Anlin Chen*
Department of Business Management National Sun Yat-Sen University
Kaohsiung 804, TAIWAN Phone: +886-7-5252000 ext. 4656 Fax: +886-7-5254698 Email: anlin@mail.nsysu.edu.tw Lanfeng Kao Department of Finance National University of Kaohsiung
Kaohsiung 811, TAIWAN Phone: +886-7-5919502 Fax: +886-7-5919329 Email: lanfeng@nuk.edu.tw Yi-Kai Chen Department of Finance National University of Kaohsiung
Kaohsiung 811, TAIWAN Phone: +886-7-5919501
Fax: +886-7-5919329 Email: chen@nuk.edu.tw
Keywords: Agency costs; Controlling shareholder; Moral hazard; Share Collateral
* We would like to thank the seminar participants at National Sun Yat-Sen University and National University of Kaohsiung for their helpful comments and suggestions. All the remaining errors are our own responsibility.
Abstract
Controlling shareholders’ share collateral is a new source of the deviation of cash
flow rights and control rights leading to minority shareholder expropriation.
However, controlling shareholders’ share collateral is not forbidden and has not
received particular restriction leading to its popularity in the capital markets.
Neglecting the potential agency costs resulting from controlling shareholders’ share
collateral would hurt the interests of creditors and minority shareholders. We need
legal regulation on controlling shareholders’ share collateral to reinforce corporate
Introduction
In the modern corporation structure, the ownership and control of corporations
are separated. Under the separation of ownership and control, Jensen and Meckling
(1976) argue that in a well-diversified corporation, the managers of the corporation,
who simply own partial ownership of the corporation, may consume more perquisites
and engage in activities that favor themselves rather than the shareholders. Jensen
and Meckling refer to this as the agency problem between the managers and the
shareholders.
Traditional agency theory is prevalent in a well-diversified economy. However,
La Porta, Lopez-de-Silanes, and Shleifer (1999) examine corporate ownership around
the world and indicate that except in economies with very good shareholders
protection such as the U.S., few firms are well-diversified. Rather, these firms
outside U.S. are typically controlled by families. The controlling families can
monitor the managers for their own benefits and thus also protect the interest of the
minority shareholders from being expropriated by managers.1 That is, the
controlling shareholders or controlling families reduce the agency problems between
managers and shareholders. In this case, the ethical problems related to managers’
bad attitudes toward the shareholders are alleviated. Nevertheless, Shleifer and
Shleifer, and Vishny (2000) argue that even though managers’ bad attitudes toward
shareholders can be alleviated by the presence of controlling families, the minority
shareholders are subject to the expropriation from the “controlling shareholders”
instead. Minority shareholders are expropriated by controlling shareholders rather
than by managers. The deviation of cash flow rights and control rights can lead to
the controlling shareholders’ expropriation on the minority shareholders. That is,
controlling shareholders’ ethical problems arise from the deviation of controlling
shareholders’ cash flow rights and their control rights. La Porta, Lopez-de-Silanes,
and Shleifer (1999) suggest that the expropriation on the minority shareholders from
the controlling shareholders should be emphasized and deserves investors’ attention.
How come the controlling shareholders’ cash flow rights deviate from their
control rights? Shelifer and Vishny (1997), La Porta, Lopez-de-Silanes, and Shelfer
(1999), Bebchuk, Kraakman, and Triantis (2000), and Claessens, Djankov, Fan, and
Lang (2002) point out that the controlling shareholders accumulate their control rights
through pyramids, cross-holding, and dual class equity. In a pyramid of two
companies, a controlling minority shareholder holds a controlling stake in a holding
company that, in turn, holds a controlling stake in an operating company. In contrast
to pyramids, companies in a cross-holding structure are linked by horizontal
Dual class equity means that a firm has issued two or more classes of stocks with
differential voting rights. Bebchuk, Kraakman, and Triantis argue that dual class
equity is the only form of deviation of cash flow rights and control rights that does not
depend on the creation of multiple firms. In this paper, we raise another source of
the deviation of cash flow rights and control rights, which does not depend on the
creation of multiple firms and does not receive legal regulation. The new source of
deviation of cash flow rights and control rights deteriorates the expropriation of
controlling shareholders on the minority shareholders and deserves the attention of
government and investors.
