973; Thompson, 2003, p.100). Critics of the Sarbanes-Oxley Act have linked the perceived defects of the legislation to its hasty passage, describing it as ‘emergency legislation’ (Romano, 2005, p.1528), which was enacted in an overheated political environment without the benefit of careful deliberation and policy assessment (Romano, 2005, pp.1549ff, 1602). Others, while acknowledging that the Act came into existence quickly as a result of political expediency, argue that it delivered real benefits and improvements in the corporate governance process (Brown, 2006). Reforms in other common law jurisdictions were enacted at a slower pace and with broad consultation. Australia’s parallel legislative response, the CLERP 9 Act, which

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commenced operation in mid-2004, was the subject of extensive public debate. Furthermore, it integrated the recommendations of the HIH Royal Commission, which itself lasted for 18 months (HIH Royal Commission, 2003). In the UK, reform processes were already underway several years prior to the corporate scandals and advanced by degrees (Ferran, 2005), only recently culminating in the passage of the massive Companies Act 2006 (UK) (UK Department of Trade and Industry (DTI), 2006).7 There are also philosophical differences between the US reforms and those introduced in the UK and Australia, in terms of reliance on rules and principles as regulatory techniques. Scholars have long debated the respective merits of rules and principles as regulatory mechanisms (Rose, 1988; Sunstein, 1995; Kennedy, 1976). Rules are generally perceived to promote certainty – they have clear, determinate boundaries defining ex ante whether conduct is or is not permissible, and allow for little discretion in the decision-maker (Ford, 2007, pp.8, 9; Sullivan, 1992). Principles (or standards), on the other hand, are often viewed as promoting substantive equality and fairness, as opposed to formal equality under rules. Their very lack of precision requires the ex post exercise of discretion based on a variety of specific factual and contextual matters, and embedded social values (Kennedy, 1976). Classic criticism of rules relates to their perceived inflexibility and the increased scope for evasion of, or ‘creative compliance’ with, rules that have precise and determinate contours (McBarnet and Whelan, 1991, p.849). Rules are also often reactive and thereby subject to over or under-inclusion, while principles avoid this problem by conferring greater discretion on the decision-maker (Ford, 2007, p.8, n.26; Sullivan, 1992, pp.58, 59). It has been argued that there is a decline in the ability of rules to provide certainty, commensurate with an increase in the complexity of the matter regulated (Braithwaite, 2002). In many situations, however, the line between rules and principles may be somewhat blurred, with regulation comprising hybrids of the two. The dynamics and interplay between rules and principles have become more complex due to greater fragmentation and internalisation of contemporary corporate governance practices (Parker, 2007). Principles and norms, embodied in self-regulatory codes of corporate governance,8 have become an increasingly important regulatory tool. As in the case of legal rules, enforcement of self-regulatory codes is obviously an important issue, and one which will vary depending on the relevant legal and social culture (Wymeersch, 2005, p.408). The international scandals resulted in a hardening of norms in both Australia and the UK. There has also been a global trend for stock exchanges to be more involved in corporate governance regulation. Although the Australian Securities Exchange (ASX) had been tangentially involved in corporate governance regulation since 1996, that involvement intensified after the corporate collapses. In 2003, following public pressure and criticism about its credibility as a regulatory body, the ASX introduced its Principles of Good Corporate Governance and Best Practice Recommendations (“the ASX corporate governance principles”; ASX Corporate Governance Council, 2003), which adopted a UK-style ‘comply or explain’ (ASX Corporate Governance Council, 2004)9 regulatory model that was more stringent than the previous disclosure requirement in Australia (Bird and Hill, 1999, pp.598–600).10 Corporate governance norms were also enhanced in the UK as a result of the Review of the Role and Effectiveness of Non-Executive Directors (Higgs, 2003). The Higgs Report recommended strengthening the independence of the board from management within the preexisting ‘comply or explain’ regulatory framework, and these

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recommendations were subsequently incorporated into the UK Combined Code on Corporate Governance 2003 (‘the Combined Code’). Traditionally, the development of self-regulatory codes has tended to be either a response to the lack of specific governmental regulation in particular areas, or, in some cases, a justification for the absence of such regulation. A number of the post-scandal reforms in Australia and the UK fall into the latter category. They also reflect a strong preference for the flexibility offered via regulation by principles rather than mandatory legal rules, and recognition that inadequate enforcement of good governance practices could result in the imposition of onerous government regulation (Humphry, 2003, p.3). In contrast to the reforms in Australia and the UK, the US reforms appear to reflect the process of ‘juridification’ (Wymeersch, 2005, p.418), in their conspicuous shift towards a rules-based approach to corporate governance with a higher level of mandatory governance standards. The final NYSE corporate governance rules, for example, introduced a range of mandatory requirements concerning board structure to reflect generally accepted best practice in corporate governance,11 the substance of which is often stricter than its counterparts in other jurisdictions, such as Australia (Hill, 2005a, p.383). The Sarbanes-Oxley Act also imposed many new prescriptive rules, thereby affecting the balance of regulatory power between the states and federal law. However, not all of the reforms under the Sarbanes-Oxley Act are of this ilk. Sections 406 and 407 respectively direct the SEC to issue rules requiring a company to disclose whether it has adopted a code of ethics for senior financial officers (and if not, why not), and whether at least one member of the audit committee is a financial expert (and if not, why not). While these provisions are framed as disclosure provisions only, they have been described as ‘disguised substance’, the likely contextual effect of which will be to mandate compliance (Thompson, 2003, p.104). The Sarbanes-Oxley Act has been depicted as creating a ‘shadow corporation law’ (Chandler and Strine, 2003, p.973), and criticised for deviating from the traditional US model of corporate law, under which state-based law is viewed as facilitative and competitive (Romano, 2005, pp.1523, 1528, 1529). The Sarbanes-Oxley Act also laid greater emphasis on criminal liability in corporate governance12 than reforms in Australia and the UK. Nonetheless, some commentators have viewed the Act’s criminal provisions as adding little to pre-existing US law, and unlikely to be an effective form of deterrence (Perino, 2002). While some countries in continental Europe, such France and Germany, adopted reforms based on the Sarbanes-Oxley Act (Enriques, 2003, p.918ff), there was an explicit rejection in Australia and the UK of the rules-based regulatory approach to corporate governance which underpinned the Act. At the time the ASX corporate governance principles were introduced in Australia, for example, the then-Managing Director and CEO of the Australian Stock Exchange stated that “[t]hrough a disclosure based approach, the ASX is keen to avoid a US style Sarbanes-Oxley legislative solution” (Humphry, 2003, p.3). The Chair of the Higgs Committee, Derek Higgs, was similarly direct in his preference for regulation by principles over rules, commenting that the “brittleness and rigidity of legislation cannot dictate the behaviour, or foster the trust, I believe is fundamental to the effective unitary board and to superior corporate performance.” (Higgs, 2003, p.3)

The Chief Executive of the London Stock Exchange has recently confirmed this regulatory preference (Furse, 2006).

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The Canadian post-scandal approach to corporate governance and securities regulation, led by British Columbia, also appears to favour a principles-based approach, focusing on voluntary compliance over regulatory enforcement (Ford, 2007; Broshko and Li, 2006). Canada’s publicly listed corporate sector, like that of Australia (Lamba and Stapledon, 2001), contains a high level of controlling blockholder ownership structures and many ‘small-cap’ firms, and it has been suggested that principles-based regulation may be better suited to this kind of market profile (Ford, 2007). The presumed dichotomy between rules and principles, and between rigidity and flexibility, is relevant to the issue of regulatory amendment. Romano, in her critique of the Sarbanes-Oxley Act, notes that “legislation drafted in a perceived state of emergency can be difficult to undo” (Romano, 2005, p.1602). By contrast, the norms embodied in the ASX corporate governance principles appear to be extremely fluid. The principles have been the subject of almost continual assessment and consultation since their introduction in 2003, including two reports by the Implementation Review Group (ASX Corporate Governance Council Implementation Review Group (IRG), 2004, 2005). Following a 12 month review, in November 2006 the ASX Corporate Governance Council released an Explanatory Paper and Consultation Paper on proposed changes to the principles (ASX Corporate Governance Council, 2006). A consistent message in these reviews has been the inherent flexibility and non-prescriptive nature of the ASX corporate governance principles. The reviews have stressed the fact that “the only compliance required is disclosure” (ASX Corporate Governance Council Implementation Review Group (IRG), 2004, p.1) and that corporations are free to depart from the principles, provided they explain why (ASX Corporate Governance Council, 2006, p.6). Reflecting this underlying philosophy, the reviews have also recommended removal of the term ‘best practice’ from the title of the ASX corporate governance principles, on the basis that it might imply that other practices are inferior (ASX Corporate Governance Council Implementation Review Group (IRG), 2004, p.1; ASX Corporate Governance Council, 2006, p.9). This is a theme which also resonates in the Canadian securities regulation context (Ford, 2007, pp.38, 39). In its 2006 Explanatory and Consultation Paper, the ASX emphasises the evolving nature of the corporate governance debate, and the interrelation of the principles with other parts of the corporate governance ecosystem (ASX Corporate Governance Council, 2006, p.5). Several proposed changes to the ASX corporate governance principles are due to the need to update them in light of recent progress in related areas, such as risk management and corporate responsibility and sustainability. For example, the ASX Corporate Governance Council notes that recent developments have emphasised the broad scope of the term ‘risk’ and explicitly incorporates this expansive interpretation into the concept of ‘material business risks’ in its revised draft of the principles (ASX Corporate Governance Council, 2006, p.17ff). This new emphasis on risk represents a further point of linkage between developments in corporate governance and regulation theory more broadly, given that risk management has taken an increasingly central role in the regulation debate (Black, 2002, pp.9, 10; Black, 2005). In the wake of the growing popularity of principles-based regulation, some commentators have become wary of the rhetoric associated with it, and of the corresponding denigration of rules-based regulation (Cunningham, 2007; Kershaw, 2005). Cunningham, for example, rejects the standard dichotomy between rules and principles-based regulation, arguing that most complex regulatory systems cannot be meaningfully characterised as falling within one or the other category

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(Cunningham, 2007, pp.1426–1435). He suggests that the rhetoric surrounding principles-based regulation may have flourished primarily as a form of product-differentiation (Cunningham, 2007, pp.1482–1485). A prime example of this is the post-Sarbanes-Oxley power struggle between US state and federal corporate law. Given that the Sarbanes-Oxley Act has been widely criticised as overly-prescriptive, Delaware judges and lawyers have sought to assert the supremacy of Delaware law by emphasising its flexible, principles-based nature (Cunningham, 2007, pp.1483–1484). Claims that the UK avoided any Enron-style financial fiascos due to its principles-based accounting system have also attracted criticism (Kershaw, 2005).

4

Shareholder interests vs. participatory rights: what the post-scandal reforms did and did not address

Enhancing managerial accountability for the benefit of shareholders was a common goal in various reforms adopted following the international corporate scandals. On one interpretation, gatekeepers, such as auditors, and boards of directors, bore much responsibility for the scandals (Coffee, 2002a, 2004b; Gordon, 2002), with shareholders seen as innocent victims (Coffee, 2005, pp.2, 15).13 Although not all commentators accept this benign view of shareholder involvement in the scandals (Karmel, 2004, p.4; Strine, 2006, pp.1764, 1772, 1773), it is an image that underlies many of the post-scandal reforms in common law countries. However, the reforms differ in the manner in which they seek to achieve the goal of enhanced managerial accountability vis-à-vis shareholders. Specifically, there is an intriguing dichotomy between strengthening of shareholder participatory rights vs. protection of shareholder interests. Strengthening shareholder participatory rights in corporate governance was an explicit governance objective in the Australian reforms (McConvill and Bagaric, 2004, p.131). The Explanatory Memorandum to the CLERP 9 Act contains numerous references to the desirability of increasing shareholder activism14 and improving shareholder participation and influence in the companies in which they invest.15 A clear example of this is in the reforms relating to executive remuneration (Hill, 2006, pp.67, 68). The CLERP 9 Act permits greater shareholder participation in remuneration issues by requiring shareholders of a listed company to pass an advisory resolution at the annual general meeting approving the directors’ remuneration report (Chapple and Christensen, 2005).16 Although non-binding, the explicit goals of the procedure are to provide shareholders with greater voice in relation to remuneration issues,17 and encourage greater consultation and information flow concerning remuneration policies between directors and shareholders.18 The reform also seeks to constrain excessive compensation by ‘shaming’ and censure (Skeel, 2001), and from this perspective may be a potentially powerful governance mechanism (Hill, 2006, pp.69–71). Nonetheless, the Australian government’s professed enthusiasm for shareholder activism is not unqualified, and in one particular respect, the government has attempted to restrict shareholder participation in corporate governance. This is in relation to the so-called ‘100 member rule’, which permits 100 shareholders to convene a general meeting of the company.19 The rule, which is remarkably generous to shareholders compared to many other jurisdictions, has attracted criticism as being open to possible abuse by activist shareholders with a social agenda (CASAC, 2000, p.15). In 2005, the federal government announced that it intended to remove the 100 member rule

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(Pearce, 2005),20 however its proposal to this effect was rejected by state leaders at a meeting of the Ministerial Council for Corporations in July 2006 (Gettler, 2006; Pearce, 2006). Increased shareholder participation and influence was a theme in the UK reforms (which included a version of the non-binding shareholder vote on the directors’ remuneration report)21 and the UK government has issued strong rhetoric about the need to encourage greater shareholder democracy and activism (Ferran, 2005, pp.27, 28). This policy goal was also reflected in the UK Combined Code, which included recommendations of the Higgs Report (2003) specifically aimed at strengthening the position of both institutional investors and independent directors, through a range of techniques designed to establish a close relationship between the two groups (Hill, 2005a, p.391). The UK Combined Code stressed the need for the board to communicate with investors generally and to encourage their participation in the annual general meeting.22 The US reforms present an interesting contrast in this regard. Protection of shareholder interests was a clear priority (Karmel, 2004, p.2) and part of the legislative intent of the reforms. The preamble to the Sarbanes-Oxley Act states, for example, that the aim of the Act is “[t]o protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes”. Yet, in spite of this focus on protection of shareholder interests, enhancement of shareholder participatory rights and power vis-à-vis management was conspicuously absent in the US reforms (Hill, 2005a, p.392). Commentators have described the refusal of the Sarbanes-Oxley Act to grant shareholders greater governance power and participatory rights in, for example, the director election process, as notable (Langevoort, 2007, p.1829) and ‘the forgotten element’ of the Act (Chandler and Strine, 2003, p.999). Another potentially forgotten element in the US reforms was the issue of executive compensation. Executive compensation was deeply implicated in Enron and other corporate scandals. Conflicts of interest were evident in the structure of many executive compensation packages, which, rather than aligning managerial and shareholder interests, often appeared to create perverse incentives for executives to manage earnings and share price to enhance the value of options and pursue short-term goals (Anabtawi, 2004, p.839ff; Bolton et al., 2006; McClendon, 2004; Yablon and Hill, 2000, pp.86–88). Indeed, this misalignment of interests in executive pay is one possible interpretation of the corporate collapses (Coffee, 2004b). Yet, in spite of its prominence in the scandals, executive compensation received virtually no attention in the US reforms (Hill, 2005a, p.412). Also, US reforms on board independence arguably had quite different implications for shareholder power than parallel reforms in the UK. The UK Combined Code sought to strengthen the position not only of independent directors, but also institutional investors, by fostering active dialogue between the two groups and encouraging greater participation in governance issues by institutional investors. However, the strict definition of director ‘independence’ under the US 2002 reforms suggests that US directors should generally be independent, not only from management, but also from major shareholders (Hill, 2005a, pp.388–390). It has been argued that this aspect of the US reforms can be seen as contributing to an emerging concept of independent directors as ‘public’ directors in America, potentially shifting the Sarbanes-Oxley Act towards a model of public accountability rather than its stated intent of shareholder protection (Langevoort, 2007, p.1831; Coglianese, 2007, pp.163, 164).

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Thus, even where reforms are unified by similar goals, this is no guarantee that their ultimate effects will coincide. Professor Langevoort has recently noted this gap between motivation and regulatory outcome, due to variability in compliance and enforcement decisions, in relation to the Sarbanes-Oxley Act (Langevoort, 2007). Unpredictability in the long-term effects of legislation is compounded in the case of an array of international legislation, where ‘legal irritants’ and underlying differences in regulatory ecosystems can create new divergences (Teubner, 1998).

5

Current policy debates and regulatory backlash

The shape of current academic and policy debates in the USA, UK and Australia has been determined to a considerable degree by what was, and what was not, incorporated into the various post-scandal reforms. These recent policy debates, like the earlier regulatory responses themselves, have a distinctly local flavour. Thus, for example, the lacuna in the US reforms concerning shareholder participation rights has had a clear influence on the direction of subsequent academic debate on the need to enhance shareholder power in the USA. Bebchuk, a leading proponent of increased shareholder power and participation, has identified two key areas of corporate governance need. First, he has argued strongly for the reform of US proxy rules to allow shareholders greater influence over the director nomination process (Bebchuk, 2003), a reform for which the Securities and Exchange Commission (SEC) originally exhibited some enthusiasm (SEC, 2003). Bebchuk’s second set of reform proposals focuses on increasing shareholder power, by permitting shareholders to initiate and effect changes to the corporate charter (Bebchuk, 2005, 2006). These reform proposals would significantly alter the current balance of power between shareholders and the board of directors in the USA. It is, as yet, unclear how much traction the proposals will ultimately gain. They have provoked intense debate in academic circles.23 While few US scholars doubt that there is plenty of scope for increasing shareholder power (Anabtawi, 2006, p.569), many doubt the wisdom of doing so, particularly when it would be at the expense of managerial autonomy and power (Anabtawi, 2006; Bainbridge, 2006; Strine, 2006). In addition, the SEC’s reformatory zeal concerning the director nomination process has waned (Strine, 2006, pp.1776, 1777). However, the issues raised by this academic debate are now undeniably in the US corporate ether. One example of this attitudinal shift is in relation to the issue of executive compensation. In spite of the surprising lack of attention given to executive compensation in the 2002 US reforms, regulatory momentum on this issue has gathered pace since that time. In early 2006, the SEC announced that it would conduct a significant overhaul of its disclosure rules on executive compensation (SEC, 2006) and political rhetoric on the topic of excessive executive pay has recently intensified (Rutenberg, 2007). Activist investors, such as the AFSCME,24 submitted shareholder proposals seeking an advisory vote on executive pay, comparable to the non-binding shareholder vote introduced in the Australian and UK post-scandal reforms. Proposals to this effect were successful at some companies, such as Blockbuster and Verizon Communications, during the 2007 proxy season (Morgenson, 2007). The issue of an advisory vote for shareholders on executive remuneration also became the subject of Democrat-instigated Congressional consideration (White and Patrick, 2007). In April 2007, the House of Representatives overwhelmingly passed a bill which would accord

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US shareholders an advisory vote on executive remuneration, however, ultimate translation of the bill into legislation is in doubt, due to White House opposition (Scannell and Hughes, 2007). Another aspect of long-term regulatory unpredictability is the impact of backlash (Roe, 1998).25 Backlash can operate in either direction on a convergence-divergence axis. A recent example of backlash is the Report of the Committee on Capital Markets Regulation (Paulson Committee, 2006), which lays to rest any interpretation of common law post-scandal legislation as representing a unified, homogeneous regulatory response. Rather, a central tenet of the Paulson Committee Report is that the regulatory approach of the Sarbanes-Oxley Act was idiosyncratic and unduly stringent by international standards, and has reduced the competitiveness of US markets (Paulson Committee, 2006, p.xi). Similar concerns regarding the declining preeminence of New York and US financial markets are evident in another report, Sustaining New York’s and the US’ Global Financial Services Leadership (Bloomberg and Schumer, 2007; Anderson, 2007).26 This feature of the Paulson Committee Report is interesting from the perspective of the debate on cross-listing, which emerged at the high-point of the convergence-divergence controversy in comparative corporate governance. At that time, it was often assumed that the marked trend towards cross-listing of foreign firms in the USA during the 1990s constituted a desirable form of regulatory competition (Coffee, 2002b), in which companies incorporated in jurisdictions with weak minority shareholder protection could voluntarily adopt higher standards. This trend was seen as further possible evidence for the convergence of corporate governance practices towards a US model (Jordan, 2007; Licht, 2004, pp.196–198). The Paulson Committee, however, suggests that the stringency of the Sarbanes-Oxley Act and increased associated compliance costs (Asare et al., 2007) have resulted in the opposite phenomenon, whereby foreign companies are now avoiding cross-listing on US markets (Lew and Ramsay, 2006, pp.9–12; Licht, 2003; Maitland, 2004; Piotroski and Srinivasan, 2007). Whereas a central goal of the Sarbanes-Oxley Act was to restore investor confidence via rule-based regulation (Asare, 2007, p.82), the Paulson Committee stresses the need to protect shareholders from excessive regulation which may impair the competitiveness of US markets (Paulson Committee, 2006, p.xi). This shift in the regulatory pendulum is arguably reflected in the recent rejection of greater oversight for hedge funds in the USA (Labaton, 2007). However, some commentators have questioned the supposed nexus between the prescriptive tenor of the post-Enron reforms and any loss of competitiveness in US capital markets. Coffee, for example, notes that much of the decline in the listing premium associated with foreign cross-listings occurred prior to the introduction of the Sarbanes-Oxley Act, and argues that foreign firms continue to list on US markets because of their higher regulatory standards (Coffee, 2007, pp.7, 8, 57, 58).27 He also observes that firms which do cross-list on a US exchange appear to gain a significant valuation premium (Coffee, 2007, pp.8, 9). Davidoff, while acknowledging the decline in foreign listings on US markets, has suggested that this decline is primarily due to “the inevitable maturation of non-US capital markets rather than … to the Sarbanes-Oxley Act or any other recent change in US regulation” (Davidoff, 2007, pp.9–23). The issue of shareholder empowerment, prevalent in recent US academic debate, is also a subtext in the Paulson Committee Report. The Committee suggests that increased shareholder rights could themselves achieve greater board accountability, thereby reducing the need for heavy-handed formal regulation (Paulson Committee, 2006,

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pp.xi, xii) and recommends enhancement of shareholder rights across several areas.28 While issues of efficiency and firm value underpin much of the Paulson Committee’s discussion, the fundamental power imbalance between managers and shareholders is also a clear concern.29 Shareholder empowerment, now permeating the US corporate law debate, provides an interesting contrast to current policy concerns in Australia and the UK, which are strongly focused, not on shareholder rights, but on the interests of stakeholders. The plight of stakeholders, such as employees, and corporate responsibility generally, were major themes of the corporate scandals (Langevoort, 2007, p.1828). Nonetheless, the Sarbanes-Oxley Act in the USA and the CLERP 9 Act in Australia were mainly concerned with protection of shareholders and their interests.30 In the UK, however, ‘a third way’, advocating a long-term, enlightened shareholder value approach to corporate governance issues, was already gaining momentum (Williams and Conley, 2005). Political issues, including concern by the EU to harmonise the laws of member states, contributed to this development in the UK (Williams and Conley, 2005, pp.498, 499). This enlightened shareholder value principle has been given legislative force under s 172 of the recently enacted UK Companies Act 2006, which imposes a new duty on directors to “promote the success of the company”, requiring them to consider stakeholder interests and the long-term effects of their decisions (Austin, 2007). Corporate social responsibility has also become a major issue in Australia, largely as a result of two high-profile local corporate scandals. The first was the James Hardie saga. This involved a corporate reconstruction whereby asbestos-related liabilities were separated from other assets in the company through the creation of a foundation,31 which was subsequently found to have insufficient funds to meet legitimate compensation claims (Dunn, 2005). The second concerned the Australian Wheat Board Ltd, one of the world’s largest wheat marketing and management companies, which was found to have made corrupt payments to Iraq under the Oil-for-Food program. These scandals were responsible for generating not only heated public debate about corporate social responsibility, but also two governmental reports on the topic – reports by the Parliamentary Joint Committee (‘PJC Report’)32 and the Corporations and Markets Advisory Committee (‘CAMAC Report’).33 A central issue in these reports was the scope of directors’ duties, and the extent to which the current Australian legal framework permits directors to consider the interests of stakeholders or the broader community. This issue arose directly from the James Hardie matter, where James Hardie executives and directors sought to justify their conduct by arguing that current law essentially required them to privilege shareholder interests ‘at all costs’ (PJC, 2006, pp.47, 181). The PJC Report observed, however, that “rampant corporate irresponsibility certainly decreases shareholder value” (PJC, 2006, p.19). Scrutiny of the actions of the James Hardie directors will inevitably persist, with the Australian Securities and Investments Commission (ASIC) announcing in mid-February 2007 that it would bring civil penalty proceedings against the entire board of directors (Durie, 2007; Priest and Skulley, 2007). Both the PJC Report and the CAMAC Report rejected legislative change to directors’ duties in Australia to embody “enlightened shareholder value” explicitly as in s 172 of the Companies Act 2006 (UK). The PJC Report was critical of the UK amendment to directors’ duties (PJC, 2006, pp.54–56), on the basis that it was overly prescriptive and would result in confusion, while the CAMAC Report considered that a comparable statutory amendment in Australia would provide ‘no worthwhile benefit’

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(CAMAC, 2006, p.111). Overall, there is a degree of overlap between the tone and ultimate conclusions of the PJC Report and the CAMAC Report, with both demonstrating a preference for industry-based regulation and initiatives, rather than formal legislative change, to address corporate social responsibility issues. The CAMAC Report, in particular, acknowledged the limits to the law’s ability to control corporate decision-making by prescription, portraying corporate responsibility as a fluid part of a company’s operations, not a legislative ‘add-on’ (CAMAC, 2006, pp.3, 4).

6

Conclusion

While post-scandal reforms in the USA, UK and Australia were prompted by similar motivations, interesting differences in terms of their focus and structure still resonate in current corporate governance debate. The unique contours of the various regulatory responses challenge not only the traditional convergence hypothesis, but also the idea that a unified common law corporate governance model exists. Rather, a fluid, dynamic and increasingly fragmented picture of corporate governance has emerged. Within this developing corporate governance framework, various jurisdictions are able to test regulatory techniques and learn by their own trial and error, and that of other jurisdictions. If any evidence of long-term convergence can be gleaned from these developments, paradoxically, it would appear to be away from the US post-scandal regulatory model. These developments reflect a complex and interesting picture of contemporary corporate governance, worthy of ‘La Règle du Jeu’.

