Corporate governance are defined as a set of mechanisms–both internal and external-that induces the self-interested controllers of a company to make decisions that maximize the value of the company to its owners (Denis and McConnell 2003).
The internal governance mechanisms of primary interest are the board of directors and the equity ownership structure of the firm (Denis and McConnell 2003). Among the board, independent directors are in a better position to monitor managerial behavior as they would not scruple to contradict the management (Choi et al. 2007). Regarding the equity ownership, large shareholders have the incentive to monitor management to make decisions that maximize the welfare of all shareholders (Shleifer and Vishny 1986 cited in Cremers and Nair 2005). As such, an appropriate corporate governance mechanism design is suppose to enhance firm valuation. However, each governance mechanism may not work independently to affect firm valuation (Danielson and Karpoff 1998). The aim of this thesis is trying to provide a better understanding of how these internal governance mechanisms interact. The thesis proceeds via four questions: Which governance mechanisms are value-enhancing? How do independent director and blockholder interact to affect firm valuation? How does this interaction depend on firm characteristics? And what implementation does it have for the corporate governance mechanism design?
Theoretical viewpoints regarding how governance mechanisms interact with each other are dichotomized. On the one hand, Shleifer and Vishny (1986 cited in Cremers and Nair 2005) suggest that different mechanisms might be complements and substantially facilitate each other. On the other hand, Pound (1992 cited in Cremers and Nair 2005) proposes that different mechanisms can be viewed as substitutes if their effects overlap each other. Accordingly, firms with both
mechanisms obtain similar governance outcome to those with only one mechanism.
Independent director and blockholder both have some trait that the other party is short of and thus may function as complements. On the one hand, the more abundant wealth incentive of blockholder complements the shortcoming of independent director for mitigating shareholders’ collective action problem (Becht et al. 2003 p.18); on the other hand, the neutrality of independent director complements the tendency of blockholder to collude with management when the entrenchment effect exceeds the alignment effect (Morck et al. 1988 and McConnell and Servaes 1990 cited in Denis and McConnell 2003 p.10). However, independent director and blockholder also have some similar trait that may function as substitutes. Fama and Jensen (1983) points out that independent director is induced by the “reputation incentive” to monitor the management in order to develop the expert prestige. Yermack (2004) corroborates this argument by an empirical research, finding that independent director receives positive performance incentives of compensation, turnover, and opportunities to obtain new board seats. The reputation incentive of independent director might play a substitute role for the wealth incentive of blockholder in the governance outcome.
This thesis tries to clarify whether the substitution effect or the complementary effect outweighs the other between independent director and blockholder. Independent director has been obligate to newly-public firms in Taiwan since 2002. Other public-listed firms can choose to set it or not during the buffer period. Starting from 2007, independent director is instituted thoroughly; all public listed firms that exceed a certain capital amount have to set at least two seats of independent director and at least 20 percent of the board comprising of independent directors (United Group Daily News 2005). Since during the past 5 year, independent director was optional for firms, this thesis conducts a retrospective research, investigating whether this
legitimated standard of board independence had a positive valuation effect on firms adopt it.
The importance of the interaction between governance mechanisms lies in the construction of a cost-efficient governance mechanism design. Each corporate governance mechanism that initiated to monitor management discretion and mitigate agency costs actually has its opportunity cost1. To avoid either paying multiple costs yet receiving overlapping effects, or receiving inefficient effect due to lack of complementary mechanisms, it is crucial to understand how governance mechanisms interact with each other, so that it is feasible to construct a cost-efficient governance mechanism design.
Recently the research is increasingly interested in the effect of multiple governance mechanisms (Gillan 2005). Some analyses have attempted to study this issue by principle analysis yet find it difficult to interpret. Other researches alternatively choose to study this issue means of the substitution or complementary effect analysis. Shleifer and Vishny (1986 cited in Cremers and Nair 2005) take blockholder and anti-takeover provision as example, arguing that the latter in some cases can not perform successfully without the existence of the former. Following Shleifer and Vishny (1986), Cremers and Nair (2005) further prove that not only anti-takeover provisions but also blockholder can not function efficiently alone. So far
1 For instance, firstly, independent directors are paid good salaries. Basing on Taiwan Economic Journal Great China Database (TEJ), on average each firm paid 1.8 percent of its pre-tax income to directors in 2006, and the average salary of each director is 2.33 million. Secondly, blockholder, via its tremendous influence, intervenes in management decision and sacrifices firm autonomy (Aghion and Tirole 1997, Burtkart et al. 1997 and Paganoand and Roell 1998 cited in Becht et al. 2003 p.26).
Thirdly, diminishing the anti-takeover provisions exposes the company to the highly disruptive and costly takeover market, and induces management to seek after short-term profit (Gompers et al. 2003 and Becht et al. 2003 p.19). Fourthly, minimizing the control rights in excess of cash flow rights, a mechanism more prevailing in non-US market (Denis and McConnell 2003 p.19), forces insiders to plunge more money into shareholding and thus subjects insiders to high level of idiosyncratic risk,
western literatures mostly deal with the interaction of anti-takeover provisions and other governance mechanisms (for example, Shleifer and Vishny 1986 and Cremers and Nair 2005 compare it with blockholder, while Danielson and Karpoff 1998 compare it with independent director). To the best of my knowledge, there has not been any paper discussing the interaction of governance mechanisms in the emerging market such as Taiwan. As takeover activities are only active in US and UK markets and very rare in most of emerging markets (Becht et al. 2003), this thesis examines the substitution and complementary effects of the internal corporate governance mechanism in association with firm valuation in Taiwan following Cremers and Nair’s (2005) methodology.
In order to make up for the shortage of not discussing the takeover mechanism, this thesis discusses an alternative equity ownership structure issue that is especially prominent in emerging markets: the shareholding leverage. Deviation of control rights away from cash flow rights is one form of the “shareholding leverage” concept and is especially prevailing in emerging countries (Denis and McConnell 2003 p.19). A similar and more specific form of shareholding leverage in Taiwan is the pledge ratio, defined as the percentage of the shareholding of controlling shareholder pledged for bank loans (Lee and Yeh 2004). Both forms of shareholding leverage enable the incumbents to leverage small amount of own capital to hold large stake of firm control, which offers them the ability and incentive to gain private benefits and expropriate from minority shareholders (Claessens et al. 2000). This thesis also examines the valuation effect of these negative governance mechanisms.
The findings of this thesis are easily summarized as follows. Independent director, as well as domestic blockholder and foreign blockholder have significant positive valuation effects, while both forms of shareholding leverage show
insignificant effects. Moreover, independent director show substitution effect to domestic blockholder and complementary effect to foreign blockholder. These interactions depend on firm characteristics. Substitution effect exists in large or high-leveraged firms and complementary effect exists in small or low-leveraged firms.
The remainder of this thesis is presented in the following sequence. Section 2 illustrates the theoretical background. Section 3 reviews the literatures. Section 4 introduces the data. Section 5 elaborates the methodology. Section 6 interprets the results, and section 7 draws the conclusions.