What is the new source of the deviation of cash flow rights and control rights?
We argue that the controlling shareholders’ collateralizing shares as collateral is a new
source of the deviation and is popularly used in the real world. Controlling
shareholders’ share collateral does not depend on the creation of multiple firms, either.
Knowing the potential damage from controlling shareholders’ share collateral can
help establish a solid business ethical standard and protect the minority shareholders’
interest. Controlling shareholders’ share collateral is that the controlling
shareholders pledge their shares as collateral from financial institutions for funding.
It is pretty common for shareholders, either controlling shareholders or minority
Share collateral is popular and there are no particular regulations or restrictions on
shareholders’ share collateral, especially the voting rights of the collateralized shares.
In this paper, we would like to raise attention on controlling shareholders’ share
collateral since it really influences the controlling shareholders’ attitudes toward the
minority shareholders with Taiwan evidence. The reason why we use Taiwan
evidence is because Taiwan SEC requires the disclosure of controlling shareholders’
share collateral and because the data of controlling shareholders’ share collateral is
available. The uniqueness of Taiwan data makes it possible to examine ethical
problems related to controlling shareholders’ share collateral.
The remaining of this paper is organized as follows. In section 2, we express
the share collateral scheme in capital markets. We discuss why shareholders pledge
their shares as collateral in section 3. Section 4 describes the deviation of cash flow
rights and control rights due to controlling shareholders’ share collateral. The
agency problems resulting from controlling shareholders’ share collateral are
investigated in section 5. We provide Taiwan evidence related to the effect of
controlling shareholders’ share collateral on firm performance in section 6. Finally,
section 7 concludes.
Share Collateral Mechanism
institutions. Typically, the publicly traded shares with high liquidity are preferred as
collateral to protect the lenders’ interest. Share collateral is popular as a kind of
margin trading in stock markets when the shareholders use the funding from share
collateral for further stock investments. Of course, the funding from share collateral
can be used for other purposes other than stock investments. To protect the lenders’
interest on the loans, the borrowers cannot borrow the full amount of the value of the
collateralized shares. For example, the shareholders may simply borrow up to a
certain percentage, say 60%, of the market value of the collateralized shares. Since
the stock prices fluctuate, the borrowers might be asked to pledge more shares to meet
the margin requirements when the collateralized shares drop in market value. If the
borrowers cannot provide more shares as collateral to meet the margin requirements,
the lenders may sell the collateralized shares at the capital markets and get their
money back.
Even though the stocks are collateralized to the lenders, the borrowers still own
the stocks unless the borrowers default on the loan. In other words, the shareholders
who pledge their shares for funding at the financial institutions still keep their rights
related to the shares such as the cash flow rights (cash dividends) and the control
rights (voting rights for board elections) once they do not default. Since the
controlling shareholders will not lose their control rights due to their share
collateralization. Brigham and Ehrhardt (2002, p.714) argue that “one would
normally expect the price of a stock to drop approximately the amount of the dividend
on the ex-dividend date.” Before the ex-dividend date, investors expect to receive
the announced dividend. However, after ex-dividend date, the investors would not
be able to receive the announced dividend. That is, even though the collateralizing
shareholders still nominally keep the cash flow rights of cash dividends, the cash
dividends will cause the ex-dividend stock price to drop leading to the decrease of the
market value of the collateralized shares, and consequently the collateralizing
shareholders may have to pledge more shares to meet the margin requirements.
Collateralizing shareholders can keep their control rights but not the cash flow rights
as they pledge their shares as collateral.
There are no securities acts or regulations governing the share collateralization
by minority shareholders in most of the countries. However, the securities acts or
regulations do not impose any restriction on controlling shareholders’ voting rights on
collateralized shares, either. We cannot find any regulation to ban the controlling
shareholders’ share collateral in U.S or in other major countries. The only thing we
find is that controlling shareholders’ share collateral might need to be disclosed. For
share collateral in the prospectus when a firm wants to raise funds through public
offerings. Apparently with respect to the controlling shareholders’ share collateral,
Taiwan Securities Acts protect new fund providers but not existing fund providers.