Acknowledgement I am grateful to Lucian Bebchuk and Robert Thompson for providing me with helpful information concerning some recent developments and to Stephen Bottomley for valuable feedback. My thanks to Alice Grey for her excellent research assistance. Funding for this research was provided by the University of Sydney and the Australian Research Council. This article was originally presented as a conference paper at an ESRC/GOVNET Sponsored Workshop on The Dynamics of Capital Market Governance in March 2006 at the Australian National University, Canberra, Australia, and appears in the book of conference proceedings (O’Brien, 2007).

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Notes 1

From Jean Renoir’s 1961 interview with the Office de Radiodiffusion Télévision Française (ORTF), cited in Sesonske (1980, p.382). 2 Who pose the question “Is the Anglo-American model of shareholder capitalism destined to become standard or will sharp differences persist?”. 3 Cf Roe (1993) and Romano (1993). 4 These legislative reforms include the Sarbanes-Oxley Act, Pub. L. No. 107–204, 116 Stat. 745 (2002) [hereinafter Sarbanes-Oxley Act]; the Combined Code on Corporate Governance (2003) (UK) (an updated version of the Combined Code, with limited amendments, was released in June 2006 and is available at http://www.frc.org.uk/corporate/combinedcode.cfm) [hereinafter UK Combined Code]; the Companies Act 2006 (UK); the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 (Cth) [hereinafter CLERP 9 Act]. 5 For example, NYSE, Inc., Listed Company Manual Section 303A (2003) (corporate governance rules approved by the SEC on November 4, 2003); ASX Corporate Governance Council (2003). 6 Via the Sarbanes-Oxley Act 2002 and the NYSE Corporate Governance Rules and NASDAQ listing requirements. 7 The Companies Act 2006 (UK) received Royal Assent on 8 November 2006. All parts of the Act will be operational by October 2008 (UK Department of Trade and Industry (DTI), 2006).

Evolving ‘rules of the game’ in corporate governance reform 8

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For a comprehensive guide to international corporate governance codes, see the European Corporate Governance Institute website at http://www.ecgi.org/codes/all_codes.php 9 The preferred terminology under the Australian model, however, appears to be an “if not, why not” model (ASX Corporate Governance Council, 2004). 10 Previously, it had only been necessary for a company to disclose in the annual report its main corporate governance practices, if any. 11 NYSE, Inc., Listed Company Manuals 303A (2003). 12 See, for example, the Sarbanes-Oxley Act, Title VIII (“Corporate and Criminal Fraud Accountability”); Title IX (“White Collar Crime Penalty Enhancements”); Title XI (“Corporate Fraud and Accountability”). 13 Although cf Coffee (2005, pp.9, 10), where he identifies the preference of institutional investors for equity-based executive compensation as indirectly influencing the US corporate scandals. 14 See, for example, Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Bill 2003, Explanatory Memorandum, paras [1.4] and [4.71]. 15 See, for example, Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Bill 2003, Explanatory Memorandum, paras [1.4] and [4.71], paras [4.174], [4.271]-[4.280]. 16 See ss 250R(2) and 249L, Corporations Act 2001 (Cth). 17 Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Bill 2003, Explanatory Memorandum, paras [5.434]-[5.435]. 18 Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Bill 2003, Explanatory Memorandum, paras [4.353] and [5.413]. 19 Section 249D Corporations Act 2001 (Cth). 20 Corporations Amendment Bill (No 2) 2005, Explanatory Memorandum, Exposure Draft. 21 The Director’ Remuneration Report Regulations 2002, S.I. 2002/1986 (UK). The provision requiring shareholder approval of the directors’ remuneration report is now found in section 439 of the recently passed UK Companies Act 2006. 22 See generally Combined Code on Corporate Governance, Principle D.2 (“Constructive Use of the AGM”) (June 2006). 23 For example, a recent issue of the Harvard Law Review is devoted to the issue of shareholder empowerment (see Bainbridge, 2006; Bebchuk, 2006; Strine, 2006). 24 American Federation of State, County and Municipal Employees. 25 On the political role of backlash generally, see Roe (1998). 26 See also Anderson (2007). 27 Coffee acknowledges that foreign issuers have migrated from US markets, however attributes this to the development of a ‘separating equilibrium’. According to this explanation, firms that wish to reap the high valuation premium available in US markets, or who require shareholder support, will accept the higher costs of regulation associated with a US listing. In contrast, those firms with a ‘control group’ of managers or shareholders who are interested in maintaining private access to the benefits of that control will choose to list on less-regulated markets (Coffee, 2007, pp.7–10). 28 Key proposals of the Paulson Committee relating to enhancement of shareholder rights include: •

the requirement that classified boards gain the approval of shareholders prior to implementing a poison pill

•

the adoption of majority, rather than plurality, voting for board directors

•

clarification of the rights of shareholders with respect to gaining access to the company proxy to nominate directors for election

•

enhancing shareholders’ ability to access alternative means of dispute resolution (Paulson Committee, 2006, pp.xii, xiii, 93–114).

48 29

J. Hill

According to the Paulson Committee, “When firms have a choice of legal regime, any policy proposal should adopt as a default the option most favorable to shareholders, given the fundamental asymmetry of power between managers and shareholders.” (Paulson Committee, 2006, p.103) 30 Cf however, Langevoort (2007, pp.1828, 1833), claiming that although the Sarbanes-Oxley Act was, by its terms about investor protection, its long-term effects may ultimately be about public accountability. 31 The Medical Research and Compensation Foundation. 32 The PJC announced its Inquiry into Corporate Responsibility in June 2005 and released its Report in June 2006 (PJC, 2006). 33 CAMAC received a reference in March 2005 and issued its Discussion Paper in November 2005 (CAMAC, 2005). Its Final Report was released in December 2006 (CAMAC, 2006).

Int. J. Corporate Governance, Vol. 1, No. 1, 2008

49

The impact of a cross-listing on dividend policy Wissam Abdallah Lebanese American University, Lebanon E-mail: [email protected]

Marc Goergen* University of Sheffield Management School, UK European Corporate Governance Institute (ECGI), Belgium E-mail: [email protected] *Corresponding author Abstract: This paper conducts a test of La Porta et al.’s (2000) outcome hypothesis on a sample of firms from 18 countries cross-listing on 19 foreign stock markets. La Porta et al.’s outcome hypothesis states that firms that are listed on a stock exchange with better investor rights pay higher dividends given that shareholders are able to make them disgorge more of their cash. Therefore, one expects firms that cross-list on a market with better shareholder protection to increase their dividend payout after they cross-list. The results from the univariate and multivariate cluster analyses provide support for the outcome hypothesis. In particular, there is strong support for the hypothesis if the dividend payout ratio is measured by dividends over sales. Keywords: cross-listing; corporate governance; corporate control; investor protection. Reference to this paper should be made as follows: Abdallah, W. and Goergen, M. (2008) ‘The impact of a cross-listing on dividend policy’, Int. J. Corporate Governance, Vol. 1, No. 1, pp.49–72. Biographical notes: Wissam Abdallah teaches at the Lebanese American University. His research interests are in the field of corporate finance. Marc Goergen is a Professor in Finance at the University of Sheffield Management School. He is also a Research Associate of the European Corporate Governance Institute (ECGI) and a fellow of the Institute for International Corporate Governance and Accountability (IICGA) at the George Washington School of Law. His research interests are in empirical corporate finance and cover: corporate governance, initial public offerings (IPOs), mergers and acquisitions, dividend policy, insider trading, and investment models.

1

Introduction

There is now a growing literature on the reasons why firms cross-list on foreign stock exchanges. One of the reasons for firms to cross-list is to improve the legal protection

Copyright © 2008 Inderscience Enterprises Ltd.

50

W. Abdallah and M. Goergen

they offer their shareholders. According to Coffee (2002), by cross-listing on a foreign market with better listing standards, a firm commits or bonds itself to protect its minority shareholders. Indeed, under a weak legal system, one of the potential threats that minority shareholders face is the expropriation of the funds they have invested by the firm’s management and/or large shareholder. Further, La Porta et al. (1997, 1998, 1999) argue that weak investor protection is the reason why Berle and Means’s (1932) prediction that corporate ownership will separate from control as the firm grows is not valid for companies from most countries. By cross-listing on a market with higher standards, the firm’s founder may be able to diversify his investment portfolio, which he may not be able to do on the home market. According to La Porta et al. (2000), one of the ways whereby firms operating in countries with weak legal systems may expropriate their shareholders is by not paying out any dividends or by paying out very low dividends. Based on a sample of more than 4000 companies from 33 countries, they find support for their so-called outcome hypothesis, which predicts that, owing to their stronger rights, minority shareholders from countries with better legal standards are able to pressurise firms into paying out higher dividends than those from countries with weak legal systems. If La Porta et al.’s (2000) outcome hypothesis is indeed correct, then the firm’s dividend, after it has cross-listed on a market with better legal standards, should increase given the increased pressure from its (foreign) minority shareholders to disgorge cash. To our knowledge, there is as yet no study that analyses the changes in dividends around the cross-listing on a foreign stock exchange. This paper is also innovative in terms of the methodology it uses. The multivariate methodology used in this paper is a two-step cluster analysis, which generates clusters based on similarities in terms of a number of characteristics (or variables). As this methodology does not assume a particular direction of causality between variables, it is therefore particularly appropriate in this case given the possibility of multiple interacting relationships between a whole range of variables. The rest of the paper is organised as follows. The next section reviews the literature on the link between corporate governance (including shareholder protection) and dividend policy. Section 3 explains the methodology adopted by this study and discusses the data sources and other data-related issues. The following section provides a univariate analysis of dividend policy around the cross-listing. Section 5 presents the results from a two-step cluster analysis. Section 6 concludes.

2

Literature review

Although there are now substantial bodies of literature on corporate governance and dividend policy, there are as yet few theoretical models and empirical studies that link the two. Correia da Silva et al. (2004) survey the sparse literature that exists. For example, Rozeff (1982) argues that dividend policy is part of a firm’s bonding and monitoring package aimed at reducing agency problems. Easterbrook (1984) provides another agency based explanation of dividend policy. High dividends act as a self-disciplining mechanism as they reduce the internal funds and force the firm to go to the stock market regularly to raise financing. Thereby, the firm subjects itself at regular intervals to the scrutiny of outsiders such as its investment bank, brokers and financial analysts. Similarly, Jensen (1986) argues that high dividends reduce the amount of free

The impact of a cross-listing on dividend policy

51

cash flow available to the firm and thereby prevent corporate funds from being invested in projects that destroy shareholder value. To our knowledge, apart from La Porta et al. (2000), there is only one other extensive cross-country study on dividends and corporate governance, Faccio et al. (2001). Faccio et al. argue that a priori the dividend policy of Continental European and East Asian firms should be similar as firms from both regions tend to have a controlling shareholder, which is often a family. Hence, firms from both regions are also likely to suffer from the same agency problem, which is the expropriation of minority shareholders by the large, controlling shareholder. However, contrary to expectations, Faccio et al. find that Western European firms pay higher dividends than East Asian firms. While these two studies focus on country characteristics to explain dividend policy, there are also some studies that focus on a single country and attempt to explain differences in dividend policy by differences in firm characteristics. These studies argue that dividends are a substitute for large shareholder monitoring. Hence, dividend payout ratios are expected to be higher and more stable in firms where (large) shareholder monitoring is sub-optimal, whereas they are expected to be lower and more flexible in firms that benefit from adequate monitoring of their management. For example, Gugler (2003) studies the dividend policy of a sample of mainly unquoted Austrian firms. He finds that government-owned firms pay out the highest dividends and have the most stable dividends whereas family-controlled firms have the lowest and most volatile payout ratios. The dividend policy of bank and foreign-controlled firms is somewhere in between. Gugler interprets this as evidence that dividends play a more important role in firms with higher agency costs. In detail, as government-controlled firms are ultimately held by the nation and are therefore widely held, the role of dividends in these firms is particularly important. Conversely, family-controlled firms benefit from the monitoring of their large shareholder and the role of dividends in terms of keeping a check on the management should, therefore, be much less important. Similarly, Goergen et al. (2005), who studied the dividend policy of listed German firms, find that firms that are controlled by banks are more likely to cut or omit their dividend when they suffer a temporary drop only in performance. They argue that this is evidence that banks mitigate problems of asymmetry of information and agency and reduce the need for high dividends.1 All of the above studies suggest that there is a link between dividend policy and corporate governance at both the country and firm levels. The question that then arises is whether a firm’s dividend policy changes after it cross-lists on a stock market with better investor protection. There are at least two reasons why this may be the case. First, if La Porta et al.’s (2000) outcome hypothesis is correct, then by cross-listing on a market with better investor protection, the firm will be forced to increase its dividend to bring it in line with the typical dividend payout on its host market. Second, the cross-listing may enable the founders to diversify their investment portfolios, which may not have been possible on their home market. Hence, the firm may end up with (more) dispersed ownership, which in turn calls for a more important role of dividends to serve as a monitoring and disciplining device of the firm’s management.

52

3

W. Abdallah and M. Goergen

Methodology and data

3.1 Methodology This study uses two types of methodologies: a univariate analysis and a multivariate methodology. The aim of the univariate analysis is to investigate whether the dividend behaviour of firms changes as a result of the cross-listing. In detail, firms cross-listing on markets providing higher levels of investor protection are expected to increase their dividend when compared with those cross-listing on markets that do not improve existing levels of shareholder protection. Although the univariate analysis constitutes a fairly straightforward test, it also assumes that changes in dividend behaviour are uniquely driven by improvements in investor protection. Hence, it ignores other factors such as firm size, growth and investment opportunities, which may also influence dividend behaviour. Therefore, a multivariate analysis is carried out to take into account these other factors that may influence dividend behaviour. A potential methodology is to run a Lintner (1956) model covering the period before and after the cross-listing and to test whether there is a structural break around the cross-listing for those firms that cross-list on a foreign market offering better protection to their shareholders. However, most firms have only a limited number of observations and this would violate the assumption of normality underlying Ordinary Least Squares (OLS). As a result, the multivariate analysis carried out in this study is a two-step cluster analysis.2 The two-step cluster analysis is based on the methodology developed by Chiu et al. (2001).3 Its aim is to identify relatively homogeneous groups of firms based on a range of specific characteristics. The underlying algorithm starts with each firm in a separate cluster and then combines clusters until only one is left. The log-likelihood distance and Schwarz’s Bayesian Information Criterion (BIC) have been chosen as a measure of similarity and for the determination of the number of clusters, respectively. If the outcome hypothesis is correct, then there should be two clusters of firms consisting of the firms cross-listing on a stock exchange with better investor protection and those cross-listing on a market, which does not provide better protection. The first cluster is then expected to increase its dividend payout after the cross-listing, whereas the second one is not expected to change its dividend behaviour.

3.2 Data Our initial sample consists of 168 companies that initially cross-listed on 19 different stock exchanges during the period 1990–2000. The dates of the listing and cross-listing for these companies are mainly obtained from the stock exchanges. However, for a few companies, these dates are obtained from the Extel cards, annual reports, prospectuses and in some cases directly from the companies. We exclude 11 companies without dividend data before the cross-listing. The table in Appendix A reports the countries and stock exchanges that are covered in this paper. Following La Porta et al. (2000), we use three alternative measures for the dividend payout ratio, which are: the dividends over sales ratio, the dividends over cash flow ratio, and the dividends over earnings ratio. The numerator of each of these ratios is the total amount of cash dividends paid to the common and preferred shareholders of the company. Cash flow is the total cash flow from the operating, financing and investing activities. Earnings are the net income before

The impact of a cross-listing on dividend policy

53

extraordinary items and preferred dividends. Accounting variables and market data are sourced from Datastream. We use two proxies for minority shareholder protection: La Porta et al.’s (1998) anti-director rights index and the accounting standard index. The La Porta et al. index measures how strongly the legal system protects minority shareholders against the possible expropriation by managers or large shareholders.4 The accounting standards index was compiled by the Centre for International Financial Analysis and Research who rated companies’ 1993 annual reports on their inclusion or omission of 85 items.5 The additional variables used in the cluster analysis are all sourced from Datastream. These variables are the seasonally adjusted US CPI index, the US dollar exchange rates, total assets, total liabilities, total market capitalisation (including preferred stock) and the number of employees. The US CPI index is available on a monthly basis and is measured on the 15th of each month. Dollar exchange rates are also measured on the 15th of each month.

4

Univariate analysis

Table 1 compares the dividend paying behaviour during the three years preceding the cross-listing to that during the three years after the cross-listing. The table distinguishes between two types of dividend behaviour: zero dividends and strictly positive dividends. Panel A of the table shows that the vast majority of firms, i.e. 86%, do not change their dividend behaviour after the cross-listing. In particular, 46 out of the 53 firms that paid a dividend in at least one of the three years preceding the cross-listing pay a dividend in at least one of the three years after the cross-listing. Similarly, 26 out of the 31 firms that did not pay a dividend before the cross-listing carry on not paying a dividend. Panels B and C focus on the firms that cross-list on a market providing better anti-director rights and those that do not, respectively. There is no evidence that either group of firms changes its dividend behaviour after the cross-listing as the vast majority of firms are situated on the diagonal from top left to bottom right in the panel. Similarly, when the quality of the host market is measured by its accounting standards, both firms cross-listing on a better market than their home market (Panel D) and those that do not cross-list on a better market (Panel E) do not change their dividend policy after the cross-listing. Further, only four out of the 84 firms initiated their dividend following the cross-listing (not reported in the table).6 Finally, we also use La Porta et al.’s (1997, 1998, 2000) classification of legal systems into civil law and common law countries. In detail, La Porta et al. argue that, given the higher discretionary role of judges under the common law system, this system provides better investor protection. Conversely, whereas in the common law system, judges make law by setting precedents in court, the role of judges under the civil law system is limited to interpreting extensive law texts. As a result, judges have less discretionary power and investor protection is weak. Based on this classification, a firm is assumed to cross-list on a better market if its home market is in a civil law country and it cross-lists on a common law market. All other firms are assumed not to improve their investor protection.7 Again, the results (which are not reported in the table) suggest that firms stick with the dividend policy they had before the cross-listing. Hence, there is no evidence that those firms that did not pay a dividend before the cross-listing and cross-list on a better market are forced to pay a dividend.

54 Table 1

W. Abdallah and M. Goergen Dividend paying firms around the cross-listing (La Porta et al.’s anti-director rights index)

Panel A: All firms Number of firms paying a Number of firms not paying a dividend in at least one out of the dividend over three years three years preceding cross-listing preceding cross-listing 46 5 Number of firms paying a dividend in at least one out of the three years after cross-listing Number of firms not paying a 7 26 dividend over three years after cross-listing Panel B: Firms cross-listing on a market with better anti-director rights Number of firms paying a Number of firms not paying dividend in at least one out of the a dividend over three years three years preceding cross-listing preceding cross-listing Number of firms paying a dividend in 15 3 at least one out of the three years after cross-listing Number of firms not paying a 2 8 dividend over three years after cross-listing Panel C: Firms that do not cross-list on a market with better anti-director rights Number of firms paying a Number of firms not paying dividend in at least one out of the a dividend over three years three years preceding cross-listing preceding cross-listing Number of firms paying a dividend in 31 2 at least one out of the three years after cross-listing Number of firms not paying 5 18 a dividend over three years after cross-listing Panel D: Firms cross-listing on a market with better accounting standards Number of firms paying a Number of firms not paying dividend in at least one out of the a dividend over three years three years preceding cross-listing preceding cross-listing Number of firms paying a dividend in 25 3 at least one out of the three years after cross-listing Number of firms not paying 2 18 a dividend over 3 years after cross-listing Panel E: Firms that do not cross-list on a market with better accounting standards Number of firms paying a Number of firms not paying dividend in at least one out of the a dividend over three years three years preceding cross-listing preceding cross-listing Number of firms paying a dividend in 21 2 at least one out of the three years after cross-listing Number of firms not paying a 5 8 dividend over three years after cross-listing

The impact of a cross-listing on dividend policy

55

The tests conducted in Table 1 are clearly very simple and even simplistic. For example, they ignore the possibility that firms that already pay a dividend may be increasing their dividend payout as a result of the cross-listing. The following three tables attempt to address this issue. Table 2 reports the dividend payout as measured by the ratio of dividends over sales for the year of the cross-listing as well as for each of the three years preceding and each of the three years following the cross-listing. Panel A of the table suggests that there is a slight increase in the dividend payout ratio around the time of the cross-listing as the average payout ratio increases from 1.2% to about 2% after the cross-listing.8 Further (these numbers are not reported in the table), the average dividend payout for the three years preceding the year of the cross-listing is 1.6%, whereas the average for years 0–3 is 4.5%. However, the increase is less pronounced when one considers the median payout ratio. The firm with the 847% payout ratio in year two is Haslemere NV, the Dutch property company, which paid out a regular dividend of £2.79 per share plus special dividends amounting to a total of £34.50, which were mainly paid from the share premium reserve.9 The reason for this massive dividend payout in 2002 seems to have been the expectation of a slump in the property market. When Haslemere is dropped in year two, the average for the ratio is 1.7%.10 Table 2

Dividend payout (dividends/sales)

Year relative to cross-listing Mean (%) Median (%) Minimum (%) Maximum (%) Panel A: All the firms (81 observations) –3 1.2 0.2 0.0 17.6 –2 1.5 0.3 0.0 16.9 –1 2.0 0.4 0.0 40.0 0 2.3 0.5 0.0 43.7 1 2.0 0.4 0.0 43.2 2 12.1 0.5 0.0 846.9 3 1.6 0.3 0.0 12.4 Panel B: Firms cross-listing on a market with better anti-director rights (28 observations) –3 0.8 0.2 0.0 6.5 –2 1.5 0.3 0.0 16.9 –1 2.3 0.4 0.0 40.0 0 2.9 0.5 0.0 43.7 1 2.8 0.5 0.0 43.2 2 31.6 0.6 0.0 846.9 3 1.3 0.4 0.0 7.7 Panel C: Firms that do not cross-list on a market with better anti-director rights (53 observations) –3 1.4 0.2 0.0 17.6 –2 1.5 0.4 0.0 13.8 –1 1.9 0.4 0.0 14.5 0 2.0 0.4 0.0 18.8 1 1.6 0.4 0.0 16.4 2 1.8 0.3 0.0 14.8 3 1.7 0.3 0.0 12.4

56 Table 2

W. Abdallah and M. Goergen Dividend payout (dividends/sales) (continued)

Year relative to cross-listing

Mean (%)

Median (%)

Minimum (%)

Maximum (%)

Panel D: Firms cross-listing on a market with better accounting standards (46 observations) –3

0.7

0.0

0.0

4.1

–2

1.1

0.0

0.0

16.9

–1

1.9

0.1

0.0

40.0

0

2.6

0.4

0.0

43.7

1

1.9

0.2

0.0

43.2

2

19.4

0.3

0.0

846.9

3

1.2

0.0

0.0

8.2

Panel E: Firms that do not cross-list on a market with better accounting standards (35 observations) –3

1.9

0.7

0.0

17.6

–2

2.1

0.8

0.0

13.8

–1

2.1

0.6

0.0

14.5

0

1.9

0.5

0.0

14.3

1

2.1

0.5

0.0

16.4

2

2.4

0.6

0.0

14.8

3

2.2

0.6

0.0

12.4

The dividend payout ratio is the sum of the dividend on common stock and the dividend on preferred stock (if outstanding) as a percentage of sales. The year of the cross-listing is year 0.

Panels B and C of the same table report the dividend payout for firms cross-listing on a stock exchange with better anti-director rights and those that do not cross-list on a better market, respectively. The two panels suggest that the increase in the dividend payout ratio is mainly due to the sub-sample of firms cross-listing on a better market. Indeed, except for year −3, the average dividend payout ratio in Panel B is always higher than the average for the whole sample, whereas the average payout ratio in Panel C is always lower.11 Panels B and C also show that, except for years −3 and 3, the firm with the maximum dividend payout is always part of the sub-sample of firms cross-listing on a better market. Conversely, there is no evidence of large one-off dividend payments in the other sub-sample as the maximum for the payout ratio stays remarkably constant across the entire period. The next two panels of Table 2 show the average dividend payout ratio for the firms cross-listing on a stock exchange with better accounting standards (Panel D) and those that do not cross-list on an exchange with better standards (Panel E). The table shows that although the firms that cross-list on a better market initially have lower dividend payouts (0.7% in year −3 and 1.1% in year −2, respectively), they catch up during the year of the cross-listing.12 Similar to the conclusion about Panels B and C, there is a much greater variation in terms of payout ratios among the sub-sample of firms cross-listing on a better market and the firm with the highest payout ratio for the entire sample is always in this sub-sample. Again, this suggests that there are major one-off dividend payments in this sub-sample, but not in the other sub-sample. A similar

The impact of a cross-listing on dividend policy

57

conclusion is drawn when firms are classified in terms of the firms whose home market is based in a civil law country and that decide to cross-list on a common law market and all the other ones (the results are not reported in the table). Similar to the data in Panels D and E, the firms that cross-list on a better market start off with a lower average payout ratio in year −3 (0.6% compared with 1.4%), but end up with a much higher payout ratio after the cross-listing. These firms also have consistently higher median payout ratios and the difference in median payout ratios between the two sub-samples is significantly different from zero at the 11% level of significance in years one and two. There is also further evidence of one-off large dividend payouts in the sample of civil law firms cross-listing on common law markets. Table 3 is similar to Table 2, but it is based on the ratio of dividends over cash flow. Unfortunately, owing to limited data availability, the sample size is reduced to only 44 firms. Panel A of the table shows the ratio of dividends over cash flow for the whole sample. This ratio is much more volatile over the entire period than the dividends over sales ratio. Still, the figures suggest that the ratio increases during the two years leading to the year of the cross-listing. The figures in Panels B and C are somewhat more difficult to interpret than those in the previous table. There is no clear trend as in the previous table, which would suggest that firms cross-listing on a market with better anti-director rights increase their dividend payout after the cross-listing. However, when the quality of the host market is measured by its accounting standards, a clear trend emerges with firms that do not cross-list on a better market (Panel E) having on average a higher dividend payout ratio than those that do (Panel D). This result contradicts the outcome hypothesis. One possible interpretation of this result is that firms that do not cross-list on a market with better accounting standards are able to understate their cash flows (by e.g., deviating or understating cash inflows or inflating cash outflows), which would explain the higher dividend ratio. Another possible reason for this result is the small sample and sub-sample sizes that may make the sub-sample averages highly sensitive to outliers. When firms are classified into civil law firms that cross-list on a common law market and all other firms, the figures (which are not reported in Table 3) are much more in line with the outcome hypothesis. As expected, the firms that cross-list on a better, common law market have lower dividend payout ratios before the cross-listing, but higher dividend payout ratios after the cross-listing.13 Table 3

Dividend payout (dividends/cash flow)

Year relative to cross-listing

Mean (%)

Median (%)

Minimum (%)

Maximum (%)

Panel A: All the firms (44 observations) –3

4.0

0.0

0.0

39.0

–2

7.3

0.0

0.0

76.4

–1

12.4

0.0

0.0

267.8

0

7.6

0.0

0.0

87.7

1

4.5

0.0

0.0

57.0

2

4.5

0.0

0.0

23.8

3

7.9

0.0

0.0

93.9

58 Table 3

W. Abdallah and M. Goergen Dividend payout (dividends/cash flow) (continued)

Year relative to cross-listing

Mean (%)

Median (%)

Minimum (%)

Maximum (%)

Panel B: Firms cross-listing on a market with better anti-director rights (13 observations) –3 5.1 0.0 0.0 –2 2.7 0.0 0.0 –1 4.5 0.0 0.0 0 7.4 0.0 0.0 1 6.8 0.0 0.0 2 3.9 0.0 0.0 3 11.4 0.0 0.0 Panel C: Firms that do not cross-list on a market with better anti-director rights (31 observations) –3 –2 –1 0 1 2 3

3.5 9.3 15.7 7.6 3.5 4.7 6.4

0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0

29.4 20.8 29.7 87.7 57.0 23.8 93.9

39.0 76.4 267.8 68.9 19.3 21.3 56.2

Panel D: Firms cross-listing on a market with better accounting standards (26 observations) –3 3.4 0.0 0.0 –2 6.6 0.0 0.0 –1 3.2 0.0 0.0 0 6.3 0.0 0.0 1 3.2 0.0 0.0 2 3.3 0.0 0.0 3 4.7 0.0 0.0 Panel E: Firms that do not cross-list on a market with better accounting standards (18 observations) –3 –2 –1 0 1 2 3

4.9 8.5 25.7 9.3 6.2 6.1 12.4

0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0

39.0 76.4 29.7 87.7 21.3 15.3 33.9

29.4 52.1 267.8 68.9 57.0 23.8 93.9

The dividend payout ratio is the sum of the dividend on common stock and the dividend on preferred stock (if outstanding) as a percentage of cash flow. The year of the cross-listing is year 0.

Table 4 shows the evolution of the dividend payout ratio defined as the ratio of dividends over earnings with earnings being defined as net earnings before extraordinary items and preferred dividends. Panel A of the table shows that there is an increasing trend in the dividend payout ratio. The trend is even more visible when firms with dividend payout ratios of more than 100% are excluded from the panel: the payout ratio starts with a value

The impact of a cross-listing on dividend policy

59

of 8.4% in year −3 and increases to 14% in year 3. When firms are classified in terms of whether they cross-list on a market with better anti-director rights (Panel B) or not (Panel C), the figures suggest that both groups of firms initially have similar payout ratios,14 but that, in line with the outcome hypothesis, the former group (Panel B) ends up having a higher average payout after the cross-listing. The trend in the median payout is even more obvious with firms cross-listing on a better market ending up with a positive median payout, whereas those that do not cross-list on a better market retain a zero median payout. Table 4

Dividend payout (dividends/earnings)

Year relative to cross-listing

Mean (%)

Median (%)

Minimum (%)

0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0

Maximum (%)

Panel A: All the firms (55 observations) –3 –2 –1 0 1 2 3

10.6 12.2 37.7 19.1 15.7 54.3 38.3

60.7 79.0 1274.8 140.7 79.9 1784.1 1024.8

Panel B: Firms cross-listing on a market with better anti-director rights (19 observations) –3 –2 –1 0 1 2 3

10.4 12.1 18.3 24.1 19.2 115.1 69.1

0.0 0.0 0.0 9.3 11.6 16.0 7.4

0.0 0.0 0.0 0.0 0.0 0.0 0.0

46.3 46.6 156.3 140.7 71.4 1784.1 1024.8

Panel C: Firms that do not cross-list on a market with better anti-director rights (36 observations) –3 –2 –1 0 1 2 3

10.7 12.2 47.9 16.4 13.9 22.2 22.1

0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0

60.7 79.0 1274.8 88.6 79.9 136.2 92.9

Panel D: Firms cross-listing on a market with better accounting standards (34 observations) –3 –2 –1 0 1 2 3

8.2 9.2 13.5 20.1 14.3 70.2 47.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0

46.3 46.6 156.3 140.7 71.4 1784.1 1024.8

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W. Abdallah and M. Goergen

Table 4

Dividend payout (dividends/earnings) (continued)

Year relative to cross-listing

Mean (%)

Median (%)

Minimum (%)

Maximum (%)

Panel E: Firms that do not cross-list on a market with better accounting standards (21 observations) –3

14.4

0.0

0.0

60.7

–2

17.0

11.1

0.0

79.0

–1

76.8

11.1

0.0

1274.8

0

17.3

7.0

0.0

88.6

1

17.9

8.8

0.0

79.9

2

28.5

14.3

0.0

112.7

3

24.2

10.2

0.0

92.9

The dividend payout ratio is the sum of the dividend on common stock and the dividend on preferred stock (if outstanding) as a percentage of not income before extraordinary items and preferred dividends. The year of the cross-listing is year 0.

Similar to Table 3, when the host market’s quality is measured by its accounting standards, the trend in the dividend payout ratio is less clear-cut. However, it is fair to say that there is some evidence that the dividend payout ratio increases after the cross-listing for the firms listing on a better market when compared with the firms that do not cross-list on a better market. When the firms with a dividend ratio of 100% or less are dropped,15 the trend is less obvious as the mean in Panel D starts with 5.3% in year −3 and ends up being 7.5% in year 3, whereas the median is zero throughout all the periods. The Panel E mean, after dropping these firms, is 13% in year − 3 and 17.9% in year 3; the median is 0 in year −3 and 8.3% in year 3.16 Finally, when firms are classified into two groups – the group of civil law firms cross-listing on common law markets and the group of all other firms – there is further evidence (not reported in the table) that firms cross-listing on a better market increase their dividend payout (more substantially) after the cross-listing. To summarise, the univariate analysis provides some evidence in support of the outcome hypothesis. Firms cross-listing on a better quality market increase their dividend payout ratio after the cross-listing, whereas those firms that do not cross-list on a better market do not change their dividend payout.

5

Cluster analysis

This section focuses on the two-step cluster analysis based on the methodology developed by Chiu et al. (2001). As stated in Section 3.1, the aim of the cluster analysis is to identify relatively homogeneous groups of firms based on a range of specific characteristics. If the outcome hypothesis is valid, then there should be two clusters of firms consisting of the firms cross-listing on a stock exchange with better investor protection and those cross-listing on a market, which does not provide better protection. The former cluster is expected to increase its dividend payout around the cross-listing, whereas the latter one is not expected to change its dividend behaviour. The cluster analysis uses several additional variables when compared with the univariate analysis from the previous section. All of these variables are sourced from

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Datastream. These variables are the ratio of market value of assets over total assets, and three variables measuring firm size (number of employees, real total assets, and real market capitalisation). The two latter size variables are calculated as follows. Real total assets is the firm’s total assets in its home currency converted into thousands of US$ and adjusted for US inflation by the US CPI index (the base year being the year 2000).17 The real market capitalisation (which includes preferred stock) is derived in a similar way and is also expressed in thousands of year 2000 US$. A total of 18 different cluster analyses were run, based on two alternative measures for the quality of the host market (La Porta et al.’s anti-director rights index and the accounting standards index), three alternative measures of firm size (number of employees, real total assets, and real market capitalisation) and three alternative dividend payout ratios (dividends over sales, dividends over cash flow, and dividends over earnings). The measure of the quality of the host market is a relative, dichotomous measure, which is set to 1 if the host market’s quality is superior to that of the firm’s home market, and is set to 0 otherwise. The three alternative size measures are defined as above. The dividend payout ratios are the same as those used in the univariate analysis with the difference that we use the average of the dividend payout ratio over the three years preceding the year of the cross-listing and the change over the three years after the cross-listing. Each cluster analysis also uses the ratio of market to book value of total assets. Indeed, Denis et al. (1994) argue that dividend increases are more likely in firms with high market to book values. Owing to space constraints (the total output exceeds more than 200 pages), Appendix B only contains the detailed results from the cluster analysis using the number of employees as a measure of firm size, La Porta et al.’s anti-director rights index as a measure of the relative quality of the host market and dividends over sales as the payout ratio.18 This particular two-step cluster analysis – as well as all of the other analyses – has generated two distinct clusters. Table B1 provides information on the number of firms in each cluster. The large number of excluded cases can be explained by the fact that the data file contains one row for each of the seven years (year −3 to year 3) around the cross-listing and that the data used in the cluster analysis refers to the year of the cross-listing and variables presented in aggregate form (e.g., the average dividend payout ratio over the three years preceding the cross-listing). Table B2 provides information for each cluster on the mean value and standard deviation of each continuous variable. Tables B.3 and B.4 provide information on the categorical variables that are the home market of the firm and the fact whether the firm cross-lists on a stock exchange with better investor protection (the variable equals 1) or not (the variable is equal to 0). Table B3 shows that cluster 1 contains mostly firms from Anglo-American countries, i.e., firms based in common law countries whereas cluster 2 contains mostly firms from civil law countries. Table B4 shows that cluster 2 contains all the firms that cross-list on a better market and cluster 1 contains all those firms that do not cross-list on a better market. Therefore, the two clusters that have been obtained make perfect sense in the light of the outcome hypothesis. Figures B.1–B.4 compare the mean value of each continuous variable for each cluster to the overall sample mean (the horizontal line). Figure B1 shows that firms from cluster 1 are smaller (as measured by the number of employees) than the sample mean, whereas those from cluster 2 are large, but the differences are not significantly different from zero (see also Figure B5). Importantly, Figure B2 (see also Figure B6) shows that the firms from both clusters do not differ significantly in terms of their investment opportunities (as measured by the market to

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book value of assets). Similarly, Figure B3 (see also Figure B7) illustrates that the two clusters are not different in terms of the average dividend payout over the three years before the cross-listing. Conversely, Figure B4 (see also Figure B8) shows that the evolution of the dividend ratio is different across the two clusters: firms that do not cross-list on a better market have an increase in their dividend payout ratio, which is significantly lower than the sample average. Table 5 summarises the results from the cluster analysis. The table consists of two panels. Panel A measures the relative quality of the host market using La Porta et al.’s anti-director rights index and Panel B uses the accounting standards index. Overall, if the dividends over sales ratio is used as the dividend payout ratio, the results obtained from the cluster analysis strongly support the outcome hypothesis. Some additional, albeit not consistent, support is provided when dividends over earnings is used. The results from the cluster analyses using the dividends over cash flow ratio do not provide any support to the outcome analysis. However, this may be due to the fact already mentioned in Section 4 that cash flow figures are not very meaningful under low accounting standards. Also, as mentioned in that same section, the sample size is significantly reduced when using this measure for the dividend payout ratio as a majority of firms do not report cash flow figures or do not provide enough accounting information to calculate these. In detail, Panel A shows that whatever the measure of firm size, if the payout ratio is measured as dividends over sales, for firms that do not cross-list on a market with better anti-director rights, the change in the dividend ratio over the three years following the year of the cross-listing is significantly lower than the sample mean. This result is in accordance with the outcome hypothesis, which states that firms cross-listing on a better market should increase their dividend payout ratio as a result of increased pressure from shareholders (backed up by stronger shareholder rights). Panel B confirms these results. When the accounting standards index is used to measure the relative quality of the host market and the dividends over sales ratio is used as a measure of the dividend payout ratio, firms that do not cross-list on a better market experience a change in their dividend payout, which is significantly lower than the sample average. Table 5

Two-step cluster analysis

Size measure/dividend Dividends over Dividends over ratio sales cash flow Panel A: La Porta et al.’s anti-director rights index Number of employees Change in dividends significantly lower than sample average for firms not cross-listing on a better market Real total assets Change in dividends significantly lower than sample average for firms not cross-listing on a better market Real market Change in dividends capitalisation significantly lower than sample average for firms not cross-listing on a better market

Dividends over earnings

Change in dividends significantly lower than sample average for firms not cross-listing on a better market

The impact of a cross-listing on dividend policy Table 5

63

Two-step cluster analysis (continued)

Size measure/ dividend ratio

Dividends over sales

Dividends over Dividends over cash flow earnings

Panel B: Accounting standards index Number of employees

Change in dividends significantly lower than sample average for firms not cross-listing on a better market

Real total assets

Change in dividends significantly lower than sample average for firms not cross-listing on a better market

Initial dividends significantly lower than sample average for firms cross-listing on a better market

Real market capitalisation

Change in dividends significantly lower than sample average for firms not cross-listing on a better market

Initial dividends significantly lower than sample average for firms cross-listing on a better market

The two-step cluster analysis is based on the methodology developed by Chiu et al. (2001). Its aim is to identify relatively homogeneous groups of firms based on a range of specific characteristics. The underlying algorithm starts with each firm in a separate cluster and then combines clusters until only one is left. The log-likelihood distance and Schwarz’s BIC are used as the measure of similarity and for the determination of the number of clusters, respectively. Panel A uses La Porta et al.’s anti-director rights index to measure whether the host market’s quality is superior to that of the home market. Panel B uses the accounting standards index. Each cluster analysis uses a different variable to measure firm size: the number of employees, the real total assets, and the real market capitalisation. Real total assets are obtained by converting the firm’s total assets into ‘000 of US$ and adjusting this amount by the US CPI index (the base year is 2000). Similarly, the real market capitalisation is ‘000 of year 2000 US$.

Panel A provides further support for the outcome hypothesis. When dividends over earnings are used to calculate the payout ratio and the real market capitalisation is used to measure firm size, again firms that do not cross-list on a better market experience a change in their dividend over the three years following the cross-listing, which is significantly below the whole sample average. Panel B shows that when real total assets or the real market capitalisation is used as a measure of firm size, the results from using dividends over earnings as the payout ratio suggest that firms cross-listing on a better market have significantly lower initial dividends than the sample average. However, the change in dividends over the three years following the cross-listing is not significantly different from the sample average for either group of firms. This contradicts the outcome hypothesis. Still, this perverse result may be due to the fact that the firms that cross-list on a market with better accounting standards may be reporting relatively higher earnings after the cross-listing (Ceteris paribus) than those that do not cross-list on a better market. Indeed, the latter group of firms may still be able to carry on underreporting their earnings after the cross-listing. The combination of higher dividends and higher reported earnings may then explain the insignificance in the change in the dividend payout ratio over the three years after the cross-listing for either group of firms. Further support is provided for the outcome hypothesis by the fact that there is no statistically significant difference between the market to book value ratio for the sub-sample of firms cross-listing on a better market and that for the sub-sample of firms that do not cross-list on a better market. Hence, our results are not driven by the higher

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investment opportunities of firms that choose to cross-list on a better stock market. Finally, as a robustness test, we also reran the cluster analyses using the average growth rate in total assets over the three years preceding the cross-listing as an alternative measure of investment opportunities. However, overall, the results from the cluster analyses did not show any significant differences in growth between the two clusters.

6

Conclusion

This paper has conducted a test of La Porta et al.’s (2000) outcome hypothesis on a sample of firms from 18 countries cross-listing on 19 foreign stock markets. La Porta et al.’s outcome hypothesis states that firms that are listed on a stock exchange with better investor rights pay higher dividends given that shareholders are able to make them disgorge more of their cash. The sample used in this paper is particularly relevant for testing the outcome hypothesis. Indeed, as some firms cross-list on markets with a better quality and others do not, if the hypothesis is correct, one expects an increase in dividends after the cross-listing for the former group, but not for the latter. The results from the univariate analysis and the multivariate cluster analysis provide some support for the outcome hypothesis. In detail, there is strong support for the hypothesis if the dividend payout ratio is measured by dividends over sale. There is also some support if dividends over earnings is used as the payout ratio, but no support if dividends over cash flow is used. This paper does not pretend to speak the last word on the evolution of dividends around the cross-listing event. Indeed, given the nature of the study, in particular the need of data from various sources, the sample sizes used are relatively small. However, given the methodology used in this paper (two-step cluster analysis), we feel fairly confident about the results obtained. To summarise, while being a pilot study, this paper suggests that firms change their dividend behaviour if they cross-list on a better market. Finally, contrary to La Porta et al. (2000), the paper does not make any judgement as to whether higher dividends are good or bad for the long-term value and survival of the firm. However, this study does not find that those firms that did not pay a dividend before the cross-listing and cross-list on a better market are forced to pay a dividend. Hence, there is no compelling evidence, which suggests that firms that have investment opportunities with positive net present values may have to forego these in order to disgorge cash to their shareholders. Still, this is an issue that needs to be addressed further by future research.

References Berle, A. and Means, G. (1932) The Modern Corporation and Private Property, Macmillan, New York. Chiu, T., Fang, D., Chen, J., Wang, Y. and Jeris, C. (2001) ‘A robust and scalable clustering algorithm for mixed type attributes in large database environment’, Proceedings of the 7th ACM SIGKDD International Conference on Knowledge Discovery and Data Mining, pp.263–268. Coffee, J. (2002) ‘Racing towards the top? The impact of cross-listings and stock market competition on international corporate governance’, Columbia Law Review, Vol. 102, pp.1757–1831.

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Correia da Silva, L., Goergen, M. and Renneboog, L. (2004) Dividend Policy and Corporate Governance, Oxford University Press, Oxford. Denis, D.J., Denis, D.K. and Sarin, A. (1994) ‘The information content of dividend changes: cash flow signaling, overinvestment, and dividend clienteles’, Journal of Financial and Quantitative Analysis, Vol. 29, pp.567–587. Easterbrook, F. (1984) ‘Two agency-cost explanations of dividends’, American Economic Review, Vol. 74, pp.650–659. Faccio, M., Lang, L. and Young, L. (2001) ‘Dividends and expropriation’, American Economic Review, Vol. 91, pp.54–78. Goergen, M. and Renneboog, L. (2007) ‘Dividend policy in a global perspective’, forthcoming in Baker, K. (Ed.): The Blackwell Companion on Dividends and Dividend Policy, Basil Blackwell, Oxford. Goergen, M., Renneboog, L. and Correia da Silva, L. (2005) ‘When do German firms change their dividends?’, Journal of Corporate Finance, Vol. 11, pp.375–399. Gugler, K. (2003) ‘Corporate governance, dividend payout policy, and the interrelation between dividends, and capital investment’, Journal of Banking and Finance, Vol. 27, pp.1297–1321. Jensen, M.C. (1986) ‘Agency costs of free cash flow, corporate finance and takeovers’, American Economic Review, Vol. 76, pp.323–329. La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny, R. (1997) ‘Legal determinants of external finance’, Journal of Finance, Vol. 52, pp.1131–1150. La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny, R. (1998) ‘Law and finance’, Journal of Political Economy, Vol. 106, pp.1113–1155. La Porta, R., Lopez-de-Silanes, F. and Shleifer, A. (1999) ‘Ownership around the world’, Journal of Finance, Vol. 54, pp.471–517. La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny, R. (2000) ‘Agency problems and dividend policies around the world’, Journal of Finance, Vol. 55, pp.1–33. Lintner, J. (1956) ‘Distribution of incomes of corporations among dividends, retained earnings and taxes’, American Economic Review, Vol. 46, pp.97–113. Rozeff, M.S. (1982) ‘Growth, beta and agency costs AS determinants of dividend payout ratios’, Journal of Financial Research, Vol. 3, pp.249–259.

Notes 1

See Goergen and Renneboog (2007) for a more comprehensive overview of the literature on the link between dividends and corporate governance. 2 This methodology also has the advantage that it does not assume a particular direction of causality between variables. It is, therefore, particularly appropriate when there may be multiple interacting relationships between a series of variables. In addition, the two-step cluster analysis is able to deal simultaneously with categorical and continuous variables. This study uses both types of variables. An example of a categorical variable is the nationality of the firm and an example of a continuous variable is the firm’s dividend payout ratio. Conversely, the hierarchical cluster analysis has been designed to deal with variables, which are all of the same type (e.g., all continuous variables). Another advantage of the two-step cluster analysis is that it is able to determine automatically the optimal number of clusters. 3 SPSS is the econometric software used for this study. 4 The index is the sum of six mechanisms; each mechanism is assigned the value of 1 if it exists and 0 otherwise. The mechanisms are: •

the company law allows shareholders to mail their proxy vote to the firm

•

shareholders are not required to deposit their shares prior to the general shareholders’ meeting

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•

cumulative voting for directors or proportional representation of minorities on the board of directors is allowed

•

an oppressed minorities mechanism is in place

•

the percentage of ownership of share capital that entitles a shareholder to call an extraordinary meeting is less than or equal to 10%

•

shareholders have a pre-emptive right to buy new issues of shares and that right can be waived by a shareholders’ vote. The anti-director rights index, therefore, ranges from 0 to 6. 5 The items fall into seven categories, which are: general information, income statements, balance sheets, funds flow statement, accounting policies, share data, and supplementary items. For companies that cross-listed before 1993, we used the 1991 index. The accounting standards ranking is obtained from International Accounting and Auditing Trends published by the Centre for International Financial Analysis and Research. 6 One of the four firms initiated dividend payments in the year of the cross-listing, but then omitted them during subsequent years. 7 These are the firms that cross-list on the same legal type of foreign market as their home market, i.e., firms from civil law countries that cross-list on another civil law market and firms from common law countries that cross-list on another common law market. 8 If the firm with the dividend payout ratio of 847% is excluded from year 2, the year 2 average becomes 1.66%. (There are no other firms for that year with ratios exceeding 100%). 9 See Haslemere NV 2002 financial review and accounts. 10 While it tends to be normal practice to exclude outliers from tables, we decided against this practice given the nature of the hypothesis whose validity we intend to test. Indeed, if the outcome hypothesis is correct, then firms cross-listing on a better market than their home market and lacking major investment opportunities will be forced to pay out any large cash reserves they may have accumulated. These one-off payouts will result in major, temporary increases in payout ratios. 11 The average for year 2 in Panel B equals 1.4% if Haslemere is dropped from the sub-sample. 12 The total sample mean (median) is 3.3% (0.4%). The Panel D sub-sample mean (median) is 4.1% (0.2%). The difference in means between the sample and sub-sample is not significant, but the difference in medians is significant at the 5% level of significance. The Panel E sub-sample mean (median) is 2.1% (0.6%). The difference in means is not significant, but the difference in medians is significant at the 5% level. 13 The total sample mean (median) is 6.9% (0%). The Panel B sub-sample mean (median) is 6.0% (0%). The difference between the sample and sub-sample means is not significant. The Panel C sub-sample mean (median) is 7.3% (0%); the difference is not statistically significant. For Panel D, the sub-sample mean (median) is 4.4% (0%). The difference in means between the sample and sub-sample is significant at the 10% level. The Panel E sub-sample mean (median) is 10.5% (0%). The differences in means and medians are not statistically significant. 14 If the firm with the payout ratio of 1275% is dropped, the average for Panel C is 12.9% and the average for Panel A is 14.8%. 15 There are five such firms in Panel D and two such firms in Panel E. 16 The sample mean (median) is 26.8% (0%). The Panel B sub-sample mean (median) is 38.3% (5.9%). The difference between the sample and sub-sample means is not significant. The Panel C sub-sample mean (median) is 20.8% (0%); the difference is not significant. For Panel D, the sub-sample mean (median) is 26.1% (0%). The difference in means between the sample and sub-sample is significant at the 10% level. The Panel E sub-sample mean (median) is 28.0% (9.8%). The difference in means between the sample and the sub-sample is not significant, but the difference in medians is significant at the 5% level. 17 For each firm, we use the value of the US CPI index, which is closest to the firm’s accounting year-end. 18 The full results from the cluster analyses are available from the authors upon request.

The impact of a cross-listing on dividend policy

Appendix A

67

Names of countries and stock exchanges included in the study

Stock exchange

Country

Australian Stock Exchange Irish Stock Exchange Johannesburg Stock Exchange London Stock Exchange NASDAQ New Zealand Stock Exchange New York Stock Exchange Toronto Stock Exchange Amsterdam Stock Exchange Borsa Italiana Brussels Stock Exchange Copenhagen Stock Exchange Frankfurt Stock Exchange Oslo Stock Exchange Paris Stock Exchange Stockholm Stock Exchange SWX Swiss Exchange Tokyo Stock Exchange Wiener Börse AG

Australia Ireland South Africa UK USA New Zealand USA Canada Netherlands Italy Belgium Denmark Germany Norway France Sweden Switzerland Japan Austria

Appendix B Table B1

Cluster distribution

Cluster

1 2 Combined

Excluded cases Total Table B2

N 45 26 71 2787 2858

Percentage of combined 63.4 36.6 100.0

Percentage of total 1.6 0.9 2.5 97.5 100.0

Cluster profiles (continuous variables)

Employees Std. Mean deviation Cluster 1 11968.31 21924.953 2 32376.58 67374.335 Combined 19441.76 44959.806

Market to book value ratio Std. Mean deviation 9.1090 22.44703 7.0056 11.39583 8.3387 19.08245

Change in dividends over sales over years –3 to –1 Std. Mean deviation 0.0137 0.02571 0.0147 0.03723 0.0141 0.03018

Change in dividends over sales over years 1 to 3 Std. Mean deviation 0.0008 0.01499 0.1133 0.54364 0.0420 0.32965

68 Table B3

W. Abdallah and M. Goergen Distribution of firms across clusters by nationality of home market

The impact of a cross-listing on dividend policy Table B4

69

Anti-director rights of the host market by cluster 0

Cluster

1 2 Combined

Frequency 45 0 45

1 Percent 100.0 0 100.0

Frequency 0 26 26

Percent 0 100.0 100.0

Firms are given a value of 1 if they cross-list on a market with better anti-directors rights, and a value of 0 otherwise. Figure B1

Within cluster variation in size as measured by number of employees

Figure B2

Within cluster variation in market to book value ratio

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Figure B3

Within cluster variation in dividend over sales ratio over years −3 to −1

Figure B4

Within cluster variation in dividends over sales ratio over years 1–3

The impact of a cross-listing on dividend policy Figure B5

Test for the difference in size (measured by the number of employees) between the two clusters

The figure shows the values for the t-tests testing whether the cluster mean is significantly different from the overall mean number of employees. Figure B6

Test for the difference in market to book value ratio between the two clusters

The figure shows the values for the t-tests testing whether the cluster mean is significantly different from the overall mean market to book value ratio.