To sum up, to borrow money by collateralizing shares as collateral from financial
institutions is easy for both the controlling shareholders and the minority shareholders
once they have agreements with the financial institutions.
Why Shareholders Pledge Shares as Collateral
Shareholders can pledge their shares as collateral for funding easily from the
capital markets. Why the shareholders pledge their shares for funding? For
minority shareholders who are not interested in the control over the firms, they pledge
their shares for funding for liquidity preference or for margin trading. Publicly
traded stocks can be liquidated easily, and therefore the lenders prefer them as
collateral for loan. Hence, shareholders who have demands on liquidity and still
want to keep their shares can pledge their shares as collateral at financial institutions
for money. Margin trading means that the investors raise loans to buy stocks.
Margin trading gives the stock investors greater buying power and financial flexibility
to boost their investment potentials. Investors who believe that they can make
money on certain stocks can easily make even more by margin trading. Certainly,
In this paper, we focus on controlling shareholders’ share collateral. Basically,
besides the purposes of liquidity preference and margin trading, the controlling
shareholders would probably pledge their shares for funding to finance the firms’
projects or to gain more control rights over the firms by buying more shares. When
firms cannot finance their projects due to lack of funds, their controlling shareholders
might pledge their shares as collateral for funding to finance the firms’ projects.
However, The Commercial Times (October 7, 2000) and Kao, Chiou, and Chen (2004)
indicate that the controlling shareholders’ share collateral in Taiwan is not related to
the story of firms’ lack of funds. The Commercial Times argues that the controlling
shareholders typically pledge their shares as collateral to buy more shares of the same
companies to gain more control rights over the firms in a self-financing cycle. The
purposes of shareholders’ share collateral can be summarized as liquidity preference,
investment by margin trading, financing firms’ projects, and control rights over the
firms.
Effects of Share Collateral on the Deviation of Cash Flow Rights and Control
Rights
Cash Flow Rights
As we mentioned, even though the borrowers pledge their shares at financial
shareholder lists and keep their related rights of the shares unless they default.
Therefore, controlling shareholders who pledge their shares as collateral would not
lose their “nominal” ownership of the firms. However, since the shares are
collateralized as collateral, the value of the collateralized shares is used to protect the
lenders’ interest from default. Hence, the “real” ownership (the cash flow right) of
the collateralizing shareholders decreases. We set up several cases to explain how
share collateral affects the cash flow rights and control rights of the controlling
shareholders.
Case A: There are two shareholders, X and Y. Both X and Y own 10 shares of
the firm, which are individually 10% of the total number of outstanding shares.
Suppose X pledges all his shares as collateral for personal liquidity use, but Y does
not. Nominally, both X and Y own 10 shares of the firms. Now the firm pays $1
dividend per share. The stock is normally expected to drop by the amount of
dividend on the ex-dividend date. Therefore, the ex-dividend stock price drops by
$1. Obviously, both X and Y will receive $10 as dividend payment from the firm.
However, the $10 received by X should be used to protect the value of the
collateralized shares because the value of collateral falls by $10. Typically, X will
be asked to pledge more shares. Therefore, the dividends received by X should be
collateralized. Once the ex-dividend stock price drops, X’s cash flow right on the
firm’s dividend payment is less than $10. On the other hand, Y can have his $10
dividend for any use and his cash flow right on the dividend payment is $10. Hence,
the cash flow rights of X on the firm are smaller than those of Y even though X and Y
have the same quantity of the shares of the firms. Shareholder X loses his cash flow
rights due to his share collateral.
Case B: Both X and Y own 10 shares of the firm. X pledges all his shares as
collateral and buys 10 more shares of the same firm (suppose no margin is required
for share collateral). Now the firm pays $1 dividend per share and the ex-dividend
stock price drops by $1 leading to the value of collateralized shares decreasing by $10.