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Figure B7

Test for the difference in mean dividends over sales ratio over the three years before the cross-listing between the two clusters

The figure shows the values for the t-tests testing whether the cluster mean is significantly different from the overall mean change in dividends over sales ratio during the three years preceding the cross-listing. Figure B8

Test for the difference in mean dividend over sales ratio over the three years after the cross-listing between the two clusters

The figure shows the values for the t-tests testing whether the cluster mean is significantly different from the overall mean change in the dividends over sales ratio during the three years following the year of the cross-listing.

Int. J. Corporate Governance, Vol. 1, No. 1, 2008

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A minimum theory of boards Steen Thomsen Center for Corporate Governance, Copenhagen Business School, Porcelænshaven 24A, Building No. 65, 2000 Copenhagen F, Denmark E-mail: [email protected] Abstract: I propose a ‘minimum theory’ of company boards. Compared with other actors like managers, large owners and auditors, boards have a comparative advantage in classical board functions such as monitoring, management replacement, control and ratification of major decisions. While the expertise accumulated by doing these jobs may also be useful in business strategy, risk management, shareholder and stakeholder relations, I argue that the marginal value of additional board work declines steeply and becomes negative if boards are overloaded with responsibility. Because of the empowerment of boards, the risk of overload appears to have increased in recent years. Keywords: company boards; company performance. Reference to this paper should be made as follows: Thomsen, S. (2008) ‘A minimum theory of boards’, Int. J. Corporate Governance, Vol. 1, No. 1, pp.73–96. Biographical notes: Steen Thomsen is a Professor in the Department of International Economics and Management at the Copenhagen Business School and also Director of the Center for Corporate Governance. His research interests are in the field of corporate governance.

1

Introduction

There is no doubt that boards are central to the corporate governance discussion. In fact, to many observers and researchers, the concepts of ‘boards’ and ‘corporate governance’ are almost synonymous. In this paper, I will argue theoretically and empirically that boards have an important but limited role to play in corporate governance, and that on average boards do not – and should not – matter much. I go on to assess the recent empowerment of boards in the light of this and argue that boards are quite likely to become overloaded and either fail to live up to expectations or have dysfunctional effects on company behaviour and performance. To clarify the proposition, I do not claim that management does not matter. There is a great deal of empirical evidence, which indicates that top managers make a difference for company performance, although perhaps not quite as much of a difference as popular opinion would have it (Denis and Denis, 1995; Hayes and Schaefer, 1999; Huson et al., 2004; Bennedsen et al., 2006). The proposition is concerned with the board, particularly Copyright © 2008 Inderscience Enterprises Ltd.

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the non-executive directors or (in two-tier board systems) with the function of supervisory boards. Nor do I claim that no board will ever under any circumstances make a difference. The proposition is that the average board does not have much of an influence on company behaviour or performance. The strong form proposition is that the average board might as well be replaced by a new team. It might be cut in half, double in size, introduce or abolish board committees, have meetings with or without the executives. It would make no difference. Again, the proposition is concerned with ‘normal’ boards within the range of behaviour, which we observe in normal business companies. What would happen in extreme cases is another matter. For example, it might – or might not – make a difference if the non-executive board members were replaced by chimpanzees. But this question will not be analysed in this paper. Finally, I do not claim that boards have no role to play in corporate governance, although this might be a more entertaining case to make. Summarising recent board research, I propose that boards are just one of many corporate governance mechanisms that they play a valuable but limited role in certain key decisions and that overextending their responsibilities beyond these functions will most likely have detrimental effects on company performance. In the theory of boards, it is customary to refer to board behaviour as a ‘black box’. This is a metaphor, which is borrowed from the theory of the firm and resonates well with the mystique, which surrounds board work. My proposition is that most of what we call corporate governance takes place ‘outside the box’. Hence, we have the title of the paper. However, because of the procedural formality of board meetings and best practice codes, I argue that the black box metaphor is ill-founded: we actually know more about what goes on in boardrooms than about many other kinds of company behaviour. The paper is structured as follows. In Section 2, I present some stylised facts, which demonstrate a gross imbalance between the limited resources available to boards and the daunting list of responsibilities that they are burdened with. I recall the important distinction between formal and real authority. Boards have a great deal of formal authority, but since they have very limited information, their real authority is much more limited. In Section 3, I argue theoretically that boards are designed to address a limited set of decision-problems in which managers have conflicts of interest. Drawing on the distinction between formal and real authority (Aghion and Tirole, 1997), I propose that extending board work to other functions is subject to declining marginal returns and beyond some point, it is likely to lead to overload and value destruction. In Section 4, I review the empirical evidence on board performance and find it to be consistent with the minimum theory. In Section 5, I analyse what happens when boards are overloaded and argue that overload can lead to organisational innovation as well as substitution by other governance mechanisms. In Section 6, I conclude by discussing hypotheses for empirical testing and management implications.

2

Board functions: facts and fiction

Following the warning against ‘blackboard economics’ (Coase, 1991) or ‘armchair economics’ (Simon, 1986), I begin by describing some stylised facts about boards in

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large listed companies (Cadbury Commission, 1992).1 The idea is to define a normal board and to get some intuitive appreciation of what boards can and cannot do. I show that boards face severe limitations in terms of manpower, time, information and decision processes, which appear to be inconsistent with the wide range of tasks that they are expected to undertake. It is true that boards have enormous formal power. Company law across the world stipulates that all important decisions must be made (i.e., at least approved) by the board. However, we know that formal authority does not always imply real authority (Aghion and Tirole, 1997). In particular, boards – like shareholder meetings – may have much less real than formal authority because they do not have sufficient information to exercise their authority. Unlike shareholder meetings, which occur in the public domain, board meetings are confidential, and this lack of transparency is usually fertile ground for myths. We know – or rather we think – that there is not much going on at shareholder meetings. It is tempting, therefore, to assume that the important decisions are made in the boardroom. But, this is evidently a non-sequitur. The available facts indicate that boards are relatively small entities who only account for minute fraction of overall business activities. In terms of size, boards consist of a limited number of members, e.g., 12, more in large organisations, but rarely larger than 20 members are rare (e.g., de Andres et al., 2005; Conyon and Peck, 1998). They meet 6–8 times a year, occasionally more, but rarely more than 12 times a year (Vafeas, 1999). There is little scientific evidence on the duration of board meetings, but a normal meeting is believed to take 3–4 h up to a whole day in large corporations. Company directors interviewed by consulting companies indicate that they spend some 180–200 h a year (i.e., 4–5 work weeks) on board-related tasks (Price Waterhouse Coopers, 2005; USC and Mercer/Delta, 2005), but this includes both executive directors and chairs (who probably spend more time preparing the meeting), the time spent by directors with several board positions (some only do board work) and preparation time. Nevertheless, the survey studies agree that the time spent on board work has increased significantly over the past few years. If we count seven meetings a year times 12 board members times two days of work (to account for preparation), we get 168 work days or in total half a year’s work put in by the average board. If we compare this to the number of employees measured in tens of thousands (e.g., 16,558 in the study by Brick et al.), the work of non-executive directors accounts for 0.004% of the work put in by the corporation as a whole. This does not necessarily mean that boards are useless, but rather that their contribution is limited. In fact, like penicillin they may be essential for a limited range of very important tasks, and companies might find it difficult to function without them. But, on the margin their contribution is probably negligible. If boards were very useful – for example, if more board effort or better qualified board member could add 5% to company value, it would be relatively simple – and inexpensive and profitable – to double the number of board meetings or double the fees to attract better board members. Non-executive directors get paid in tens of thousands of dollars – for example 67,225 in a study of US directors (Brick et al., 2006), whereas CEOs get paid in hundreds of thousands or millions (e.g., an average of 4.054 million dollars in the same study). Sales, however, are counted in billions of dollars ($2.8 billion in the study by Brick et al.), so that director compensation accounts for a minute fraction of sales, value added and total salaries paid by the corporation. A rough estimate is that total director compensation accounts for 0.03% of company sales or perhaps 0.06% of value

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added (total income generation) in the average company. Basic microeconomics would indicate that the marginal product of non-executive directors should equal their marginal compensation.2 Assuming that average director compensation equals marginal compensation, this would indicate that the average non-executive director accounts for a minute fraction – something like a percent of a percent – of total value creation in the average company. If we assume that marginal director pay should be equal to director effort and marginal director productivity (Vafeas, 1999), boards apparently do not make much of a difference. Moreover, boards are relatively inefficiently organised by collective (non-hierarchical) decision-making. Voting is democratic. Decisions are officially made in plenum. In almost all cases, decisions are unanimous. Informal contacts between board members are often discouraged on suspicion of coalition building. In agency terms, group work like this is likely to create free rider problems since individual non-executive directors can freely ride on the activities of others. In a 4-h board meeting between eight board members, each member gets in principle only 30 min to express his or her opinions. However, the executives and the chairman use much more time because they need to convey messages, to make proposals and presentations. In addition, most of the dialogues will be questions to and answers by the executives. A total of 1–2 h of interactive dialogue is therefore more realistic, and for non-executives 5–10 min voice per meeting. This is unlikely to be sufficient for questions and answers or analysis in any depth. The black box metaphor notwithstanding, we actually know quite a lot about what goes on in boardrooms and very often this is even written down in the rules of procedure. Most board meetings tend to follow a standard agenda with minor modifications (Colley et al., 2003): •

quorum/approval of agenda

•

approval/signature of minutes

•

messages (non-decision/consent items)

•

committee reports (if any)

•

current financial status

•

proposals

•

briefings

•

any other business.

In the vast majority of cases, the board ratifies decision proposals by the managers (McNulty and Pettigrew, 1999). The chair controls what items are put on the agenda and will often not include proposals that are not likely to be approved. It is instructive to compare the above-mentioned stylised facts with the relatively detailed recommendations in corporate governance codes concerning what boards should do. As an example of this, I focused on the tasks and duties of the board as outlined in the UK combined code, the ‘mother of all codes’. Similar codes are found across the world (e.g., the NYSE and NASDAQ codes). For a full view of director responsibilities, these codes must be supplemented with national law, listing requirement, etc. (Jenson, 2001).3

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In the Appendix, I summarise the key tasks and responsibilities of the board according to the British combined code of best practice in corporate governance. The ‘to do list’ is daunting. The board should be entrepreneurial, contribute to strategy, monitor performance, assess risks and set the company’s values and standards. There are even more elaborate best practice recommendations for chairs, lead directors and committees. According to the UK best practice code, the chair and a “senior non-executive director” have special tasks with regard to self-evaluation and shareholder relations (Appendix). In addition to meeting without the executives present, non-executive directors (including the chair who is a non-executive in the UK system) should hold meetings on their own. A third control – a control of the control – is undertaken by mandatory meetings between non-executive directors excluding the chair. In these meetings, the senior non-executive director (lead director) acts as a second chair. Moreover, both the chair and the lead directors should spend time meeting with major shareholders, particularly institutional investors. In large listed US firms, board committees meet separately in 3–4 meetings per year (Adams, 2005). The committees are primarily composed of independent non-executive directors since they deal with issues, in which the executives may have a private interest. Auditing committees, for example, deal with financial reports, control systems and choice of auditor. Intuitively, the rationale seems to be to ensure that information provided to the board is reliable and not biased by the executives in their own favour. Remuneration (compensation) committees set the pay of the executives, in which they also have a vested interest. Finally, the nomination committee is concerned with selecting board members and managers, so independence is intended to ensure that managers do not bias board composition in their own favour. Given the complexity and importance of the companies involved – the world’s largest multinational companies are formally governed by boards as described above – it is not easy to see how these tasks can be adequately solved with two to three weeks effort per board member. While boards play a prominent formal role in the company, the few available stylised facts tend to indicate a discrepancy between the very important formal role of boards and the limited resources that they have at their disposal.

3

The theory of boards

Drawing on institutional economics (Coase, 1937; Williamson, 1984, 1985, 2005) boards can be characterised as one of many other governance mechanisms (institutions). The current consensus view among researchers is that corporate governance – defined as “the control and direction of companies” – consists of a set of mechanisms that include company law, monitoring by large owners, the threat of hostile takeover, managerial incentives, creditor monitoring, product market competition as well as boards (Shleifer and Vishny, 1996; Becht et al., 2002; Tirole, 2006). Given this broader theoretical understanding, it is surprising that so much attention has been directed exclusively at boards in the contemporary discussion. For example, the vast majority of the recommendations in corporate governance codes across the world are concerned with board structure and board behaviour. I examine the comparative advantage of boards relative to those institutions. I characterise the board as a partially internalised, non-hierarchical corporate institution based on collective decision-making. While non-executive directors are paid by the firm,

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they are elected by shareholders and work only on a part-time basis, which distinguishes them from executives (McNulty and Pettigrew, 1999). Given the existence of boards, the central problem (as for any other institution) is to determine the range of their activities. I use the board activities suggested in the US literature (Monks and Minnow, 2001; Colley et al., 2003) as a starting point: •

evaluate the financial situation and strategy of the company

•

select, evaluate and, if necessary, replace the CEO and other chief executives

•

negotiate CEO pay

•

nomination of new board members

•

control of major strategic decisions (MandA, capital investments)

•

stakeholder policies (philanthropy, environmental protection, business ethics)

•

advising the executives on strategy and other policies

•

ensure lawfulness of company activities

•

risk management

•

facilitate good shareholder relations

•

form and maintain business relationships

and consider whether boards can be expected to do better or worse than other governance institutions in undertaking these activities. Some of the key concerns are avoiding conflicts of interest (opportunism) and aligning responsibility and information access. The division of labour between boards and management can be analysed as a delegation decision: How much should the board do, and how much should be left to the management? Impartiality concerns imply that management cannot control itself – e.g., evaluate its own performance, approve its own strategy, hire or fire itself, set its own pay or that of the non-executive directors. However, it is possible at least to some extent for boards to share these tasks with shareholders and external consultants. Shareholders will often be asked to approve major decisions (like mergers) and in voting on the annual report they also get a say on company strategy. But, it is impractical (costly) to have a large group of shareholders meet regularly, so the board steps in as an intermediary. Fama and Jensen (1983), therefore, suggest that boards will arise as a control mechanism when there is separation of ownership and control. Information asymmetries, costs of collective decision-making and free riding problems all imply excessively high transaction costs for direct shareholder democracy. Compared with shareholder meetings, boards can give more continuous and flexible feedback to the management, which will often be in the company’s best interest. To some extent, collective action problems and information costs can be reduced by large shareholders who have both the incentive and the power to act (Shleifer and Vishny, 1996; Anderson and Reeb, 2003). However, ownership concentration is costly, and a large owner may not be available. Moreover, ownership concentration gives rise to a new set of impartiality problems related to possible conflicts of interest between large and small shareholders.

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The board can also outsource some jobs to external consultants – for example, it can solicit proposals for compensation packages from pay consultants or monthly performance reviews from the auditors. Professional service firms do not face the same time and information constraints as non-executive board members. Impartiality concerns would dictate that auditors and other consultants should be selected by an entity, which is independent of the management (i.e., by the shareholders of, if this is impractical by, the board). So, here is a role for the board. Altogether, boards seem to have a comparative advantage in a small set of classical board functions, which they are designed for – overseeing performance evaluation, CEO replacement and executive pay, and approval of major decisions. It is not clear, however, that board control is particularly effective. A large literature in management and economics argues otherwise. Adam (1776) held that “negligence and profusion” must generally prevail in boards because directors are watching over other people’s money. Berle and Means (1932) argued that executives were effectively in control of the board because of their control of proxy committees. Mace (1971) and Lorsch and MacIver (1989) emphasise the power of the CEO over the board and downplay the importance of board control. Warther (1998) summarising earlier literature argues that critical board members – who voted against the management – tend to leave or be ejected. Hermalin and Weisbach (1998) show how successful CEOs can accumulate power over time by influencing the composition of the board. From a social psychology viewpoint, Westphal argues that non-executive directors display ‘pluralistic ignorance’ (underestimate that other board members may also be critical of the CEO) (Westphal and Bednar, 2005), that the CEO appeases them through ingratiation (Westphal, 1998) and that troublesome directors are subjected to ‘social distancing’ through personal networks (Westphal and Khanna, 2003). To the classic board functions (‘the control role’), some management scholars would add ‘service’ and networking (Johnson et al., 1996). Service involves giving advice and inputs to strategy discussions. For example, a lawyer on the board may advice on legal issues (Daily et al., 2003). Networking consists of establishing and maintaining contacts to important constituencies, including investors (e.g., Pfeffer and Salancik, 1978; Stearns and Mizruchi, 1993). A transaction costs argument for these other roles would be that boards acquire firm-specific knowledge through the control function, and that this knowledge can be efficiently applied here as well. Nevertheless, there are strong reasons to assume a relatively steep decline in the marginal productivity of board effort beyond the classical ‘minimum functions’. •

Non-executive board members have an information disadvantage compared with managers and will therefore make worse decisions if they delegate less.

•

Despite the recent emergence of organisational structure at the board level, boards have very limited resources in terms of time and organisational support compared with company managers.

•

Group decision-making – which is believed necessary for mutual monitoring – reduces the decision-making efficiency of boards (Hermalin and Weisbach, 2003).

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•

There is a trade-off between management and control. The more effort boards put in, the more they will become involved in management and the less objective can they be in controlling the self-same management (Adams and Ferreira, 2007).

•

There appear to be relatively strong social and psychological mechanisms, which reduce the influence of non-executive board members (cf. Westphal’s work and Buffet, 2003).

The implication is first that the marginal productivity of additional board work will decline rapidly and become negative as boards put in more effort (Figure 1) and second that value creation will become value destruction if boards overextend their reach (Figure 2). Figure 1

Marginal costs and benefits of board work

Figure 2

Board involvement and board performance

A formal argument for board inactivity or rubber stamping of CEO proposals can be found in the distinction between formal and real authority (Aghion and Tirole, 1997; Weber, 1968). Although boards have formal authority to overrule executives, non-executive directors have insufficient information to decide whether this is the right thing to do. Even if they retain formal control, Aghion and Tirole show that boards will rationally rubberstamp management decision proposals as long as they have no independent sources of information and if they can assume that the decision proposal is no worse than the benchmark of doing nothing (in other words, assuming that managers and board members have a shared interest in selecting projects that at last cover the opportunity costs of capital). In this case, the agent has the real authority. Boards may

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recognise this and delegate formal authority to managers who will then want to contribute more information to the board because their interests are safeguarded. In both cases, greater board involvement – understood as overruling of more management decisions or rejection of more project proposals – will harm organisational performance. When boards retain formal authority, the Aghion and Tirole model implies that both managers and boards maximise their respective payoff functions such that Board utility:

ub = EB + (1 – E)eαB – cb(E)

(1)

Management utility:

um = Eβb + (1 – E)eb – cm(e),

(2)

where board effort E (1 ≥ E ≥ 0) is assumed to be synonymous with the probability of correct information about all decision proposals, in which case the board will choose their most preferred project (with payoff B). There remains a probability (1 − E) of the board not being informed in which case it must choose the project proposed by management (which is assumed to at least break even). This project will maximise managerial utility and only constitute a fraction α of B (1 ≥ α ≥ 0) and this only if management has made the effort e, which with a probability e (1 ≥ e ≥ 0) has informed it sufficiently to make a proposal (alternatively managers will prefer the status quo and make no proposal). Board utility is maximised net of effort costs cb(E), which are assumed to be an increasing, convex function of E. In the same way, managers maximise the utility function um, which give managers a fraction of their maximum utility βb, when the board – with a probability E – is fully informed and chooses its preferred project. In the other case, when the board is not informed (with a probability 1 − E) and the management is informed (with a probability e), management chooses the project that it prefers (with the maximum payoff b). Likewise, managers must deduct effort costs cm(e) from their utility. Maximising these two functions with respect to E and e, respectively, gives rise to the first-order conditions Board utility maximisation:

(1 − αe)B = c’b(E)

(3)

Management utility maximisation:

(1 − E)b = c’m(e),

(4)

which show that the board will be more active (monitor more) the higher the possible gains (B), the less the effort put in by the agent (e) and the less congruent the objectives of management and the board (α). Moreover, managers will be more active the higher their maximum utility (b) and the less the board interferes (E). Given the previous arguments for relatively uninformed boards, the most interesting and realistic case seems to be when boards have little or no information, i.e., when E ≈ 0, which can, for example, occur when the marginal costs of information are high c’b(E) → ∞. In this case, equations (1) and (2) are reduced to ub (E) = eαB

(5)

um (e) = eb − cm(e) with the first-order condition c’m(e) = b,

(6)

in which case the board has a choice between rubber stamping the decisions proposed by the management (and receive a utility of eαB) or to remaining passive (and receive zero) and therefore will always choose to rubber stamp since eαB > 0. The more general case is that boards have independent access to a non-zero, but modest amount of information. In this case, their involvement (exercise of formal

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authority) will increase expected returns up to a point beyond which more involvement (more rejections) have a negative impact on board utility. Boards that maximise payoff will recognise this and limit their activity accordingly, which implies that they will rubberstamp management proposals. Interestingly, it follows from the Aghion and Tirole framework that group decision-making may add value when boards retain formal authority if the group decision-making structure leads to free riding and thereby a credible commitment not to overrule the executives. In this sense, the board may be valuable because it is relatively inefficient. Furthermore, over time the board may build up a reputation for not intervening too much, which will allow managers to share more information. The win–win situation emphasised by management scholars (e.g., Pearce and Zahra, 1991) in which the empowerment of boards does not come at the costs of managerial autonomy corresponds most closely to the situation in which the board delegates significant formal responsibility to the executives who can then feel secure enough against overruling to volunteer more information (Adams and Ferreira, 2007). Aghion and Tirole show that communication (about strategy) will increase in this case, but the board will rationally refrain from overruling the managers and so in a formal sense non-executive board members have absolutely no influence on strategy. It is possible, however, that friendly boards can occasionally come up with ideas that lead to improvements for both managers and non-executives, if the non-executives get better information access. Moreover, the ability to communicate more openly with executives may in itself be valuable for the board (and possibly also for shareholders), which gets a more realistic view of risks and expected returns. Finally, the board retains the right to reject negative NPV projects (which are inferior to the status quo). As mentioned, certain key decisions – core board activities – cannot be outsourced or shared with the CEO because of conflicts of interest. These include the basic firing, nomination, control and remuneration decisions (in contrast executives can and do give advice on the hiring of new executives). For these activities, the marginal productivity of board work will be high. However, for the more managerial tasks, boards face stiff institutional competition. Given limitations on time and information, it will be lucky if the board is able to give much valuable advice to a seasoned executive. This does not mean that coaching, mentoring, strategic sparring and all the other catchwords are completely devoid of value, but rather that the inspiration from these sources will only add marginally to total value creation in a large company. Moreover, the value of these activities will be highly conditional on the situation. Boards should not always be friendly with managers and sometimes trust can backfire. Activities such as mentoring or involvement in strategy making, which have a positive impact under some circumstances may, therefore, have dysfunctional effects in other cases. A high level of trust may be conducive to creativity and information sharing, but it can lead to catastrophe when managers are fraudulent. Very elaborate control and incentive systems can be gamed and may suppress teamwork and information sharing, which could reduce risk taking and entrepreneurship and harm performance in that way. Since it is difficult ex ante to determine which contingency will be applicable in a specific company, it may be optimal to simplify board work to the essentials. And certainly, this will hold even more across a range of companies. The minimum view is therefore that boards will typically delegate ‘business as usual’ decisions to executives and very rarely intervene in this area. In contrast, they will at least

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be consulted on major strategic issues, but will typically choose to endorse the recommendations of managers. Moreover, if they disagree with managers, they will confer with owners and consultants. Very rarely will they make independent decisions. However, boards will be concerned with strategy in the sense that an articulated strategy enables them some degree of control over the direction of the firm including business risk and expected return. Boards will, therefore, often insist that the executives have a formal strategy and a budget, which they can then use as a benchmark for assessing the development of the firm. The ‘unusual’ will then come up as deviations from strategy.

4

The empirical evidence

By and large, the empirical evidence is consistent with the proposition that boards do not – on average – matter much to company performance. I consider three types of evidence: studies of board structure and performance, studies of board structure in special situations and direct studies of behaviour in the boardroom.

4.1 Board structure and company performance Johnson et al. (1996) summarise an extensive literature review of board structure and company performance like this: “To our knowledge, there has been no documented evidence of the existence of a unicorn. With tongue slightly in cheek, there can be two general rationales for our failure to ‘discover’ this legendary species. First, this animal simply does not exist. Second, we have not searched in the right place, at the right time, with the right equipment … In many ways an aggregation and summary of the boards of directors/financial performance/other outcomes literature has this same character. Maybe such relationships simply do not exist in nature. Or, if they do exist, their magnitude is such that they are not of practical importance. Alternatively, given the heterogeneity of typical independent variables … it may be unrealistic to reasonably compare and summarise this body of work.” (Johnson et al., 1996, p.433)

In a subsequent meta-analysis, Dalton, Daily, Ellstrand and Johnson (1998) support this finding for board composition (159 samples, n = 40,160) and leadership structure (coincidence between chair and CEO) (69 samples, n = 12,915): “The results for the board composition/financial performance meta-analyses suggest no relationship of a meaningful level. Subgroup moderating analyses based on firm size, the nature of the performance indicators, and operationalisation of board composition provide no evidence of moderating influences for these variables as well. The evidence derived from the meta-analysis and moderating analyses for board leadership structure and financial performance has the same character, i.e., no evidence of a substantive relationship. These results lead to the very strong conclusion that the true population relationship across the studies included in these meta-analyses is near zero.” (Dalton et al., 1998)

In a survey of the economic literature, Hermalin and Weisbach (2003) conclude that “board composition is not related to corporate performance, while board size is negatively related to corporate performance”. However, the firm size result is based on only two studies, Yermack (1996) for US firms and Eisenberg et al. (1998) for small- and

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medium-sized Finnish firms, although it has since been supported by other studies (e.g., de Andres et al. (2005) and partly by Conyon and Peck (2003)). In contrast, Dalton et al. in a meta-analysis of 131 samples and 20,620 observations find the opposite: “the results for our overall meta-analysis of the board size-financial performance association strongly suggest a nonzero, positive relationship these relationships are consistent for market-based and accounting based firm performance measures.” (Dalton et al., 1999)

So, there is really no consensus on board size effects. There are several methodological issues, which complicate empirical studies of board structure and performance. The most important is that we have strong reasons to believe that board structure and board behaviour depends on ownership and capital structure, law and other governance mechanisms – and on company performance. Boone et al. (2007), Raheja (2005), Baker and Gompers (2003), Denis and Sarin (1999) and Hermalin and Weisbach (1998) find that board structure is influenced by ownership structure, board size, company performance and other economic variables. To estimate the effects of board structure, we need to take this interdependence into consideration, which means estimating simultaneous equation systems with many dependent equations. Very few studies have done this. A recent exception is Bhagat and Bolton (2007), who estimate ownership, governance, performance and capital structure in four simultaneous equations. They find that board structure (measured by the fraction of independent directors) has no significant effect on firm value and a negative effect on accounting returns. However, it is difficult to find instrument variables that influence either performance or governance without influencing the others, so causality is a problem even in large simultaneous equation models. All this indicates that boards are part of a complex system of governance mechanisms. In many cases, board structure and board behaviour will be determined by other corporate governance mechanisms in combination with firm-specific variables. For example, large owners often want to be represented on the board. Moreover, even if they are not present at the board, the expectations of large owners can condition board decisions to a very large extent. A board may, for example, feel compelled by anticipated shareholder reactions to fire the CEO after three years of bad performance. Or banks may make demands on board composition as a condition for extending credit to an insolvent firm, and the board may feel compelled to fire the CEO because of manifest or anticipated pressure from creditors. The point is that board structure and behaviour are endogenous, and when this is taken into account, the part of company behaviour and performance that is attributable to the board as such is diminished.

4.2 Special situations There are a number of studies of special situations – e.g. the role of the board in replacing CEOs, shareholder defences, executive compensation and MandA – and here there is more evidence that boards matter (Johnson et al., 1996; Hermalin and Weisbach, 2003). However, the implications for company performance are often unclear. It may be, for example, that independent boards are more likely to replace CEOs when performance is bad, but it is unclear whether this is the right decision. Second, even when performance is being measured as in event studies, it is unclear whether a positive effect on the

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performance effects of certain types of decisions – like adopting a poison pill – will hold for other types of decisions as well. In fact, it seems likely that greater independence and more monitoring can have adverse effects on information sharing (Adams and Ferreira, 2007). Finally, the observed correlations often run counter to expectations. In a meta-study of 38 studies with 69 samples (N = 30,650), Deutsch (2005) concludes that greater board independence is associated with higher executive pay, more unrelated diversification and more takeover defences – all contrary to expectations in a standard agency model.

4.3 What do boards do? Adams (2005) approaches the study of board behaviour indirectly. She examines the time and compensation of committee work as a proxy for director effort. Using this proxy, she concludes that company boards devote more time to monitoring (audit, compensation and nomination committees) than to strategy or network roles, but that quite many do have strategy and stakeholder committees, which account for respectively 4% and 1% of total director compensation. However, she also finds that most board work (compensation) takes place outside the committees. Based on a large number of interviews with non-executive directors, Lorsch and MacIver (1989) conclude that non-executive directors are pawns more than potentates vis-à-vis the management, partly because they do not have sufficient time and must rely on the chairman/CEO for most of their information. They also document that most US non-executive directors feel an ambiguous and partly conflicting set of responsibilities to all stakeholders rather than just to shareholders. They conclude that more empowered directors would benefit company performance. After interviewing 108 non-executive directors, McNulty and Pettigrew conclude that “the initiation and generation of strategy are much more likely to be led by executive directors. It is the executive board members, acting outside the boardroom, who tend to generate the content of strategy.” (McNulty and Pettigrew, 1999)

However, they argue that some boards shape strategic decisions through consultation with the executives (often outside board meetings), while “only a minority of boards shape the context, content and conduct of strategy”. Boards ratify most proposals by the executives (90–95%), but Pettigrew and McNulty maintain that non-executives shape strategy by an ongoing dialogue with the management in and outside board meetings. All in all, the available evidence is consistent with the proposition that boards do not on average matter much to company performance. Boards structure seems to influence the direction of decision-making certain decisions, but it is unclear whether this behaviour is value creating, and what works in one special situation may be counterproductive in another.

5

Empowerment and overload

For decades, academics have called for empowerment of boards (e.g., Lorsch and MacIver, 1989) and many studies have found that boards have in fact become more active during the past decade or two (e.g., McNulty and Pettigrew, 1999). These changes

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are often claimed to be influenced by new legislation (e.g., SOX), the diffusion of corporate governance codes, pressure from institutional investors and the influence of private equity funds (McKinsey, 2007). As noted in Section 2, the ‘to do list’ for boards appears enormously ambitious given the time and information constraints of non-executive board members. Boards should undertake entrepreneurial leadership, strategy proposals setting values and standards for the companies, meetings with major shareholders and self-evaluation in addition to a wide range of classical board jobs like hiring/firing managers, checking accounts and assessing performance. If the minimum theory proposed in this paper is correct, the call for greater board involvement (e.g., more monitoring) risks lowering company performance. This will happen because boards will make more decisions on the basis of insufficient information and therefore make more mistakes. In addition, overruling the executives will make them more reluctant to volunteer information, so boards will become less informed than before. It is difficult to predict exactly how boards will respond to these challenges, but it is possible to identify some plausible outcomes. Boards may respond by working harder, increasing preparation time as well as the number and duration of board meetings. This seems to have happened (Price Waterhouse Coopers, 2005; USC and Mercer/Delta, 2005). The risk here is that boards become too much involved in management and thereby lose the mental independence, which would allow them exercise control of management. Aghion and Tirole (1997) predict that more intense monitoring will reduce managerial incentives to take new initiatives and make them more reluctant to share information with the board. Companies may, therefore, become more risk adverse. Alternatively, boards may feel compelled to make decisions despite inadequate information. This will then lead to inferior decisions. To deal with many conflicting demands, boards may also adopt a box-checking approach documenting that they comply with corporate governance codes, have adopted standard policies for stakeholders, business ethics, executive compensation or other issues, have discussed business strategy and key decisions in the appropriate way, etc. This solution is a bureaucratic, politically correct way to provide legitimacy for board behaviour, but it has been criticised for bypassing the core objectives of corporate governance: to make good business decisions and ensure value creation (e.g., Lohse, 2006). Alternatively, board work may be reorganised to become more effective. The organisation of boards can change to become more functional and has already done so to some extent through the increasing use of specialised committees that work in parallel and therefore save time and that allow a division of labour. To be sure, committee work is partly motivated by a perceived need to separate decisions from the influence of executives, but this does not apply to all committees. Executive committees, strategy committees and social responsibility committees are to a great extent filled by executives. Moreover, an increasing division of labour between committees, chairs, lead directors, executive and non-executive directors indicates a more sophisticated internal organisation of boards. Nevertheless, the basic trade-off between management and monitoring remains. Despite additional meetings, boards will never be as well informed as managers. Third, boards may outsource more, for example they can rely more on external advisors like lawyers, auditors, search firms, compensation and strategy consultants. This also appears to be happening to a significant extent. The risk here is that board work

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is reduced to endorsing recommendations by these outside consultants whose independence of company management is open to question since their fees are paid by the company. Finally, boards may paradoxically come to rely more on managers, for example by asking managers to draft relevant reports and decisions on social responsibility, corporate governance, etc. Obviously, this is contrary to the intention of empowering the board vis-à-vis managers. Board overload will predictably lead to a substitution by other governance mechanisms. Owners may become more involved in board decisions at various levels, and in fact board failure in listed companies has provided justification for new business models (e.g., private equity funds), in which owners communicate more directly with managers. For example, institutional investors may seek to take more control of the nomination process for new board members, and it may engage in a dialogue with large owners over whom to suggest for the board, and whether this or that candidate is an acceptable CEO. This can then effectively move key decisions outside the boardroom. Large owners may also decide to intervene directly in decisions concerning executive compensation or company policy at shareholder meetings with managers. Nor is it unusual to try to seek investor approval for key decisions like MandA and corporate strategy. Bilateral meetings with major investors imply a communication channel, which investors can use to influence the board or in some cases sidestep the board and directly influence managerial decisions. Moreover, there may be a tendency to increasing interaction between non-executive directors and other stakeholders outside board meetings (McNulty and Pettigrew, 1999). McNulty and Pettigrew argue that non-executive directors can influence the shape and content of corporate strategy in this way, but an equally plausible possibility is that managers can use contacts outside the board meetings to persuade board members of their ideas. Again, major decisions may effectively move out of the boardroom. It is convenient to distinguish between temporary and permanent overload situations. Temporary overload can occur when boards are faced with isolated decisions, which overextend its capacity, for example a major acquisition or the sudden death of a CEO. In this case, minimum theory would imply that board members solicit and implement advice from major shareholders, company managers and consultants. When the problem is solved, the board will revert to business as usual. Permanent overload can occur when boards are more or less continuously faced with new decisions. In this case, the prediction would be that boards will devise institutional mechanisms to deal with the new situation. For example, companies that continuously undertake acquisitions will delegate more responsibility for MandA to the management such that only exceptionally large investments will be decision items at board meetings. In the same way, large companies that make more large-scale economic decisions will delegate more responsibility to the management team. Permanent overload can also occur because more responsibility is placed on boards as a consequence of new regulation. Boards will then try to deal with the new situation by increasing use of lawyers, committees, company secretaries, etc. To economise on information scarcity, there will predictably be a strong pressure to imitate standard solutions despite a lack of fit with the company’s specific situation. For example, family-owned companies routinely adopt the same corporate governance practices as companies with dispersed ownership despite facing very different governance problems.

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The overload situation will also influence board composition. More experienced board members with alternative sources of income may recognise the control loss and be more selective when accepting new board positions. Less experienced (or less intelligent) board members will more willingly retain and accept board positions. As a result, board talent may become increasingly scarce.

6

Discussion

The minimum theory proposed in this paper implies that boards have a comparative advantage in a few, classic tasks – evaluating company performance, hiring and firing executives, fixing executive pay and ratification of major decisions – which managers themselves cannot handle because of conflicts of interests. The expertise that boards accumulate in undertaking these tasks is also useful for business strategy, risk management, social responsibility and shareholder relations. But given time and information constraints, the marginal value of additional board work declines steeply and becomes negative, if boards begin to seriously interfere with the management of the company. The theory has a number of testable implications, which can be tested in further research. •

The board will not make much of difference for performance of the average company.

•

If anything, board involvement over and beyond the generic board tasks is likely to lower company performance.

•

Temporary overload will be more likely to occur when boards are faced with critical decisions.

•

Permanent overload can occur in dynamic business environments with many discrete decisions (e.g., MandA), which are presented at board meetings.

•

Permanent overload can also occur if regulation and corporate governance codes heap duties and responsibilities on boards without regard for their information and time constraints.

•

When boards are overloaded, other actors like shareholders, auditors and managers are more likely to fill in for the board by assuming more prominent governance roles. Examples are shareholder activism, bilateral shareholder meetings and increased use of auditors or other consultants.

•

Boards will respond to permanent overload by organisational innovations like committees, lead directors or company secretaries.

To some extent, testing these hypothesis resembles listening for “the dog that did not bark”, since it is difficult to test the null hypothesis of ‘no significance’ given the existence of a number of complications related to measurement, controlling for other factors, simultaneity, etc., which could yield the same result. But, it would seem to be possible however to identify a number of major changes (critical incidents) and then to examine qualitatively to what extent the board was a driving factor behind these changes.

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The strong form hypothesis would be that the key strategic decisions are effectively made outside the boardroom – by managers, owners, consultants – so that board members are reduced to go betweens. As for management implications, it seems useful to apply minimum theory to define the role of the board in strategic management. Boards clearly must discuss business strategy, for without it they will not be able to evaluate company performance, assess risks or understand the rationale for major decisions like MandA. Furthermore, without an articulated strategy, they will not be able to evaluate or control the future development of the company. Boards must therefore challenge managers to develop and articulate a coherent strategy, which can be used as a benchmark for decision-making. However, boards cannot be expected to make strategy, since they have too little time and information and since an executive role in this respect would conflict with their control role. Boards therefore play a role as enablers rather than generators of strategy. Their contribution can perhaps best be described as ‘vetting’ strategy, a term coined by Oracle CEO Charles Philips to indicate an intermediate position between making and monitoring strategy. It would seem idiotic to ignore ideas and suggestions that come up at board meetings, but to be constructive they must remain part of the brainstorming rather than decision decrees, since only the executives have the capacity to assess their usefulness. Under normal circumstances, the board will therefore not have much of an influence on business strategy or company performance. There are exceptions, however, which have been identified in the literature. In case of prolonged underperformance, boards face the difficult decision of whether to replace the CEO or scrap the current strategy. Both decisions are costly; they leave a decision vacuum in which the board can step in to provide direction and continuity. In this situation, board will predictably turn to large owners or consultants, but if they provide unclear answers, the board will be forced to make independent decisions. The expertise of the board can play a critical role in assessing whether to give the CEO or the strategy another chance or to abandon them. A similar situation occurs if the CEO leaves or dies. Typically, boards would prefer an orderly succession, but they can act as a safety mechanism in times of crisis. As a corollary, when the executives are weak (e.g., if the CEO is new or if performance is bad), the board will tend to intervene more (Hermalin and Weisbach, 1998) and for example ask more questions or be more critical of new decision proposals. In contrast, successful CEOs will become more influential over time (Forbes and Milliken, 1999), and the board will tend to rubberstamp more decisions. Another exception occurs when a large owner, perhaps a founder or a member of the founding family, demands a seat of the board and desires to influence the direction of the company. In this case, the board will clearly matter for better or worse. Uniquely talented individuals – the Warren Buffets, Bill Gates and Phil Knights – may create value in this way, particularly if they have previously had executive positions. Since large owners have their own money at stake, they certainly have the incentive to intervene only when they can create value. However, following the logic of minimum theory, such individuals will de facto typically be executives, for example they often have an office at the company premises and work full-time rather than part-time. The semi-independent status in the company, which we associate with non-executive directors, is therefore absent.

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Acknowledgement This paper is prepared for presentation at the Scancor Seminar 13, August 2007, Stanford University. The paper has benefited greatly from discussions with Lars Nørby Johansen. A different version of this paper is forthcoming in Steen Thomsen. An Introduction to Corporate Governance Mechanisms and Systems, Djoef Publishing, Copenhagen, 2008.

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Notes 1

Most parts of the paper are concerned with topics that cut across international differences in board structure. For example, the key issues are the same in one- and two-tier boards. In two-tier boards (Germany, Scandinavia, Finland, Austria), shareholders elect non-executive directors – and occasionally also a minority of executive directors – to a supervisory board that evaluates company performance, hires and fires the management (the executives) and must approve all major decisions. In one-tier systems, shareholders elect the board, which then appoints the executives. Executives may or may not be board members, but typically some of them are.

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In both systems, most of the board members are now non-executive directors (this holds in the USA and Europe, but not in Japan). Non-executive directors are typically part-time, and generally – in accordance with best practice codes – a majority are supposed to be independent also in the sense that they have no other material ties with the firm (the company lawyer, for example, is not an independent board member). Many non-executive directors have demanding jobs as executives, managers in other firms, lawyers or even professors. Despite these differences, boards in the two systems have similar responsibilities and in both systems the corporate governance discussion has been directed primarily at what non-executive directors do and what they should be doing. The same applies to other system differences. In some countries (the USA, France), the chief executive can also be chairman of the board (duality), but this is prohibited in two-tier systems. In the UK, the two positions are now typically separated following corporate governance recommendations (Cadbury, 1992). But in all three countries, there are similar discussions about the responsibilities of non-executive directors. Likewise, the corporate governance debate cuts across differences in employee representation. In some two-tier countries, employees have a right to elect members of the supervisory boards, typically 1/3 of the board members, but in some, large German companies up to 50%. But despite employee representation, the shareholder-elected board members have a majority of the votes (in Germany, the vote of the chairman is decisive in case of a split). 2 On the margin, director pay should also be equal to director effort (disutility). Adams (2005) applies this principle when using pay as a proxy for board effort 3 For example, contrary to views commonly expressed in textbooks on corporate finance, directors now face a complex set of responsibilities to ALL stakeholders. Consider the UK 2006 companies act: Section 172. Duty to promote the success of the company, part (1): “A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to (a) the likely consequences of any decision in the long term, (b) the interests of the company’s employees, (c) the need to foster the company’s business relationships with suppliers, customers and others, (d) the impact of the company’s operations on the community and the environment, (e) the desirability of the company maintaining a reputation for high standards of business conduct, and (f) the need to act fairly as between members of the company.” Whatever benefits there may be in adopting a stakeholder view, a multi-valued – and possibly partly conflicting – objective function beyond profit or value maximisation does not make it easier for company directors to make decisions or for shareholders to hold them accountable (Jensen, 2001).

Bibliography Almazan, A. and Suarez, J. (2003) ‘Entrenchment and severance pay in optimal governance structures’, Journal of Finance, Vol. 58, pp.519–547. Aghion, P. and Tirole, J. (1995) ‘Some implications of growth for organizational form and ownership structure’, European Economic Review, Vol. 39, Nos. 3/4, pp.440–455. Benjamin, E.H. and Weisbach, M.S. (2003) ‘Boards of directors as an endogenously determined institution: a survey of the economic literature’, Economic Policy Review, Federal Reserve Bank of New York, April, pp.7–26.

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Corley, K. (2005) ‘Examining the non-executive director’s role from a non-agency theory perspective: implications arising from the Higgs report’, British Journal of Management, Vol.16, pp.1–4. Dulewicz, V. and Herbert, P. (2004) ‘Does the composition and practice of boards of directors bear any relationship to the performance of their companies?’, Corporate Governance: An International Review, Vol. 12, July, pp.263–280. Hillman, A. and Dalziel, T. (2003) ‘Boards of directors and firm performance: integrating agency and resource dependence perspectives’, Academy of Management Review, Vol. 28, No. 3, pp.383–396. Lynall, M., Golden, B. and Hillman, A. (2003) ‘Board composition from adolescence to maturity: a multi-theoretic view’, Academy of Management Review, Vol. 28, No. 3, pp.416–431. McNulty, T., Roberts, J. and Stiles, P. (2005) ‘Undertaking governance reform and research: further reflections on the higgs review’, British Journal of Management, Vol. 16, pp.99–107. Roberts, J., McNulty, T. and Stiles, P. (2005) ‘Beyond agency conceptions of the work of the non-executive director: creating accountability in the boardroom’, British Journal of Management, Vol. 16, March, pp.5–26.

Appendix The Tasks of the board according to the combined code •

The board is collectively responsible for the success of the company.

•

The board’s role is to provide entrepreneurial leadership of the company.

•

Within a framework of prudent and effective controls, which enables risk to be assessed and managed.

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The board should set the company’s strategic aims.

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Ensure that the necessary financial and human resources are in place for the company to meet its objectives.

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Review management performance.

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The board should set the company’s values and standards.

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Ensure that its obligations to its shareholders and others are understood and met.

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As part of their role as members of a unitary board, non-executive directors should constructively challenge and help develop proposals on strategy.

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Non-executive directors should scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance.

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They should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible.

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They are responsible for determining appropriate levels of remuneration of executive directors (and senior management).

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Have a prime role in appointing, and where necessary removing executive directors, and in succession planning.

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•

The board should establish formal and transparent arrangements for considering how they should apply the financial reporting and internal control principles and for maintaining an appropriate relationship with the company’s auditors.

•

Non-executive directors should be offered the opportunity to attend meetings with major shareholders and should expect to attend them if requested by major shareholders.

The Chair and senior non-executive director should •

Hold meetings with the non-executive directors without the executives present.

•

Led by the senior independent director, the non-executive directors should meet without the chairman present at least annually to appraise the chairman’s performance and on such other occasions as are deemed appropriate.

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The chairman should ensure that the directors continually update their skills and the knowledge and familiarity with the company required to fulfil their role both on the board and on board committees. The company should provide the necessary resource.

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The chairman should ensure that the views of shareholders are communicated to the board as a whole.

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The chairman should discuss governance and strategy with major shareholders.

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The senior independent director should attend sufficient meetings with a range of major shareholders.

The Tasks of Board Committees •

There should be a nomination committee, which should lead the process for board appointments and make recommendations to the board.

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For the appointment of a chairman, the nomination committee should prepare a job specification.

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The board should undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors.

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The remuneration committee should have delegated responsibility for setting remuneration for all executive directors and the chairman, including pension rights and any compensation payments.

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The (remuneration) committee should also recommend and monitor the level and structure of remuneration for senior management. The definition of ‘senior management’ should normally include the first layer of management below board level.

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The board should establish an audit committee to review the company’s internal financial controls.

•

To review and monitor the external auditor’s independence and objectivity.

•

The effectiveness of the audit process, taking into consideration relevant UK professional and regulatory requirements.

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Develop and implement policy on the engagement of the external auditor to supply non-audit services.

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Review arrangements by which staff of the company may, in confidence, raise concerns about possible improprieties in matters of financial reporting or other matters.

•

Monitor and review the effectiveness of the internal audit activities.

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Have primary responsibility for making a recommendation on the appointment, reappointment and removal of the external auditors. Source: The Combined Code (2003)

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Institutional shareholders: their role in the shaping of corporate governance Chris Mallin Birmingham Business School, University House, University of Birmingham, Edgbaston, Birmingham B15 2TT, UK E-mail: [email protected] Abstract: Institutional shareholders have become an influential force in corporate governance in the last 25 years. In this paper, the trends in share ownership are highlighted together with the resultant emergence of institutional shareholders. Recent developments, in an international context, of the expectations of the role that institutional shareholders will perform, and in particular the implications for their role in shaping corporate governance, are discussed. Keywords: institutional shareholders; corporate governance; engagement; share ownership; short-termism. Reference to this paper should be made as follows: Mallin, C. (2008) ‘Institutional shareholders: their role in the shaping of corporate governance’, Int. J. Corporate Governance, Vol. 1, No. 1, pp.97–105. Biographical notes: Chris Mallin is Professor of Corporate Governance and Finance and Director of the Centre for Corporate Governance Research at the University of Birmingham, UK. She has published widely on corporate governance issues and is a member of several international committees on corporate governance. She was also the Editor of Corporate Governance: An International Review 2000–2007.

“The effectiveness and credibility of the entire corporate governance system and company oversight will, therefore, to a large extent depend on institutional investors that can make informed use of their shareholder rights and effectively exercise their ownership functions in companies in which they invest.” (OECD, 2004, p.37)

1

Introduction

Financial crises and collapses around the world have led to the global interest in corporate governance, and the introduction of corporate governance codes, principles and guidelines. Institutional shareholders both invest cross-border and have an ongoing dialogue with institutional shareholders in other countries about corporate governance matters. Many corporate governance developments have been driven, particularly in the UK and the USA, by institutional shareholders.

Copyright © 2008 Inderscience Enterprises Ltd.

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Why would, or should, institutional shareholders be interested in good corporate governance? Clearly, it is of fundamental importance to any country. Claessens (2003), in his work ‘Corporate Governance and Development’, published by the Global Corporate Governance Forum, summarised the ways in which corporate governance affects growth and development: increased access to external financing by firms, lowering the cost of capital, better operational performance, reduced risk of financial crisis, and better relationships with stakeholders. Good corporate governance is therefore going to help build confidence in firms and in the economy as a whole, and so there are very good reasons for institutional shareholders to be interested in improving corporate governance in the companies in which they invest, whether they are home investments or part of a diversified international portfolio of shares. In this paper, the trends in share ownership are highlighted together with the resultant emergence of institutional shareholders. Recent developments, in an international context, of the expectations of the role that institutional shareholders will perform, and in particular the implications for their role in shaping corporate governance, are discussed.

2

Trends in share ownership

Over the last 40 or so years, there has been a sea change in the distribution of share ownership in many countries. The USA and the UK are particularly good examples of the way in which share ownership has moved away from individuals and become concentrated in the hands of a relatively few powerful institutional shareholders (pension funds, insurance companies, mutual funds). Countries that have seen large waves of privatisations in an era of market liberalisation also find that institutional investors are significant investors, although the state often retains an important role in former state-owned enterprises. Developing countries seeking external investment find that it is the institutional investors whom they need to attract. Therefore, the influence of institutional investors is predominant across countries, whatever their ownership structure. Institutional shareholders own over 55% of US equity whilst in the UK, the latest available figures published by the Office of National Statistics (2007) show that at the end of 2006, insurance companies, pension funds, unit trusts, investment trusts, banks and other financial institutions own some 45% of UK equity. Overseas shareholders (predominately institutional shareholders) own 40%, and individual shareholders own just 13% of UK equity. It is therefore hardly surprising that institutional shareholders wield significant power in the USA and the UK. Franks et al. (2005) carried out a study of the long-run evolution of investor protection, equity financing and corporate ownership in the UK, highlighting that formal regulation really emerged only in the second half of the 20th century. This coincided with the changes in share ownership with the sea change from individual to institutional share ownership, especially during the last 20 or 30 years. What is abundantly clear is the overall increasing trend over time in the ownership of shares in the UK by the institutional shareholders. Of course, this trend is not unique to the UK. Becht et al. (2002) point out that the growth in pension plans in many countries has led to more money being invested into pension funds and mutual funds, thus helping to create large influential institutional shareholders. Similarly, Gillan and Starks (2003, p.36) undertake a review of the global perspective on the role of institutional investors

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and conclude “due to the growth in institutional ownership and influence, worldwide institutional investors have the potential to play an important role in many markets”, and “the presence of institutional investors should lead to more informative prices, and consequently lower monitoring costs for all investors. Thus, the outcome should be better monitoring of managers and better corporate governance.” (Gillan and Starks, 2003, p.38)

In 2006, the OECD introduced Guidelines on Pension Fund Asset Management recognising that this was a key area, given that “pension funds are one of the most important players in the financial markets of the OECD countries, managing more than $15 trillion of assets in 2003, which represents over 80 % of the OECD’s area GDP.” (OECD, 2006, p.2)

3

The role of institutional shareholders: codes and principles

In the UK, the corporate governance codes have long recognised the role that institutional shareholders can play. For example, Cadbury (1992) stated that we “look to the institutions in particular … to use their influence as owners to ensure that companies in which they have invested comply with the Code”, and the Combined Code (2006) stated that “institutional shareholders should enter into a dialogue with companies based on the mutual understanding of objectives”. Similar views are expressed in corporate governance codes around the world. The UK’s Institutional Shareholders’ Committee (ISC) (2002, 2005) issued statements on the responsibilities of institutional shareholders. The ISC recommended that institutional shareholders should, inter alia, have a clear statement of their policy on activism and on how they will discharge their responsibilities, monitor performance, intervene when necessary, and evaluate and report on the outcomes of their shareholder activism. The later statement concluded that there had been a general increase in the level of engagement with investee companies. It also recommended that ‘activism’ be replaced with ‘engagement’ to reflect the importance now attached by institutional shareholders to developing a high-quality all-round relationship with the companies in which they invest, that pension funds incorporate the principles into their statement of investment principles, and that corporate governance aspects could be more integrated with the investment process. The International Corporate Governance Network (ICGN) (2007) published a statement of principles on institutional shareholder responsibilities both in relation to their external role as owners of company equity and also in relation to their own internal governance. These two areas are of fundamental importance to beneficiaries and to other stakeholders, and should help address concerns that institutional shareholders need to address their own governance as well as that of their investee companies. The ICGN principles emphasise that with the ownership of shares comes important responsibilities, and the rights attached to share ownership must be exercised responsibly (a sentiment found in many codes and principles, including the OECD (2004), Principles of Corporate Governance). To be a responsible owner, there must be transparency, probity and care. Internal governance covers areas such as oversight, transparency and accountability, conflicts of interest, and ensuring appropriate expertise along the investment chain.