Since X owns 20 shares of the firm, he will receive $20 dividend payment from the
firm. However, $10 out of the $20 dividend should be used as collateral to protect
the lenders’ interest. Even though X currently owns nominally 20 shares of the firm,
his cash flow right on the dividend is still $10, which is the same as that of Y who
simply owns 10 shares of the firm.
Case C: Both X and Y own 10 shares of the firm. X pledges all his shares as
collateral and buys 6 more shares of the same firm (suppose the margin requirement
restricts X to buy only 6 more shares from his collateral of 10 shares). Now X owns
share and the ex-dividend stock price drops by $1 leading to the value of
collateralized share decreasing by $10. Even though X receives $16 dividends, $10
of the dividend should be used to protect the value of the collateral. Finally, X
receives $6 cash flow without any restriction from the dividend payment. That is,
X’s cash flow right decreases when X pledges his shares as collateral.
Since shareholder Y does not pledge his shares, he always keeps his original cash
flow rights on the firm. However, shareholder X pledges his shares and loses his
cash flow rights. The more shares of the firm shareholder X buys from his share
collateral, the more cash flow rights he keeps over the firm.
Control Rights
The ex-dividend stock price will drop so at least part of the cash dividends from
the collateralized share should be used to protect the value of the collateralized shares
for lenders’ interest. That is the reason why that the shareholders will lose at least
part of their cash flow rights once they pledge their shares as collateral for funding.
Even though the shareholders pledge their shares as collateral, they are still the
nominal owners of the firms and have the full rights to vote for board elections, i.e.
they still keep their voting rights (or the control rights) over the firms. So far, there
is no restriction on the voting rights of the collateralized shares in U.S., Singapore or
control rights of the firm on case A, B, and C, respectively. For all the cases,
shareholder Y always keeps 10% of the control rights of the firm. Minority
shareholders gain on the liquidity preference or investment benefits from share
collateral at the costs of losing cash flow rights over the firm. On the other hand, the
controlling shareholders gain on keeping control rights from share collateral at the
costs of losing cash flow rights. Share collateral causes a change in cash flow rights
and control rights over the firm.
Agency Problems on Controlling Shareholders’ Share Collateral
Share collateral will separate control rights from cash flow rights. Bebchuk,
Kraakman, and Triantis (2000) point out that the separation of control from cash flow
rights creates agency costs and hurts the interests of minority shareholders. They
argue that under the separation of control from cash flow rights, the controlling
shareholders may hold a small fraction of the cash flow rights of the firm leading to a
sharp increase of the agency costs. The controlling shareholders may select the
projects that provide private benefits of control available only to themselves.
Similar to Jensen’s (1986) argument on agency cost of free cash flow, Bebchuk,
Kraakman, and Triantis (2000) indicate that controlling shareholders tend to extract
private benefits from unprofitable projects to expand firm scope. Controlling
of minority shareholders’ benefits. Since controlling shareholders’ share collateral
will deviate their cash flow rights and control rights, all the agency costs proposed by
Bebchuk, Kraakman, and Triantis (2000) apply directly when controlling shareholders
pledge their shares as collateral.
Besides agency costs, controlling shareholders’ share collateralization also raises
moral hazard problems. The risk preference of controlling shareholders who
pledge their shares at financial institutions diverges from that of minority shareholders
or creditors. After collateralizing shares, the controlling shareholders bear little risk
from the operations of the firms. The controlling shareholders can simply walk
away and leave the lenders with worthless shares once the firms collapse or are in
financial distress. In this paper, we further investigate some other ethical problems
toward outside investors and creditors regarding to controlling shareholders’ share
collateral. The real problem of controlling shareholders’ share collateralization is
that the risk preference they have with respect to cash flow changes.
In this section, we examine the ethical problems associated with controlling
shareholders’ share collateral in three contexts: earnings management, direct stock
manipulation, and risky project investments.
Earnings Management
application of generally accepted accounting principles.” Perry and Williams (1994),
Friedlan (1994), Erickson and Wang (1999), and Toeh, Welch, and Wong (1998)
indicate that managers engage in earnings management in order to mislead the stock
markets. Typically, if the reported financial statements reveal high earnings power
of the firms, the stock prices normally reflect positively to the reported earnings.