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External governance covers areas such as the importance of high standards of corporate governance, which “will make boards properly accountable to shareholders for the companies they manage on their behalf … they will also help investee companies make sound decisions and manage risks to deliver sustainable and growing value over time”

and ‘pursuit of high standards of governance is therefore an integral part of institutions’ fiduciary obligation to generate value for beneficiaries. Corporate governance considerations should therefore be integrated into the investment process.”

Shareholder rights should be “exercised with the objective of delivering sustainable and growing value in mind” and “rather than trying to interfere in the day-to-day management of the company, institutional shareholders should actively engage in a constructive relationship with investee companies to increase mutual understanding, resolve differences and promote value creation.”

The ICGN statement identifies the rights of institutional shareholders as including engagement with companies, the voting of shares, and addressing corporate governance concerns such as a lack of transparency.

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Institutional shareholders as shareowners

As has been seen earlier, various corporate governance codes and statements emphasise the role of institutional shareholders in corporate governance. With the changing pattern of share ownership and the emergence of the institutional shareholders as the dominant shareholding group in many countries, there has been a significant literature building upon the implications of the role of institutional shareholders, and their responsibilities as shareowners. The concept of ‘shareowners’ is a topical line of thought, which is gaining increasing momentum with the belief that it is not enough for institutional shareholders to simply hold shares, that is, to be shareholders, rather they must act more as shareowners. This implies that it is not enough to be a passive shareholder, but a more active role is called for. Institutional shareholders should engage with the companies in which they invest (investee companies), they should have an ongoing dialogue with the board of directors, they should act in the long-term interests of those on whose behalf they are holding (owning) the shares, they should utilise the tools of governance such as voting, and they should take an appropriate interest in all relevant matters. Hawley and Williams (2000) put forward the view that many large institutional investors have become ‘universal owners’, as a significant proportion of their funds are invested in indexed (tracker) portfolios. Therefore, their interests will be not just in the performance of individual firms but also in the monitoring of the portfolio as a whole. Whilst paying attention to the ‘traditional’ agency problems such as alignment of manager and investor interests in individual firms, they also feel that universal owners have a responsibility to discourage firms from creating negative externalities such as pollution, as these will in turn be associated with damaging economic consequences and a

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deterioration of the environment in which we all live and operate. Therefore, universal owners will encourage positive moves such as looking after the workforce, minimising pollution, and in general, adopting policies that have regard for social, environmental and ethical issues. They will therefore be interested in the longer-term view. Also in the US context, Gillan and Starks (1998) highlight that shareholder proposals were used extensively by individual shareholders, and by church and political groups, from the mid-1940s onwards. However, from the mid-1980s, institutional investors became more dominant and active in corporate governance, utilising a range of tools from shareholder proposals, to dialogue, to voting. Gillan and Starks point out though that monitoring activities undertaken by institutional investors are not costless. Whilst an individual institutional investor incurs monitoring costs, other institutional investors can participate in any resulting gain arising from the monitoring activities, that is, there is an element of being a free rider. So to undertake monitoring activity, institutional investors have to have the capacity to absorb the associated costs. However, gains resulting from the activity should help offset these costs. Monks and Sykes (2002) identify that in both the UK and the USA, it is the collective power of institutional shareholders, which will give them real power and influence in their investee companies. They highlight the need for the interests of CEOs and corporate boards to be re-aligned with those of their shareholders, as “the overwhelming proportion of the massive and widespread loss of shareholder value in both America and Britain is due to unchecked corporate management excess, not criminal action.” (Monks and Sykes, 2002, p.24)

Whilst there are a lot of weaknesses in the current system, Monks and Sykes (2002, p.25) feel that “the prime weakness underpinning all the others is undoubtedly the absence of effective, committed, knowledgeable long-term owners”. In their conclusions, they state that “it is no longer politically acceptable to tolerate the largely passive absentee ownership practices of pension fund trustees, institutional shareholders and their fund managers.” (Monks and Sykes, 2002, p.36)

In relation to the governance challenge facing investors, Montagnon (2004) states that “some investors can sell companies they don’t like, but this doesn’t always apply to insurance companies who are not hedge funds. With-profits funds may turn over only once in ten years. We therefore have to show an interest in the way companies are run. We owe it to the people who save with us.” (Montagnon, 2004, p.180)

It does seem then as though there is a wider recognition that institutional shareholders should be more proactive in their investee companies, as they have a duty to try to ensure the long-term sustainability of shareholder value for their ultimate beneficiaries. Cadbury and Millstein (2005) point out that although more institutional shareholders are taking on board their responsibilities to the governance agenda, “still too few institutional shareholders are actively and intelligently engaging with boards. But the trend is heading in the right direction.” (Cadbury and Millstein, 2005, p.13)

The emergence of such an influential institutional investor group has implications for both their relationship with the companies in which they invest (investee companies) and also for the ultimate beneficiaries. In the case of pension funds, the ultimate beneficiary is

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the ‘ordinary’ man/woman in the street who invests into a pension and whose pension contribution is then invested by institutional shareholders into one of their portfolio companies. In the case of insurance companies, the ultimate beneficiary is the holder of the insurance policy. In the past, it has seemed that the ultimate beneficiaries have no say in how their funds are invested. However, as can be seen from Davis et al. (2007), there is a perception that this is changing. Davis et al. point out that “in North America, Europe, Japan, and increasingly throughout the world, the owners of multinational corporations are the tens of millions of working people who have their pensions and other life savings invested through funds in shares of the world’s largest companies. Their nest eggs constitute majority ownership of our corporate world.” (Davis et al., 2007, p.xi)

They identify the ‘clout’ of the new capitalists: “the individual shareowners (new capitalists) are awakening to citizen investor power around the world, spurring institutional investors to adopt responsible portfolio and activist strategies which prompt boards of directors to embrace sweeping reform making them accountable to shareowners, creating an agenda for corporations and corporation executives who are turning to a new ‘capitalist-manifesto’ path to corporate success, which in turn hands the new capitalists unprecedented clout.” (Davis et al., 2007, p.xiv)

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Short-termism

There has been much debate in the past about whether the stock markets, and institutional shareholders in particular, are short-termist. The implications of short-termism are serious in as much as there would be a focus on the short-term performance of a company, with performance measured, for example, on earnings per share. Such a fixation on bottom line earnings could influence the choice of accounting policy, capital expenditure decisions, investment decisions and a myriad of other choices. Marsh (1990) found that the UK stock market was not short-termist but still a strong feeling persisted that it was. The Myners Review (2001) had a section on short-termism, although its findings were inconclusive. Young and Scott (2004) when discussing investment institutions stated that “Fund managers whose investment performance falls below that of the chosen comparators tend to be replaced … As fund managers typically report four times a year on their performance, two bad quarters will place extreme pressure on them to ‘do something’ … So what in times gone by tended to be an alliance between fund manager and company based on relationship and performance has become one based on short-term performance alone.” (Young and Scott, 2004, p.36)

Similarly, Rappaport (2005) stated that “In practice, investment managers attach substantial weight in stock selection to short-term performance, particularly earnings and tracking error. Corporate executives blame this behavior for their own obsession with short-term earnings.” (Rappaport, 2005)

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Rappaport goes on to explain why maximising long-term cash flow is the most effective way to create value for shareholders and suggests ways in which the obsession with short-term performance may be alleviated. Cadbury and Millstein (2005) discuss the investment horizons of fund managers, which seem to persist on focussing on quarterly earnings, and although they applaud the establishment of the Enhanced Analytics Initiative (EAI) and other initiatives, which try to combat this short-term focus, they state that “there is simply no avoiding the issue of institutional ‘short-termism’ warping capital markets” (Cadbury and Millstein, 2005, p.20). The TUC (2006) review the various pressures, perceived and real, that seem to fuel short-termism. In the conclusions, they state that “a wide range of organisations with differing backgrounds believe that there are structural issues within the pensions investment that may lead to short-termism and in turn create negative outcomes … Already practical proposals for reform are being debated and, to a much lesser extent, being put into practice.” (TUC, 2006, p.27)

When discussing short-termism and the pressure on fund managers to perform, it also highlights the complexity of the fund management business itself. Most large fund managers (institutional shareholders) will invest in tracker, or indexed, portfolios. This means that they own a certain percentage of each company in a given index, for example, the FTSE 100, based on the market capitalisation of each company within that index. In this investment approach, they are essentially investing for the longer term, as if they sell shares in a company in the index, then their portfolio is unbalanced and is no longer a true tracker, or indexed, fund, as it no longer mirrors the market constituency for that particular index. Corporate governance is often associated with taking a longer-term interest in the company, building a relationship with it, engaging with it. Yet, this is at odds with the buy/sell side of the fund management business where an emphasis on short-term performance still persists. It could be argued that responsible investment means investing for the longer term and not putting any pressure on corporate boards to produce short-term ‘highlights’ to the detriment of longer-term sustainability and performance. The complexity of the fund management business itself was mentioned and in relation to this aspect, certain potential conflicts of interest should also be pointed out. Conflicts of interest may relate to issues with the fund management house itself, such as the buy/sell side aspects; there may be conflicts of interest in relation to other institutional shareholders, where they have different policies in relation to the same company, or condone activities, which another institutional investor does not approve of. Finally, there may be conflicts of interest between what the fund manager perceives as being in the interests of the trustees (who appoint the fund managers to manage the pension funds and to whom the legal responsibility is owed) and the ultimate beneficiaries of the plan being the pension fund retirees.

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Conclusions

In this paper, we have seen how the trend of share ownership has changed in many countries and that the institutional shareholders comprising mainly pension funds,

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insurance companies and mutual funds have become the key players in many markets. With the growth in pension plans, and the accompanying continued growth in investment being channelled into these with populations looking forward to more longevity, institutional shareholders will quite likely become more and more powerful. Also because institutional shareholders manage funds on behalf of others, they have a responsibility to act as shareowners, not just as shareholders, notwithstanding potential problems caused by short-termism, and potential conflicts of interest. Many of the arguments for the active involvement of institutional shareholders in the corporate governance of their investee companies centre on the fundamental belief that good governance can help sustain, or increase, shareholder value in the longer term. However, Cadbury and Millstein (2005) also provide further important justifications for good governance that “the benefits of governance transcend economics. Enhanced consumer welfare brought about by efficient companies run by good managers increases the standard of living, narrows the gap between rich and poor and eases societal pressures that breed terrorism. It bolsters the social safety net of health care and retirement benefits. Poverty is alleviated and the welfare of populaces improved. The whole world benefits, including the beneficiaries of the institutions that can make it a reality.” (Cadbury and Millstein, 2005, p.29)

References Becht, M., Bolton, P. and Roell, A. (2002) Corporate Governance and Control, ECGI Working Paper Series in Finance, Working Paper No. 02/2002. Cadbury, S.A. (1992) Report of the Committee on the Financial Aspects of Corporate Governance, Gee & Co Ltd, London. Cadbury, S.A. and Millstein, I.M. (2005) The New Agenda for ICGN, Discussion Paper No. 1 for the ICGN 10th Anniversary Conference, July, London. Claessens, S. (2003) Corporate Governance and Development, Global Corporate Governance Forum. Combined Code (2006) The Combined Code on Corporate Governance, Financial Reporting Council, London. Davis, S., Lukomnik, J. and Pitt-Watson, D. (2007) The New Capitalists, How Citizen Investors are Reshaping the Corporate Agenda, Harvard Business School Press, Boston, Massachusetts, USA. Franks, J.R., Mayer, C. and Rossi, S. (2005) Ownership: Evolution and Regulation, ECGI – Finance Working Paper No. 09/2003; EFA Maastricht Meetings Paper No. 3205, AFA 2003 Washington DC, Meetings, http://ssrn.com/abstract=354381 Gillan, S.L. and Starks, L.T. (1998) ‘A survey of shareholder activism: motivation and empirical evidence’, Contemporary Finance Digest, Vol. 2, No. 3, pp.10–34. Gillan, S.L. and Starks, L.T. (2003) Corporate Governance, Corporate Ownership, and the Role of Institutional Investors: A Global Perspective, Weinberg Center for Corporate Governance Working Paper No. 2003-01, Available at SSRN: http://ssrn.com/abstract=439500 Hawley, J.P. and Williams, A.T. (2000) The Rise of Fiduciary Capitalism: How Institutional Investors can Make Corporate America More Democratic, University of Pennsylvania Press, Pennsylvania, USA. ICGN (2007) Statement of Principles on Institutional Shareholder Responsibilities, International Corporate Governance Network, London. ISC (2002) The Responsibilities of Institutional Shareholders and Agents – Statement of Principles, Institutional Shareholders’ Committee, London.

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ISC(2005) Review of the Institutional Shareholders’ Committee Statement on the Responsibilities of Institutional Shareholders and Agents’, Institutional Shareholders Committee, London. Marsh, P. (1990) Short-termism on Trial, Institutional Fund Managers’Association, London. Monks, R. and Sykes, A. (2002) Capitalism Without Owners will Fail: A Policymaker’s Guide to Reform, Centre for the Study of Financial Innovation, London. Montagnon, P. (2004) ‘The governance challenge for investors’, Corporate Governance: An International Review, Vol. 12, No. 2, April, pp.180–183. Myners Review (2001) Institutional Investment in the United Kingdom: A Review, HM Treasury, London. Office of National Statistics (2007) Share Ownership, A Report on Ownership of Shares, as at 31 December 2006’, HMSO, Norwich. Organisation for Overseas Co-operation and Development (OECD) (2004) Principles of Corporate Governance, OECD, Paris. Organisation for Overseas Co-operation and Development OECD (2006) Guidelines on Pension Fund Asset Management, OECD, Paris. Rappaport, A. (2005) ‘The economics of short-term performance obsession’, Financial Analysts Journal, Vol. 61, No. 3, May–June, pp.65–79. Trades Union Congress (TUC) (2006) Addressing Corporate and Investor Short-Termism, London. Young, D. and Scott, P. (2004) Having their Cake … How the City and Big Bosses are Consuming UK Business, Kogan Page, London.

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Int. J. Corporate Governance, Vol. 1, No. 1, 2008

Takeovers, corporate control, and return to target shareholders Han Donker* and Saif Zahir College of Science and Management, University of Northern British Columbia, Canada E-mail: [email protected] E-mail: [email protected] *Corresponding author Abstract: In this paper, we investigated the impact of ownership concentration on the returns to target shareholders. In order to determine such impact, we have employed three models namely:

• • •

the atomistic shareholder model the large shareholder model the single shareholder model.

We found empirical evidence that the degree of ownership concentration in target firms has a significant negative effect on the returns to shareholders. These findings are consistent with the theoretical takeover models which support a negative relationship between bid premium and ownership concentration of target firms. Keywords: takeovers; free-rider problem; corporate control; ownership structure. Reference to this paper should be made as follows: Donker, H. and Zahir, S. (2008) ‘Takeovers, corporate control, and return to target shareholders’, Int. J. Corporate Governance, Vol. 1, No. 1, pp.106–134. Biographical notes: Han Donker is an Associate Professor of Accounting at the University of Northern British Columbia (Canada) and he is the Editor-in-Chief of the International Journal of Corporate Governance (IJCG). He received his PhD in Finance from Tilburg University (CentER, The Netherlands). Previously, he worked as a manager of the Department of Business Administration at KPN Telecom in the Netherlands. His research focuses on empirical issues of takeovers, corporate restructuring and corporate governance. He is an author of many publications on corporate governance, mergers and acquisitions, and international accounting. Saif Zahir is an Associate Professor of Computer Science at the University of Northern British Columbia (Canada) and he is the Editor-in-Chief of the International Journal of Corporate Governance (IJCG). He received his MS and PhD Degrees in Electrical and Computer Engineering from the University of Wisconsin and the University of Pittsburgh respectively. His research areas are in corporate governance, business ethics, information technology and image processing. He authored more than 50 journal and conference papers in different areas. In addition he chaired many technical sessions in international conferences.

Copyright © 2008 Inderscience Enterprises Ltd.

Takeovers, corporate control, and return to target shareholders

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Introduction

In the case of mergers and acquisitions, ownership concentration significantly influences the returns to target shareholders. Theoretical models have demonstrated that the wealth to shareholders of target firms is at its maximum when ownership is atomistic (widely held). Grossman and Hart (1980) have proved that in target firms with widely held shareholdings, shareholders believe that they have no influence on the share price and will behave as free-riders. Shareholders of target firms are keen to free-ride in order to capture the post-takeover value-enhancements realised by bidding firms. They argued that the decision of any individual target shareholder does not affect the success of a tender offer outcome. No target shareholder will accept any conditional bid below the post-takeover value of the target company. As a result, bidding firms will be successful when they pay out all the post-takeover benefits. In such a case, the takeover premium will be at a maximum level. Bagnoli and Lipman (1988), as well as Holmström and Nalebuff (1992), analysed takeover models with a finite number of shareholders in which bidders can overcome the free-rider problem by making some shareholders crucial. When a shareholder becomes crucial (large), he or she can affect the outcome of the takeover. This concept makes it possible for bidders to lower their bid premium and gain from takeovers. Shleifer and Vishny (1986) and Hirshleifer and Titman (1990) solved the free-rider problem by introducing a large shareholder (bidder with toehold) who is willing to take over a target firm even if he or she can realise small post-takeover value-enhancing improvements. As a result, the higher the toeholds of the bidder, the lower the minimum level of value-increasing improvements and the lower the takeover bid premium. In the case of a single shareholder model, the bidding firm has to bargain with the controlling shareholder of the target firm. Corporate sell-offs are good examples of the single shareholder model in which the parent firm is the controlling shareholder of the subsidiary (target firm). This paper provides several contributions related to the impact of ownership structure on takeover premiums. In our research, we incorporate the whole ownership spectrum from single shareholder to widely held firms in one study which is done for the first time. Our results provide empirical evidence that the higher ownership is concentrated, the lower the cumulative abnormal returns to target shareholders. This is consistent with Grossman and Hart (1980), Shleifer and Vishny (1986), Hirshleifer and Titman (1990), Bagnoli and Lipman (1988), as well as Holmström and Nalebuff (1992) who support a negative relationship between bid premium and ownership concentration of target firms. The paper proceeds as follows. The next section, we develop our hypothesis. In Section 3, we describe our sample and research methodology, and in Section 4, we present our results. Section 5 discusses the implications of our results and finally we present the conclusions.

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Hypotheses development

In the atomistic shareholder model, Grossman and Hart (1980) explain that, without dilution, the free-rider problem completely excludes bidders from capturing any of the post-takeover value increases. They argue that atomistic shareholders have the ability to free ride on a bidder’s attempt to improve the value of the target. The decision of any

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individual target shareholder does not affect the success of a tender offer outcome. No shareholder will accept any conditional bid below the post-takeover value of the target company. The target shareholders will refuse to tender until the bidder is prepared to pay out all post-takeover gains. Not tendering is a dominant strategy when the bid is conditional. As a result, raiders will be successful when they pay out all post-takeover benefits. In this case, the takeover premium will be at a maximum level and hence takeovers are not profit. In order to solve this problem, Grossman and Hart (1980) suggest that bidders should prevent target shareholders from capturing post-takeover value-increasing opportunities. Holmström and Nalebuff (1992) argue that the free-rider problem depends on the assumption of equal and indivisible shareholdings. There is no possibility to split up the surplus, because each shareholder has only one share (one-share-per-shareholder model). Therefore, tendering is an all-or-nothing decision. Target shareholders are atomistic and behave as price-takers. Bagnoli and Lipman (1988) show that when there is a finite number of shareholders, some of them must be crucial (in the sense that they do recognise that they may influence the takeover outcome). Once a shareholder is crucial, he will tender his shares at a small takeover bid premium (otherwise, the takeover may fail). The main outcome of increased ownership concentration is that if shareholders become crucial and recognise that they can influence the takeover outcome, they will accept a low takeover bid premium. Holmström and Nalebuff (1992) demonstrate that once shareholdings are large and potentially unequal, a bidder may capture a part of the post-takeover value improvements. Shleifer and Vishny (1986) argue that large shareholders are valuable for firms because they will monitor incumbent management. Shleifer and Vishny (1986) demonstrate that the value of the firm increases when there is a large shareholder who forces incumbent management to implement value-increasing changes in corporate strategies. Such improvements may not lead potential bidders to offer a high premium above the prevailing stock price due to the likelihood of post-takeover value-enhancing improvements reduction. Shleifer and Vishny (1986) point out that the takeover bid premium above the prevailing stock price is lower if there is a large shareholder. If the large shareholder owns more shares, then he is willing to take over the firm for a smaller increase in the post-takeover profits of the target firm. In addition, Hirshleifer and Titman (1990) show that the average bid premium declines if initial shareholdings of the bidder increase. A higher toehold of the bidder makes it more profitable for lower-type bidders to make an offer; hence, the average bid declines. Large shareholders can rigorously monitor target management. As a result of such effective monitoring, firms are valued higher, and potential bidders will offer a lower takeover premium (because of the limited value-increasing post-takeover opportunities). Large outside shareholders use rigorous monitoring to discourage incumbent management from shirking. In very diffusely owned firms, the monitoring costs that each individual shareholder would have to bear to prevent management from consuming externalities, such as perquisites through management, is relatively high. The divergence between benefits and costs of monitoring is more favourable for large shareholders than for small shareholders (Demsetz and Lehn, 1985). Burkhart (1995), Liebler (1997) and Singh (1998) have come up with alternative hypotheses.1 Liebler (1997) argues that the larger the toehold of the bidder, the higher the probability of takeover success. The opportunity for target shareholders to free ride increases. Therefore, the bidder will pay a larger takeover bid premium. Burkhart (1995)

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and Singh (1998) argue that the bidder will overbid in order to extract a counter offer from another bidder. When the large shareholder loses the takeover contest, he will gain on his initial shareholdings because he can sell these shares at a high price to the winning bidder. In the takeover models of Grossman and Hart (1980), Shleifer and Vishny (1986), Bagnoli and Lipman (1988) and Holström and Nalebuff (1992), the takeover premium decreases with ownership concentration. In the atomistic shareholder case of Grossman and Hart (1980), the takeover bid premium is at its maximum level. As shareholders become crucial (pivotal), a lower takeover bid premium will be sufficient (Bagnoli and Lipman, 1988). In the large shareholder model of Shleifer and Vishny (1986), a small bid premium will be enough to take over the target firm. As a result, they suggest a negative relation between ownership concentration in target firms and the bid premium paid in the takeover. However, Burkhart (1995), Liebler (1997) and Singh (1998) suggest a positive relation between ownership concentration (large initial stake) and the takeover bid premium. Slusky and Caves (1991) suggest that large shareholders increase the value of the firm through intensive monitoring of incumbent management. Hence, the takeover bid premium decreases with the fraction of outside shareholdings. They find statistically significant evidence for a negative relation between the takeover bid premium and the concentration of external shareholdings. Sudarsanam et al. (1996) find that the bid premium is small for target firms with large shareholders.2 Högfeldt and Högholm (2000) argue that large shareholders of target firms hold the bargaining power in takeover negotiations. If this bargaining power is severe, they can enforce a higher takeover bid premium. However, they do not find support for their hypothesis. More than that, they find a negative relation between large shareholdings and the returns to target shareholders, which implies that a large shareholder, who is crucial, cannot capture all the post-takeover value-enhancing improvements. Hypothesis 1: The cumulative abnormal returns to target shareholders decrease with the degree of concentration in the ownership structure of the target company. The convergence-of-interest hypothesis emphasises the joint interests of managers and outside shareholders. Jensen and Meckling (1976) argue that the costs of deviation from value-maximisation will decline if managerial shareholdings rise. High levels of management ownership encourage management to behave in the interest of the shareholders, and squander a lesser amount of corporate wealth. Monitoring by the board of directors will force managers to act in concert with the interests of outside shareholders. The interests of outside shareholders and managers converge when management ownership increases according to the convergence-of-interest hypothesis. The value of the firm will increase, the larger the fraction of shares held by the management. Agency problems arise whenever management owns fewer than the total number of common shares of the firm. Accordingly, agency problems are severe at low levels of managerial ownership. If management is not operating efficiently, then replacement will cause a value increase. If replacement of inefficient management causes large post-takeover value improvements, then potential bidders are willing to pay a higher takeover premium. Therefore, firm value will be low at low levels of managerial ownership (severe agency problems). At the same time, a potential bidder is more likely to offer a high bid premium, because of the low current value of the target firm and the prospects of high post-takeover value improvements.

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Stulz (1988) devised a model in which (at low levels of management ownership) increased managerial shareholdings enhance the convergence of interests between management and outside shareholders. As a result, firm value increases. At high levels of management ownership, managerial entrenchment will arise and cause bid resistance to takeover attempts. Takeovers become more costly. He shows that an increase in the fraction of shares held by the management of target firms decreases the likelihood of a tender offer. Tender offers will be successful only if the bidder is willing to offer a large takeover bid premium. Assuming an upward-sloping supply curve for target shares, Stulz argues that if target management tenders for a low premium, then bidders have fewer shares to acquire from atomistic shareholders. However, when management does not offer its shares or offers them just for high bid premiums, then bidders are forced to buy a larger fraction of shares from the atomistic shareholders. As a result, the bidder is forced to acquire shares from shareholders with higher reservation prices. The crucial shareholder is higher on the supply curve and forces the bidder to pay a higher bid premium to the target shareholders, which means that the bidder receives a smaller fraction of the post-takeover gains. The prediction of the entrenchment hypothesis is that there is a positive relation between managerial ownership and the takeover bid premium. Mikkelson and Partch (1989) report (in accordance with the results of Stulz, 1988) that target firms with low management holdings can be taken over at lower prices because managers are more willing to allow a takeover. Another reason for a positive relationship between managerial shareholdings and the returns to target shareholders is that managers will be compensated for their losses. Particularly in hostile takeovers, managers fear loss of employment and other non-pecuniary losses when the takeover is successful. An alternative explanation for a positive relation between management ownership and the returns to target shareholders is that management will increase its bargaining power at higher levels of managerial shareholdings. Management with high bargaining power has a stronger position in negotiations. Consequently, target management will drive up the takeover price, which will increase the returns to target shareholders. Billett and Ryngaert (1997) argue that managers will tender at higher takeover premiums in comparison with institutional shareholders, because they will tender only if they are compensated for the loss of control benefits. A number of empirical studies have tested the relationship between managerial ownership and market valuation of the firm’s assets in order to distinguish between both hypotheses. Morck et al. (1988) find a non-linear relation between management ownership and Tobin’s q.3 They have tested firm performance at different levels of managerial ownership and report a positive relationship between 0% and 5%, a negative, but less pronounced, relationship between 5% and 25% and a positive relationship above 25%. They suggest that entrenchment dominates between 5% and 25%, and the convergence-of-interest hypothesis holds between 0% and 5%, and above 25%. McConnell and Servaes (1990) reported a significant curvilinear relation between Tobin’s q and insider ownership. First, Tobin’s q increases towards the inflection point4 and decreases beyond that point – although the downward slope is not steep. Others, such as Morck and Yeung (1992), recognised the existence of a non-linear relation between firm value and insider holdings. The value of the firm rises at the beginning with insider holdings (convergence-of-interest hypothesis), and then falls with insider holdings (entrenchment hypothesis). In order to test this non-linear relation for bidding firms,

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Morck and Yeung (1992) use the fraction of insider holdings5 and an indicator variable6 to measure convergence-of-interest and entrenchment. They examine the influence of insider holdings on the abnormal returns for bidding firms and found significant support for convergence of interest (alignment) at low levels of insider holdings, and entrenchment at insider holdings above 20%.7 Cotter and Zenner (1994) and Bugeja and Walter (1995)8 find a negative relation between managerial shareholdings and the returns to target shareholders. Their results are consistent with the convergence-of-interest hypothesis which predicts a negative relation between managerial shareholdings and the takeover bid premium.9 Stulz et al. (1990) examine 104 successful takeovers bids from 1968 to 1986. Managerial ownership contains target stock ownership of officers, directors, and other insiders reported by Value Line. They find that managerial ownership has a positive effect on the target’s abnormal return,10 but is significant only in the multiple-bidder sample. They suggest that the management of the target firm, which has a large stake, is better off in transforming the auction into a multiple-bidder contest. Song and Walking (1993) also find support for a positive relation between managerial shareholdings and the cumulative abnormal returns to target shareholders in their sample of contested successful takeovers. Hypothesis 2a: The takeover premium is a decreasing function of managerial shareholdings (convergence-of-interest hypothesis). Hypothesis 2b: The takeover premium is an increasing function of managerial shareholdings (entrenchment hypothesis). Effective and constant monitoring of management is a costly process, only large shareholders and bondholders are motivated to monitor incumbent management and actively participate in the corporate strategic decisions. This implies that target firms with active institutional investors will be properly valued, because firms with large monitoring shareholders will operate efficiently. The activism of institutional shareholders will increase the value of the firm and will lower agency costs. Because of the high valuation of these target firms, bidding firms will offer a small bid premium just above the current share price of the target firm. Gillan and Starks (2000) mentioned that opponents of institutional shareholder activism are sceptical about the expertise of institutional investors to advise management on corporate strategic decisions. The criticism is focused on the issue of whether shareholder proposals change corporate investment decisions. In the literature, there is another approach that considers the behaviour of institutional investors on the capital market. Stulz et al. (1990) suggest that typical institutional investors are in low tax brackets. The larger the fraction of institutional investors in low tax brackets, the lower the premium offered by bidders and the smaller the takeover gains to the target shareholders for a given total takeover gain. Institutional shareholders are on the lower part of the supply curve. A small premium over the current share price will be sufficient to buy these shares. Furthermore, institutional shareholders are likely to have low transaction costs and information costs. Stulz et al. assume that institutional investors ignore their influence on the probability of tender offer success, because the number of different institutional investors is generally large. The authors assume that institutional investors behave as atomistic shareholders. If the fraction of shares held by institutional shareholders is large, then the crucial shareholder is lower on the supply curve and the premium offered by the bidder will be lower. Stulz et al. (1990) and Billet and Ryngaert (1997)11 find support for shareholder activism. They report that institutional holdings have a negative effect on the abnormal returns to target shareholders.

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Hypothesis 3: The takeover premium is a decreasing function of institutional shareholdings (monitoring hypothesis). Bradley et al. (1988) estimated a significantly positive slope supply of target shares. The cumulative abnormal returns to target shares in successful tender offers is an increasing function of the fraction of target shares purchased in the offer by a successful bidder. Bradley et al. (1988) find a slope coefficient (0.167) of the supply curve that was significantly positive (t = 4.26). Bagwell (1992) shows that in a Dutch auction stock repurchase, the average elasticity of the supply curve is equal to 1.65.12 In order to purchase 15% of the outstanding target shares, a bidder must offer a 9.1% premium above its pre-announcement market price. Stulz et al. (1990) report that in the sample of multiple-bidder contests, the target gain is a significantly decreasing function of the fraction of target shares held by institutional investors and increasing with managerial ownership. This is consistent with the hypothesis that institutional investors with low capital gains tax rates are more likely to tender for a given premium. It is also consistent with the hypothesis that managerial resistance will lead to a higher premium being offered by bidders. In that case, bidders have to receive more shares from the remaining group of atomistic shareholders which implies that the crucial shareholder is higher on the supply curve. Bradley et al. (1988), Eckbo and Langohr (1989),13 Stulz et al. (1990), Song and Walking (1993) and Billett and Ryngaert (1997)14 find empirical evidence for an upward-slope supply curve of target shares, which mean that the return to target shareholders will be positively related to the outstanding shares acquired by bidders.15 Eckbo and Langohr (1989) find a significantly positive effect of the fraction of shares purchased by bidders on the takeover premium. Hypothesis 4: The greater the percentage of shares acquired by the bidder, the higher the cumulative abnormal returns to target shareholders (upward-slope supply curve). Bradley et al. (1988) and Stulz et al. (1990) argue that competition between bidders increases the demand for target shares. With an upward-slope supply curve for target shares, increased demand for target shares implies that the takeover price will be higher on the supply curve for target shares. The impact of competition on the returns to bidding firms is ambiguous. One can distinguish between the winner’s curse and high valuation signalling. Generally, competition between bidders will drive up takeover bid premiums. Roll (1986) developed the winner’s curse, which suggests that the return to bidders is negative. He proposes that managers of bidding firms overestimate the value of their targets (winner’s curse; hubris hypothesis). However, when other bidders appear in the takeover battle, the return to the first bidders may be positive, because the probability of their takeover success decreases with competition. First bidders will gain on the holdings they already possess. Fishman (1988) launched a model of pre-emptive bidding, which provides a rationale for bidding firms to offer high pre-emptive initial bids if there is competition, rather than making low initial offers and raising them little by little (English auction). Fishman analyses a two-bidder model with strategic interaction between bidders. The model starts with a first bidder who makes an initial offer. A second bidder revises his prior information about the first bidder’s valuation. After updating his beliefs, the second bidder determines his bidding strategy. When a first bidder determines his initial offer, he takes the updates and decisions of the second bidder in his calculations. Fishman called this strategic interaction. The higher the private valuation of the first bidder, the lower is the second

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bidder’s expected outcome from entering the bidding process. In equilibrium, a first bidder may offer a high bid premium (pre-emptive) in order to signal a high valuation and to discourage a second bidder from making a competing bid. On the other hand, a low bid premium of the first bidder indicates a low private valuation and encourages a second bidder to enter the takeover contest (De et al., 1996).16 The pre-emptive bidding models have in common that first bidders offer high bid premiums, either to signal the market that there are high valuation bidders or to provoke a high counter-offer.17 Alternatively, an offer announcement of a bidder may be a signal to other potential bidders that there are high synergistic gains are available in the target firm. The presence of high potential gains in the target firm will attract more bidders who can generate high net present value takeovers. In that case, competition in takeovers is also a signal that the creation of wealth is not firm-specific (Shleifer and Vishny, 1989). Numerous empirical studies have investigated the impact of competition on the returns to shareholders. Bradley et al. (1988) examine 236 tender offer contests, which include 163 single-bidder contests and 73 multiple-bidder contests between 1963 and 1984. The abnormal returns to target shareholders [–20, +5] represent 4.5% points higher in the multiple-bidder sub-sample than in the single-bidder sub-sample. The abnormal returns to bidding firms [–5, +5] represent (–0.95%) for the multiple-bidder sub-sample, and positive (1.55%) for the single-bidder sub-sample. In the regression model, the coefficient on competition between bidders is significantly positive (t = 4.23) for the abnormal returns to target shareholders, and insignificantly negative (t = –1.32) for the abnormal returns to bidding firms. They conclude that the net effect of multiple-bidder contests is to increase the abnormal returns to target shareholders and to decrease the abnormal returns to bidding firms. Stulz et al. (1990) examine 104 successful takeovers from 1968 to 1986, and find that the average cumulative abnormal return for target shareholders is 45.58% in the multiple-bidder sub-sample. The average cumulative abnormal return for target shareholders is significantly (t = 14.27) higher in the multiple-bidder sub-sample than it is in the single-bidder sub-sample. The average abnormal return for bidders is –4.21% (t = –1.11) in multiple-bidder contests. Hypothesis 5a: The cumulative abnormal returns to target shareholders increase with competition. Hypothesis 5b(1): The cumulative abnormal returns to bidding firms increase with competition (signalling high synergistic gains). Hypothesis 5b(2): The cumulative abnormal returns to bidding firms decrease with competition (overbidding). Shleifer and Vishny (1986) predict a negative relation between initial shareholdings and the bid premium. A low bid signals a small increase in the post-takeover value of the target. It is in the interest of the large shareholder to convince small shareholders that he will continue with low value improvements after the takeover occurs. Hirshleifer and Titman (1990) argue that the probability of takeover success increases with the takeover premium and the initial holdings of the bidder. They further suggest that the probability of an offer’s success decreases with the fraction of shares necessary to acquire control. They argue that the average bid premium decreases with the initial shareholdings held by the bidder in the target firm. Larger toeholds make it profitable for lower-type bidders

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with smaller improvements to profit on their bids. As a result, the average bid declines under Hirshleifer and Titman’s model. Stulz et al. (1990) explained that large initial shareholdings held by the bidder imply that fewer shares of stocks need to be tendered for a successful outcome. This means that the crucial shareholder is lower on the supply curve. Therefore, the larger the toehold of the bidder, the lower the bid premium offered to target shareholders. In contrast with the previous studies, Chowdhry and Jegadeesh (1994), Burkhart (1995), Liebler (1997), and Singh (1998) suggest a positive relation between the bid premium and initial shareholdings. Chowdhry and Jegadeesh (1994) predict that the extent of the shareholdings prior to the tender offer will be positively related to the tender offer premium. The Chowdhry and Jegadeesh model assumes that the shares of target firms are held by atomistic shareholders and that the potential synergistic gains obtained from the corporate takeover are known only to the bidder (private information). The initial shareholdings of the bidder signal his private information about synergistic gains. Chowdhry and Jegadeesh (1994) argue that bidders with low toeholds signal that the post-takeover improvements will be small; they are thus able to offer a lower bid premium. The high valuation bidder will not follow the low valuation bidder because the benefits of a low bid are offset by the costs of mimicking. These costs contain the lower probability of takeover success as well as the opportunity of acquiring a larger fraction of target shares at the lower pre-tender offer price. The opportunity cost of an unsuccessful offer is greater for the high valuation bidder. As a consequence, a high valuation bidder has no incentive to mimic a low valuation bidder with a small toehold. The size of the toehold is used to signal the post-takeover value of the target. Burkhart (1995) model shows that initial shareholdings lead bidders to overbid. Bidders with a toehold may have an incentive to submit a high bid in order to provoke a high counterbid. The bidder with a toehold has an incentive to offer a price per share that is in excess of the post-takeover value of the target. Whereas the models of Shleifer and Vishny (1986), Hirshleifer and Titman (1990) and Stulz et al. (1990) predict a negative relation between toehold and bid premium, the models developed by Chowdhry and Jegadeesh (1994), Burkhart (1995), Liebler (1997) and Singh (1998) propose an opposite relation. The Chowdhry and Jagadeesh model (1994) predicts the opposite relation between the level of initial shareholdings and the cumulative abnormal returns. Figure 1 provides an overview of the literature on initial shareholdings and bid premiums. Several empirical studies have examined the impact of toeholds on bid premiums and shareholder wealth. The US studies of Walking and Edmister (1985), Robinson and Shane (1990), Stulz et al. (1990) and Billet and Ryngaert (1997), as well as the Australian study of Bugeja and Walter (1995), and the UK study of Sudarsanam et al. (1996), find empirical evidence that is consistent with the Shleifer and Vishny (1986) model. Walking and Edmister (1985) consider initial shareholdings of the bidder as a direct measure of bargaining strength. If bidders have a strong bargaining position, they may acquire the target at a low premium. Walking and Edmister (1985) define the bid premium as the percentage difference between the bid price specified in the offer and the target’s market price 14 days prior to the offer announcement date. They find a significantly negative relation between the bid premium and the initial shareholdings of the bidder. Conversely the French study of Eckbo and Langohr (1989), and the UK study of Franks and Harris (1989) the Chowdhry and Jegadeesh model (1994).

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Hypothesis 6a: The larger the initial shareholdings of the bidder, the higher the bid premium offered to the shareholders of the target firm. Hypothesis 6b: The larger the initial shareholdings of the bidder, the lower the bid premium offered to the shareholders of the target. Figure 1

3

Initial shareholdings and the bid premium

Research methodology and the study sample

3.1 Research methodology In this research, we consider the whole spectrum of corporate ownership structure. To do so, we classify takeover models based on the number of bidders (demand) and the ownership structure of target firms (supply). Table 1 shows such classifications. If a shareholder gains control over a company, we assume that he owns a portion (αi) of shares greater than 0.5 of the total shares [0.5 < αi ≤ 1]. This case is called the single-shareholder model or controlling shareholder model, because this shareholder has a controlling power over the firm. Table 1 shows the single-bidder-shareholder model in the form [0.5 < αi ≤ 1; βj = 1] where βj is the number of bidders. For example corporate divestitures, such as sell-offs, can be categorised within this quadrant. The number of bidders [βj > 0] reflects the demand side of the takeover market. We distinguish between a single-bidder situation and a multiple-bidders contest. If each shareholder owns a fraction of shares less than or equal to 0.5, this shareholder is large [0 < αi ≤ 0.5], which means that he has some voting power, but not the absolute controlling power over the company (large-shareholder model). Finally, the atomistic-shareholder model is reflected by a large number of shareholders who own a small number of shares. Each of them owns a small number of shares and has no significant role [αi ≈ 0].

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Table 1

Microeconomic structure of takeover models

Microeconomic structure [αi βj ]

Single shareholder [0.5 < αi ≤ 1; βj]

Large shareholder(s) [0 < αi ≤ 0.5; βj ]

Atomistic shareholders [αi ≈ 0; βj ]

Single bidder [αi βj = 1]

Bargaining modelsc

Shleifer and Vishny (1986), Stulz (1988), Stulz et al. (1990), Hirshleifer and Titman (1990), Chowdhry and Jegadeesh (1994), Liebler (1997) and Högfeldt and Högholm (2000)

Grosmann and Hart (1980, 1981), Bagnoli and Lipman (1988) Bebchuk (1989) and Holmström and Nalebuff (1992)

Multiple bidders [αi βj > 1]

Auction modelsc

Stulz et al. (1990), Burkhart (1995), Sercu and van Hulle (1995) Singh (1998), Giammarino and Heinkel (1986)b, Hirshleifer and Png (1990)b and De and Knez (1994)b

Bradley et al. (1988), Fishman (1988)a, Harrington and Prokop (1993)a and Khanna (1997)a

a

The study is concentrated on the role of bidders, and no explicit characteristics are presumed towards target shareholders; we, therefore, assume that the target firm has widely dispersed ownership – otherwise, the study would have mentioned the role of either management or a large shareholder (initial shareholdings). b The study is concentrated on the role of bidders, but management plays an active role (for example, management resistance, management as a first bidder). c Takeover types such as sell-offs, owner-controlled target firms.

Table 1 presents the microeconomic structure of different takeover models. The microeconomic structure refers to the number of bidders and target shareholders. The number of bidders is represented by βj, and the fraction of shares held by the target shareholders is represented by αi.

3.2 The study sample The sample used in this study consists of mergers and acquisitions that occurred over the period 1987–1996 at the Amsterdam Stock Exchange (AEX). For each target firm, we collected financial data and ownership data from Datastream, Het Financieele Dagblad (Dutch Financial Times) and AFM filings (Authorities Financial Markets). The final sample includes 104 target firms (including parent firms) listed on the Amsterdam Stock Exchange (AEX) from 1987 through 1996. We estimate the following multiple-regression model: CARTj,[t–n,t+n] = α0 + α1 OWNj + α2 MANj + α3 INSj + α4 OUTj + α5 TOEj + α6 ACQj + α7 MTBj + α8 LEVj + α9 SIZEj + α10 DUMFOR j + α11 DUMCOM j + uj, where CARTj,[t–n,t+n] Cumulative abnormal returns over the t – n to t + n event window for firm j Ownership concentration is measured by a HH-index (Herfindahl-Hirsch OWNj index of shareholdings)

Takeovers, corporate control, and return to target shareholders MANj INSj

117

Total percentage of shares held by management Total percentage of shares held by banks, insurance companies, pension funds, investment companies, and venture capitalists Total percentage of block holdings owned by large outside shareholders (other than management and institutional shareholders) who own more than 5% of all outstanding shares Percentage of shares held by the bidding firm prior to the announcement of the takeover Shares purchased by the bidding firm, exclusive of its initial shareholdings Market value (the number of shares times the stock market price 21 days before the announcement day) divided by the book value of equity reported at the end of the year prior to the takeover Total debt divided by the book value of total assets reported at the end of the year prior to the takeover Total sales of the target firm divided by the total sales of the bidding firm reported at the end of the year prior to the takeover Dummy variable for cross-border acquisitions that equals one if the target or bidding firm is a foreign firm Dummy variable that equals one if more than one bidder takes part in the takeover process Measured by a concentration index.

OUTj

TOEj ACQj MTBj

LEVj SIZEj DUMFORj DUMCOM j OWN

Demsetz and Lehn (1985) employ two measures of ownership concentration: the percentage of a firm’s outstanding shares owned by the largest shareholders18 and an index19 of ownership concentration. The HH index is calculated by summing the squared percentage20 of shares controlled by each shareholder: N

HH = ∑ hi2 i =1

where hi

Percentage of shares held by shareholder i.

We construct an alternative HH index that is concerned with the initial holdings of the bidding firm.21 2

    hi 1 HHa = ∑   =  i =1  (100 − ta )   (100 − ta )  N

2

N

∑h

2

i

i =1

where hi

Percentage of shares held by shareholder i

ta

Fraction of initial shareholdings held by the bidder.

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A property of the HH index with squared hi is that large shareholdings carry a greater weight than small shareholdings. Small shareholdings have very little effect on the magnitude. Hence, if the shareholdings of the largest shareholders are known, then an HH index can be computed that will vary only slightly from the actual index based upon knowledge of all shareholdings. An alternative measure of ownership concentration is obtained by the Theil index, which is equal to the sum of the shares multiplied by their logarithm: N

T = ∑ hi ⋅ log hi i =1

where hi

4

Percentage of shares held by shareholder i.22

Empirical results

In this section, we present the results of our research in a tabulated format. Table 2 presents summary statistics for ownership variables of the target firms.23 The ownership structure variables used are obtained from the articles of Het Financieele Dagblad close to the event day (t = 0)2 and filings of major shareholdings from the Authorities Financial Markets (AFM). Table 2

Ownership structure of Dutch target firms from 1987 through 1996

Variable

Meana

Median

Min

Max First quartile Third quartile

Largest shareholder (H1)

26.49

23.93

0

78.53

9.99

41.91

Largest 3 shareholders (H3)

35.84

34.40

0

90.0

15.05

51.25

Largest 5 shareholders (H5)

37.23

34.50

0

90.0

16.52

54.40

Managerial shareholdings (MAN)

6.95

0

0

70.75

0

0

Institutional shareholdings (INS)

14.35

10.0

0

88.0

0

20.0

Ownership concentration (OWN)

2.73

3.04

0

4.0

2.40

3.46

Ownership concentration (Theil)

1.58

1.81

0

2.30

1.34

2.0

Market value (MV)

451

137.62

4.20 4438

37.18

442.71

19.35

0

0

40.18

Toehold (TOE)

0

83.57

a

All variables are significant at 1% level (two-tailed tests).

Table 2 presents the summary statistics of target firms listed on the Amsterdam Stock Exchange involved in successful takeovers during the period 1987 through 1996.a H1, H3, and H5 represent the total percentage owned by the largest (H1), largest three (H3), and the largest five (H5) inside and outside block holders. Managerial shareholdings (MAN) are the total percentage block holdings owned by the managerial board and the supervisory board of the target firm. Institutional shareholdings (INS) are the total percentage block holdings owned by banks, insurance companies, pension funds, venture capitalists and investment companies. Ownership concentration is represented by the logarithmic HH index of ownership (HH), which is calculated by summing the squared

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percentage of shares possessed by the inside and outside block holders adjusted for initial shareholdings held by the bidder. The Theil index of ownership concentration is equal to the sum of the percentage of shares multiplied by their logarithm adjusted for initial shareholdings held by the bidder. Market value (MV) is obtained by multiplying the number of outstanding target shares by its closing market price on the 21st day before the first announcement. Toehold (TOE) of the bidder firm is the percentage owned by the bidder prior to the takeover. Table 2 shows that the average shareholding of the largest shareholder (H1) is 26.49% and the largest three (H3), and five shareholders (H5) are 35.84% and 37.23% respectively. The results in Table 2 indicate that the average managerial (MAN) and institutional (INS) block holdings of our sample equal to 6.95% and 14.35% which are consistent with the findings of de Jong (1999) for non-financial firms listed on the Amsterdam Stock Exchange (AEX) from 1992 through 1996.25 Bidding firms have on average a large toehold (19.35%) in target firms. We find that in 47% of the firms the largest shareholder has a stake of 25% or more. In 17% of the firms, the largest shareholder (H1) has 50% or more (a majority) of the outstanding target shares. The largest three shareholders (H3) have in 64% of the firms 25% or more of the outstanding shares. In 28% of the target firms, they have 50% or more (a majority) of target shares. Our findings correspond with the empirical findings of Kabir et al. (1997) and de Jong (1999). Kabir et al. (1997) find in their sample of 177 industrial companies listed on the Amsterdam Stock Exchange (AEX) in 1992 an average of 30.8% for the largest shareholder.26 de Jong (1999) finds in his sample of non-financial firms listed on the Amsterdam Stock Exchange from 1992 until 1996 that the largest outside block holder owns on average 23.77%. This result is somewhat lower than our findings, but de Jong excludes managerial shareholdings (6.62%). This indicates that ownership concentration in the Netherlands is higher than in the USA. Demsetz and Lehn (1985) find that 24.8% of the outstanding shares were held on average by the largest five shareholders in the USA. Table 2 shows that the distribution of the variables H1, H2, H5, management shareholdings (MAN), institutional shareholdings (INS), market valuation (MV) and toehold (TOE) are positively skewed, while the distribution of the concentration indices (OWN = HH index and Theil index) are negatively skewed.27 In Table 3, we present the correlation coefficients of the sample. The correlation coefficients are relatively low, except for the correlation coefficients of return on equity (ROE), return on assets (ROA), and the market-to-book ratio (MTB). As we expected, ROE and ROA have a highly positive correlation. This also applies for ROE and MTB. The percentage of shares acquired (ACQ) as well as toehold (TOE) are negatively correlated. If the initial shareholdings of bidding firms increase, fewer target shares are needed. Note that the correlation coefficient between institutional target ownership (INS) and ownership concentration in target firms (OWN) is significantly negative. As a result, the larger the institutional shareholdings in the target firm, the lower the ownership concentration in target firms. Financial institutions are primarily represented in more diffusely held target firms. Table 3 presents the Spearman correlation coefficients of the independent variables from the sample of 104 target firms (= total sample) involved in successful corporate acquisitions from 1987 through 1996. The Spearman correlation coefficient is used as a nonparametric measure of correlation between the independent variables. For all of the cases, the values of each of the variables are ranked from the smallest to the largest, and the Spearman correlation coefficient is computed on the ranks.

120 Table 3

H. Donker and S. Zahir Spearman correlation coefficients of independent variables of target firms

*, ** indicates that the correlation is significant at the 5% and 1% levels respectively (two-tailed test). OWN Log of the sum of the squares of ownership percentages in target firms adjusted for toeholds INS Percentage of target shares held by institutional firms MAN Percentage of target shares held by management TOE Percentage of shares held by the bidder prior to the acquisition ACQ Percentage of target shares acquired DUMCOM Dummy variable that equals one if there are multiple bidders DUMFOR Dummy variable that equals one if the target is a foreign company MV Log of the market value of the target company LEV Debt to total assets of the target company MTB Market to book value of the target firm ROA Earnings before interest and taxes, divided by total assets of target firms ROE Earnings before interest and taxes, divided by the book value of equity SIZE Log of the relative size (target to bidder), where size is defined as total sales (for financial institutions, size is defined as total assets).

In Table 4, we explain the significantly positive abnormal returns to target firms (panel A). The Cumulative Average Abnormal Returns (CAARs) of event window [–20, 20] are 12.23%, and significant at the 1% level (t = 5.21). Figure 1 shows that once the news has been assimilated into the stock price of the target, the CAARs remain constant (step function). This may indicate that the market reacts efficiently to publicly available information.28 This figure illustrates the rapid speed at which information is incorporated into stock prices. The abnormal returns for different time intervals are presented in Table 4. It should be noticed that the CAARs for target firms are not significantly different from zero during the post-event window [1, 20]. As can be seen in Figure 2, the slope is horizontal after the announcement day. The abnormal returns for target firms are generated in the pre-event period [–20, –1] and on the announcement day. As shown in Figure 2, the CAARs are based on the market model as well as on the market-adjusted model and the mean-adjusted model during the event window. The CAARs increase constantly during the event window, with a more pronounced increase some days before the event day through ten days after the public announcement.

Takeovers, corporate control, and return to target shareholders Figure 2

Table 4

121

The Cumulative Average Abnormal Returns (CAAR) of 104 target firms from 1987 through 1996 in the Netherlands

Ownership structure and cumulative average abnormal returns of target firms

CAAR

[–20, 20] [–20, –1]

[1, 20]

[–1, 0, 1]

[–5, 5]

Panel A: Event window CAAR t-test Panel B: Ownership structure

12.23

4.42

(5.21)*** (4.75)*** Single shareholder n = 46

CAAR [–20,20] t-test

0.02

8.96

10.36

(0.03)

(4.94)***

(5.30)***

Large shareholders Atomistic shareholders n = 40

n = 18

5.25

17.04

19.36

(1.62)*

(6.00)***

(2.36)**

*, **, *** indicates significance at the 10%, 5% , and 1% levels, respectively (one-tailed test).

Table 4 reports that almost 85% of the CAARs during the total event window [–20, 20] are obtained from the period [–5, 5]. Panel B of Table 4 shows the CAARs to target shareholders. Panel B indicates increasing returns to target shareholders as ownership concentration decreases. For target firms with widely held shareholdings, the CAARs are 19.36%, and significant at the 5% level. The results are consistent with the predictions that ownership concentration in target firms has a negative impact on the returns to target firms and a positive influence on the returns to bidding firms. Table 4 reports the CAAR for target firms during different event windows (panel A) based on market model returns. The sample contains 104 takeovers from 1987 through 1996 in the Netherlands. The ownership structure of target firms is divided into three categories (panel B): single shareholder (large shareholder who owns more than 50% of all shares); large shareholders (those who own more than 10%, but not more than 50% of all shares); dispersed shareholders (those who own not more than 10% of all shares).

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4.1 Regression models Table 5 presents a cross-sectional analysis of the abnormal returns to target firms observed during the announcement period. Models 1–3 regress abnormal returns of target firms against ownership variables, control variables, financial variables and market variables for the total sample of takeovers (n = 104).29 In the models 4 and 5 sell-offs (n = 38) are excluded. The reason for this exclusion is that we cannot directly estimate a supply curve of target shares when these shares are not traded on the stock exchange. All models in Table 5 are statistically significant at the 1% level. The OLS regression models have an R2 of around 30%. To accomplish the relation between abnormal returns and ownership concentration, we construct an ownership-based HH index for each firm at the time of the initial acquisition announcement. To measure an ownership-based HH index, we square all block-holdings of target firms, then sum them and adjust them for initial shareholdings of bidding firms.30 The large shareholder hypothesis suggests a negative relation between the abnormal returns to target shareholders and the concentration of ownership. If large shareholders do not tender their shares, or tender them only for high premiums, they run the risk that they may receive no takeover premium at all. Large shareholders know that their shares may be crucial for a successful offer. Consequently, we would expect that large shareholders lower their reservation prices with the prospect that the offer will succeed; otherwise, they might not receive any premium at all. The opportunity costs of missing a takeover premium increase when large shareholders own a larger fraction of target shares. An alternative hypothesis for a negative relation between the abnormal returns to target shareholders and large block-holdings is monitoring. Due to a free-rider problem, only large shareholders are motivated to undertake monitoring activities and other costly control activities. Shleifer and Vishny (1986) argue that atomistic shareholders have no incentive to monitor incumbent management because monitoring costs are high in comparison with the benefits of holding one share. On the other hand, large shareholders gain from actively monitoring target firms. As a result, target firms with large shareholders are valued properly, and acquirers are unwilling to pay large takeover premiums because post-takeover value-enhancing activities will be lower. The results in Table 5 show that ownership concentration has a strong negative impact on the abnormal returns to target firms (γols1 = –8.995; γols5 = –12.021). The coefficient of the ownership concentration variable is highly significant (tols1 = –3.46; tols5 = –2.79). Our findings support the large shareholder hypothesis or monitoring hypothesis. Sudarsanam et al. (1996) estimate a negative coefficient (γ = –0.18; t = –2.30) that supports the efficient monitoring hypothesis.31 We propose that bidders face an upward-sloping supply curve of target shares. In order to test the slope of the supply curve, the percentage of shares acquired by the bidder on the returns to target shareholders. The estimated coefficient on the fraction of target shares purchased is positive (γols1 = 17.5%; γols2 = 19.2%) and significantly different from zero (tols1 = 2.20; tols4 = 2.01). The positive coefficients are consistent with a positively sloping supply curve of target shares. By comparison, Bradley et al. (1988) report a statistically significant coefficient on the fraction of target shares purchased (γ = 16.7%; t = 4.26). Their sample contains 236 successful tender offers between 1963 and 1984 in the USA. In regression model 3 of Table 5, the estimated coefficient on the total fraction of target shares purchased32 is 16.8%, which is close to the coefficient estimated by Bradley et al. (1988). Stulz et al. (1990) also find a statistically significant

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relation in their sample of 104 successful tender offers from 1968 through 1986 in the USA (γ = 10.7%; t = 1.49). In addition, Eckbo and Langohr (1989), Song and Walking (1993), Billett and Ryngaert (1997) and Amoako-Adu and Smith (1993)33 find a positive relation between the returns to target shareholders and the percentage of target shares purchased by the bidder. Table 5

Regression estimates of the cumulative abnormal returns to target firms

Independent variables Intercept

OLS 1 46.163 (3.08)***

Ownership variables target OWN –8.995 (–3.46)*** MAN –0.099 (–0.59) INS 0.405 (3.13)*** OUT 0.139 (1.24) Control variables TOE 0.080 (0.60) ACQ 0.175 (2.20)** Total ACQ Financial variables of target MTB –0.907 (–0.71) LEV –0.357 (–2.40)*** SIZE 0.236 (0.07) Market variables DUMFOR DUMCOM No. of observations R2 F-statistics White-test (F-statistics)

1.226 (0.27) 1.367 (0.22) 97 30.5% 3.38*** 0.85

OLS 2 46.492 (3.35)***

OLS 3 38.566 (2.98)***

OLS 4 42.008 (2.21)**

OLS 5 49.579 (3.05)***

–8.596 (–3.69)*** –0.045 (–0.28)

–7.767 (–3.47)*** –0.069 (–0.44) 0.405 (3.29)*** 0.123 (1.19)

–9.093 (–1.93)** –0.224 (0.85) 0.369 (1.73)** 0.100 (0.46)

–12.021 (–2.79)*** 0.079 (0.38)

0.242a (2.81)***

0.404 a (2.40)***

0.056 (0.36) 0.192 (2.01)** 0.158 (2.00)**

0.168 (2.18)**

–1.005 (–0.79) –0.361 (–2.42)*** 0.212 (0.07)

–0.988 (–0.80) –0.299 (–2.27)***

97 26.8% 4.66*** 0.93

99 28.9% 5.29*** 0.90

0.157 (1.73)** –0.525 (0.26) –0.333 (–1.75)** –5.063 (–1.04)

–0.847 (–0.44) –0.365 (–2.27)**

0.711 (0.11) 5.934 (0.67) 60 35.3% 2.38*** 1.19

*, **, *** indicates significance at the 10%, 5% , and 1% levels, respectively (one-tailed test). a Outside blockholdings including institutional shareholdings (t-statistics in parentheses).

60 28.8% 4.07*** 1.34

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This table contains OLS estimates of the effects of ownership characteristics of target firms, control variables, financial variables of target firms, and market variables on the Cumulative Abnormal Returns (CAR) to the shareholders of targets. The cumulative abnormal returns are estimated over –20 to 20 days surrounding successful acquisition announcements. OLS- regression: CARTj,[t–n,t+n] = α0 + α1 OWNj + α2 MANj + α3 INSj + α4 OUTj + α5 TOEj + α6 ACQj + α7 MTBj + α8 LEVj + α9 SIZEj + α10 DUMFOR j + α11 DUMCOM j + uj, where CART[t–n,t+n] OWN MAN INS OUT

TOE ACQ MTB

LEV SIZE DUMFOR DUMCOM

Cumulative abnormal returns over the t – n to t + n event window for firm Ownership concentration is measured by a HH-index (Herfindahl-Hirsch index of shareholdings) Total percentage of shares held by management Total percentage of shares held by banks, insurance companies, pension funds, investment companies, and venture capitalists Total percentage of block holdings owned by large outside shareholders (other than management and institutional shareholders) who own more than 5% of all outstanding shares Percentage of shares held by the bidding firm prior to the announcement of the takeover Shares purchased by the bidding firm, exclusive of its initial shareholdings Market value (the number of shares times the stock market price 21 days before the announcement day) divided by the book value of equity reported at the end of the year prior to the takeover Total debt divided by the book value of total assets reported at the end of the year prior to the takeover Total sales of the target firm divided by the total sales of the bidding firm reported at the end of the year prior to the takeover Dummy variable for cross-border acquisitions that equals one if the target or bidding firm is a foreign firm Dummy variable that equals one if more than one bidder takes part in the takeover process.

The coefficient on managerial ownership is not statistically significant in all regression models. Cotter and Zenner (1994) and Bugeja and Walter (1995) find also a negative relation between the abnormal returns to target shareholders and managerial ownership.34 Cotter and Zenner (1994) estimate a negative coefficient (γ = –0.20; p = 0.06) in their sample of 125 tender offers. Their results are comparable with our estimates in regression model 4, where we estimate a coefficient of γols4 = –0.224. Stulz et al. (1990) regress the variables initial, management, and institutional shareholdings, as well as the percentage

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of shares acquired on the abnormal returns to target shareholders. They find a R2 of 28%, which is comparable to the R2 reported in Table 5.35 We hypothesize that a rise of institutional shareholdings (INS) is associated with an increase of monitoring activities. Monitoring of incumbent management implies that targets are highly valued prior to the takeover announcement. As a consequence, the incremental post-takeover value creation for bidding firms will be small, and the bidding firm may not be willing to pay a high premium. For this reason, we expect a negative relation between institutional shareholdings (INS) and the abnormal returns to target firms. Table 5 shows that the estimated coefficient of institutional shareholdings (INS) does not have the predicted sign. The contradictory results on institutional shareholdings may indicate that institutional shareholders offer their shares only at high premiums.36 In contrast with our findings, Stulz et al. (1990) find a significantly negative relation.37 The coefficient of the toehold (TOE) variable is positive, but not significantly different from zero. Eckbo and Langohr (1989) and Franks and Harris (1989)38 find a positive relation between initial shareholdings and the returns to target shareholders.39 Target firms with high market-to-book values prior to the takeover announcement operate efficiently or have large growth opportunities. As a consequence, bidders have only limited opportunities to increase post-takeover value of the target firm. This lowers the takeover premium that bidders can afford to pay and suggests a negative relation between the returns to target shareholders and the market-to-book value. Table 5 shows that a high market-to-book (MTB) value of target firms decreases the returns to the target firm. The negative slope of the coefficients is consistent with hypothesis that bidders will pay a lower bid premium over the prevailing market price because the post- takeover value-enhancing opportunities are lower. However, the coefficient is not significantly different from zero. Bugeja and Walter (1995) and Robinson and Shane (1990) find a negative relation.40 In the regression models, we find that if the leverage of target firms increases, then the cumulative abnormal returns to target shareholders decline. This may indicate that the post-takeover value-enhancing opportunities for bidders are small as a result of efficient monitoring by bondholders (monitoring hypothesis). Apart from that, Hearth and Zaima (1984) argue that highly leveraged target firms lose their bargaining strength in takeovers. As a consequence, shareholders of target firms will get a lower bid premium. The estimated coefficient of leverage (LEV) is significantly negative (γols1 = –0.357; tols1 = –2.40), which is in line with the monitoring and free-cash-flow hypotheses. Our findings are consistent with the results of Robinson and Shane (1990), who find a negative relation between the bid premium and leverage; but their results are not significant.41 The coefficient of relative size (SIZE) in Table 5 is not significantly different from zero. The findings in previous empirical studies are ambiguous. Asquith et al. (1983), Sudarsanam et al. (1996), Davidson and Cheng (1997) and Cheng and Chan (1995) find a positive relation, whereas Franks and Harris (1989), Sullivan et al. (1994) and Billett and Ryngaert (1997) find that relative size negatively influences the returns to target shareholders. To test the impact of cross-border acquisitions on the returns to target shareholders, we use a dummy variable (DUMFOR) that equals one if the offer is made by a foreign bidder, and zero otherwise. The estimated coefficient of the cross-border dummy variable is positive, but not significantly different from zero (tols1 = 0.27; tols4 = 0.11). We also estimate the association between competition (DUMCOM) and the abnormal returns to target shareholders. A positive slope coefficient indicates that target shareholders gain from multiple-bidder contests. As shown in Table 5, the estimated coefficient of the competition dummy variable is positive, but not

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significantly different from zero (tols1 = 0.22; tols4 = 0.67). The prior empirical literature indicates that competition between bidders increases the returns to target shareholders (Bradley et al., 1988; Franks and Harris, 1989; Stulz et al., 1990; Petry and Settle, 1991; Amoaku-Adu and Smith, 1993; Dewenter, 1995; Eun et al., 1996; Billet and Ryngaert, 1997; Suk and Sung, 1997; Sudarsanam et al., 1996; Davidson and Cheng, 1997).42 Figure 3 depicts the relation between ownership concentration (OWN) in target firms and the percentage of shares purchased by bidding firms (ACQ) on the cumulative abnormal returns to target shareholders.43 The advantage of this 3-D surface plot is that it shows simultaneously the influence of an upward-sloping supply and the impact of ownership concentration on the returns to target shareholders. Both variables have a significant effect on the returns to target shareholders. The coefficient of (ACQ) is equal to 0.16 (t = 2.50), which is comparable with the coefficient estimated by Bradley et al. (1988) and Stulz et al. (1990).44 The surface plot of Figure 3 also shows that the abnormal returns to target shareholders increase when a bidding firm gets controlling power (60–80%) in a diffusely held target company (HH index = 0). Further, we regress the abnormal returns to target firms on management shareholdings, institutional shareholdings, and other outside block holders. Figure 3

The influence of ownership concentration and percentage of shares acquired on the cumulative abnormal returns to target firms (CAR)

OLS regression: CAR = 33.82 + 0.16 ACQ − 10.30OWN (4.66) *** (2.0) *** (−4.3) *** R2 17% F-statistics 10.61*** No. of observations 103 (t-statistics in parentheses). CAR Cumulative abnormal returns to target shareholders ACQ Percentage of shares acquired by bidding firms OWN Ownership concentration of target firm (log adjusted HH index).

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4.2 Robustness test In our sample we estimate the returns indirectly to target shareholders when a parent company disposes of assets, or sells off a division. It is argued in financial research that stock prices in an efficient market reflect all publicly available information directly after the sell-off announcement. An adjustment for size is not necessary. It is implicitly argued that the relative weight of a sell-off is incorporated in the stock price reaction of the parent company. Weighted least squares regression analysis is conducted in order to estimate how the size of sell-offs affects the abnormal returns to target shareholders. First, we multiply the original CARs with a scale factor ri = vparent / vsell-off; we then estimate the scaled CARs with weighted least squares, using wi = 1 / ri as weights. Table 6 presents the regression results using weighted least squares.45 In general, the regression results remain the same in comparison with the results of Table 5. The signs of the coefficients remain unchanged, but the significance level varies for some variables. The significance level of the coefficient of ownership concentration (OWN) decreases, but the variable still remains significant in WLS models 2 and 3. Table 6

Weighted least square regression estimates of target cumulative abnormal returns

Independent variables Intercept Ownership variables of target OWN MAN INS OUT

WLS 1 33.034 (2.07)** –3.362 (–1.02) –0.353 (–1.82)** 0.265 (1.78)** –0.100 (–0.65)

Control variables TOE

Financial variables of target MTB LEV SIZE

–4.465 (–1.39)* –0.398 (–2.09)** 0.155 (1.02) –0.111 (–0.75)

WLS 3 42.236 (2.72)*** –6.344 (–2.12)** –0.229 (–1.22)

0.091a (0.70)

0.010 (0.08) 0.229 (2.83)***

ACQ Total ACQ

WLS 2 42.688 (2.78)***

0.211 (2.68)***

0.191 (2.31)***

–0.781 (–0.45) –0.398 (–2.38)***

–0.624 (–0.37) –0.393 (–2.40)***

–1.157 (–0.66) –0.404 (–2.38)***

–3.051 (–0.73)

–3.773 (–0.95)

–2.702 (–0.66)

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Table 6

Weighted least square regression estimates of target cumulative abnormal returns (continued)

Independent variables

WLS 1

WLS 2

WLS 3

97

97

Market variables DUMFOR

3.541 (0.63)

DUMCOM

6.763 (0.90)

No. of observations R

2

F-statistics White-test (F-statistics)

97 35.7%

37.5%

31.4%

4.78***

5.80***

5.81***

1.02

0.66

1.03

*, **, *** indicates significance at the 10%, 5% , and 1% levels, respectively (one-tailed test). a Outside block holdings including institutional shareholdings (t-statistics in parentheses). OWN Ownership concentration is measured by a HH-index (Herfindahl-Hirsch index of shareholdings) MAN Total percentage of shares held by management INS Total percentage of shares held by banks, insurance companies, pension funds, investment companies, and venture capitalists OUT Total percentage of block holdings owned by large outside shareholders (other than management and institutional shareholders) who own more than 5% of all outstanding shares TOE Percentage of shares held by the bidding firm prior to the announcement of the takeover ACQ Shares purchased by the bidding firm, exclusive of its initial shareholdings MTB Market value (the number of shares times the stock market price 21 days before the announcement day) divided by the book value of equity reported at the end of the year prior to the takeover LEV Total debt divided by the book value of total assets reported at the end of the year prior to the takeover SIZE Total sales of the target firm divided by the total sales of the bidding firm reported at the end of the year prior to the takeover DUMFOR Dummy variable for cross-border acquisitions that equals one if the target or bidding firm is a foreign firm DUMCOM Dummy variable that equals one if more than one bidder takes part in the takeover process.

Table 6 contains WLS estimates of the effects of ownership characteristics of target firms, control variables, financial variables of target firms, market variables, and method of acquisition on the Cumulative Abnormal Returns (CAR) to the shareholders of targets. The cumulative abnormal returns are estimated over –20 to 20 days surrounding successful acquisition announcements. In order to adjust our cross-sectional regression model for the relative size of sell-offs, we used Weighted Least Squares with weights equal to the sales of the divestiture divided by the sales of the parent. These weights are used just for sell-offs, otherwise the weights are equal to one.

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The original CARs were multiplied with a scale factor ri = vparent / vsell-off and the scaled CARs were estimated with weighted least squares, using wi = 1 / ri as weights. The coefficient of managerial shareholdings is significant in WLS model 1, and is consistent with the convergence-of-interest hypothesis. Bugeja and Walter (1995) and Cotter and Zenner (1994) find also a negative relation between the abnormal returns to target shareholders and managerial shareholdings.

5

Conclusions

In this paper, we investigated the impact of ownership concentration on the returns to target shareholders. We distinguished between three models: the atomistic shareholder model or free-rider problem (Grossman and Hart, 1980), the large shareholder model (Shleifer and Vishny, 1986) and the single shareholder model or bargaining model. We found empirical evidence that the degree of ownership concentration in target firms has a significantly negative effect on the returns to shareholders. These findings are consistent with the theoretical takeover models which support a negative relationship between bid premium and ownership concentration of target firms. Further, we found a significantly positive relationship between the percentage of target shares acquired by bidding firms and the cumulative abnormal returns to target shareholders. This result is consistent with an upward-sloping supply curve for target shares. We also found a significantly positive relationship between institutional shareholdings and the abnormal returns to target shareholders. This result implies that institutional shareholders offer their shares only at high premiums. Finally, we found a negative relationship between leverage of target firms and the cumulative abnormal returns to target shareholders. This result might indicate that efficient monitoring by bondholders reduces the post-takeover value-enhancing opportunities for bidding firms.

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Notes 1

They suggest a positive relation between ownership concentration and the takeover bid premium. Significant at the 5% level. 3 Tobin’s q is a proxy for market valuation of the firm’s assets and is defined as the firm’s market value divided by the replacement costs of the firm’s assets. 4 The inflection point is the percentage ownership at which the value of Tobin’s q reaches its maximum. McConnell and Servaes (1990) estimate an inflection point of 49% for their sample in 1976, and 37% for their sample in 1986. 5 Morck and Yeung reported a mean insider ownership of 6.37%. 6 Entrenched management indicator variable, which is set to one if insider holdings exceed 20%. 7 Slusky and Caves (1991) find a negative relation between the abnormal returns to bidding firms and managerial shareholdings. 8 Results are not significant. 9 Or, in other words, a negative relation between managerial shareholdings and the cumulative abnormal returns to target shareholders. 10 Consistent with the entrenchment hypothesis. 11 But the results of Billet and Ryngaert (1997) are not significant. 2

12

The price elasticity of the supply curve (ε): ε = % q(quantity) / % p(price); ε = 15/9.1 = 1.65. In their study, the fraction of shares purchased by the bidder had a significantly positive effect on the offer premium, as well as the abnormal returns to target shareholders. The abnormal stock returns to target shareholders were not significant. 14 However, they found also a positive relation between the bidder’s return and the fraction of shares sought. 15 Amoako-Adu and Smith (1993) find that the abnormal returns to target shareholders in complete tender offers are significantly higher than the abnormal returns to target shareholders in partial tender offers. This result could indicate an upward-sloping supply curve, but they found no empirical evidence in their cross-sectional analysis. 16 De et al. (1996) test the preemptive bidding theory and find no evidence that the returns of first bidders would be higher in a single-bid contest than in a multiple-bid contest. 17 Preemptive bidding models: Giammarino and Heinkel (1986), Fishman (1988), Hirshleifer and Png (1990), Harrington and Prokop (1993) and Khanna (1997). 18 We distinguish between the percentage of shares held by the largest shareholder (H1), the three largest shareholders (H3), and the five largest shareholders (H5). 19 The HH index (called Herfindahl-Hirsch index) is a measure of dispersion and has a background in oligopoly theory in that it measures concentration in market shares. 20 The fraction of shares, instead of the percentage of shares, can also be used in order to measure dispersion. If the fraction of shares is used, then the HH index can vary between zero and one. 21 The idea behind the alternative HH index is that, otherwise, the toeholds of the bidder tend to increase the ownership concentration, although there may be no other large shareholders than the bidder himself. 22 In our empirical study, we assume that if there is no blockholder, then each shareholder has 1% of all shares. In that case, the Theil index is zero (no ownership concentration). 23 Thirty eight sell-offs are excluded because they are in nearly all cases highly concentrated. 24 In some cases the data were obtained from a special edition of The Dutch Financial Times. 25 Managerial and institutional shareholdings. 13

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The mean of the largest shareholder (H1) in our sample does not differ significantly from the mean of the largest shareholder (H1) in their sample of 177 companies listed on the Amsterdam Stock Exchange. We compare the two population means and use the following

t-statistics z = µ1 − µ 2 / ( s12 / n1 + s22 / n2 ) . To get two independent samples, we eliminate 11 observations from 1992. The null hypothesis (H0: µ1 = µ2) is not rejected (z = –0.81). 27 It should be noticed that the variable management shareholdings (MAN) is highly positively skewed. In this sample, most firms have no managerial shareholdings, but there are some firms with very high managerial shareholdings (fourth quartile). 28 In a semi-strong form of the efficient market, stock prices reflect all relevant, publicly available information. 29 The number of observations in the OLS regression models 1–3 are lower than n =104, due to missing variables. 30 Another measure of concentration is a Theil index. The results with a Theil index are almost equal to the results with a HH index. In our regressions, we use the logarithm of the HH index. 31 Their sample contains 429 observations of UK mergers from 1980 through 1990. 32 Including the initial shareholdings of the bidder. 33 The coefficient for percentage of target shares purchased by bidder is positive and statistically significant for partial acquisitions. In their sub-sample of complete acquisitions, the relation between the abnormal returns to target shareholders and the percentage of shares purchased by the bidder is negative, but insignificant. 34 Stulz et al. (1990) and Song and Walking (1993) find a significantly positive relation. 35 Their sample contains 104 observations of successful tender offers from 1968 to 1986 in the USA. Our sub-sample of tender offers, mergers, block trading, and open-market transactions contains 66 observations and an R2 for models 4 and 5 of 35% and 29%, respectively. 36 An alternative explanation may be that large institutional shareholders have bargaining power (Högfeldt and Högholm, 2000). 37 Billet and Ryngaert (1997) and Cotter and Zenner (1994) find a negative relation, but their results are not significant. 38 Franks and Harris (1989) find a positive relation for toeholds greater than or equal to 30%, and a negative relation for toeholds below 30%. 39 Stulz et al. (1990) estimate a significantly negative coefficient. 40 Sudarsanam et al. (1996) find a significantly positive relation between the relative market-to-book value and the returns to target shareholders. 41 Billett and Ryngaert (1997) find a significantly positive relation between the target equity abnormal returns and liability/equity ratio of 145 US cash tender offers during 1980–1989. 42 Bradley et al. (1988), Franks and Harris (1989), Stulz et al. (1990), Petry and Settle (1991), Amoaku-Adu and Smith (1993), Dewenter (1995), Eun et al. (1996), Billet and Ryngaert (1997) and Suk and Sung (1997) report a positive relation between competition and the returns to target shareholders. Sudarsanam et al. (1996) and Davidson and Cheng (1997) estimate a negative relation, but their results are not significant. 43 The vertical axis represents the cumulative abnormal returns to target shareholders (CAR). We do not perform a scaling for CAR because the statistical package S-Plus depicts relative values in surface plots on the vertical axis. 44 Bradley et al. (1988) estimate a coefficient equal to 0.167, and Stulz et al. (1990) estimate a coefficient equal to 0.1675 in the single-bidder sample. 45 The results were produced using the WLS procedure in software package Eviews, with wi = 1/ri as weights.

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