Why do the controlling shareholders engage in earnings management when they
pledge their shares as collateral? When shareholders pledge their shares as collateral
at financial institutions, they can only raise up to a certain fraction of the market value
of the collateralized shares. As we mentioned earlier, the publicly traded stocks are
preferred as collateral due to the liquidity property. Since the collateralized stocks
are publicly traded at exchanges, the stock prices normally fluctuate. When the
stock price goes up, the value of the collateralized share increases and the
collateralizing shareholders can borrow more money from the financial institutions
with their initial collateral. On the other hand, when the stock price goes down, the
value of the collateralized shares decreases and the collateralizing shareholders will
be asked to pledge more shares as collateral. Faced with the changeable stock price,
controlling shareholders who pledge their shares as collateral encounter further
pressure on the falling price. Once the controlling shareholders pledge their shares
price drop and have an incentive to engage in earnings management to fool the stock
markets and other shareholders.
Once the controlling shareholders engage in earnings management, the reported
financial statements become less credible. Kao and Chiou (2002) show that the
relation between accounting information and stock return becomes weaker when the
controlling shareholders pledge their shares as collateral implying that accounting
information is less credible in the capital markets.
Earnings management will distort the information of the financial statements and
thus the financial statement will become less relevant to the capital suppliers
including the shareholders and the creditors. It is unethical for firms not to reveal
their true information to their capital suppliers.
Direct Stock Price Manipulation
Shareholders who pledge shares as collateral are very sensitive to the price
movement of the stock, especially when the shareholders accumulate their shares by
using the funds from share collateral to buy more shares of the same firms. In a
bullish market, this stock accumulation causes the price to rise further and increases
the shareholders’ profit. On the other hand, in a bear market this share accumulation
causes margin calls and substantial losses. For a minority shareholder who pledges
price when he is required to meet the margin requirements of his share collateral.
However, controlling shareholders who control the firm have control over the
resources of the firm. Once the controlling shareholders need to meet the margin
requirements, they might have an incentive to utilize the firm’s resources to
manipulate the stock price directly to avoid their personal losses, especially for the
economies without proper governance mechanisms. Chiou, Hsiung, and Kao (2002)
indicate that during the 1997 Asian financial crisis, a lot of Taiwanese firms with their
controlling shareholders’ share collateral become financially distressed. They argue
that a major cause for the firms’ financial distress is that the cash flows of the firms
are mis-used to support the stock price during the market crash.
Choice of Risky Investment Projects
Brealey and Myers (2002) argue that due to the limited liability of the
shareholders in the corporation, the shareholders prefer the risky investment projects
at the expenses of the creditors. The shareholders can capture all the benefits from
the appreciation of the risky projects. However, shareholders only partially bear the
losses from the depreciation of the risky projects due to the limited liability. That is,
even though the payoff of the risky investment is symmetric, the payoff of the risk
investment to the shareholders is asymmetric. The payoff pattern of the controlling
financial institutions. When the controlling shareholders pledge their shares as
collateral, they can benefit from the stock appreciation leaving the financial
institutions bearing the risk of stock depreciation. If the controlling shareholders use
the loan from share collateral to buy shares of the same firm, then their payoff on the
risky projects becomes even more asymmetric. When the controlling shareholders
select the risky projects, the creditors cannot earn profits from the upside benefits of
the risky projects but bear the downside risk of the projects.
Controlling shareholders who use the loan proceeds to buy more stocks of the
same firms assume greater risk because more of their assets are tied up in the firm.
Hence, the controlling shareholders may be willing to take extreme risks to keep the
firm solvent. With extreme risk, the firm may either gain lots of cash or be in
distress. However, the controlling shareholders who pledge their shares can benefit
from gains of the risky projects and walk away leaving the creditors suffering losses
when the risky projects fail. On the other hand, the minority shareholders who do
not pledge shares do not have the creditors to bear the down side risk. The moral
hazard resulting from controlling shareholders’ share collateralization exposes the
minority shareholders to higher risk.
If controlling shareholders use loan proceeds for unrelated purposes, then they
risk with respect to the future cash flow of the firm. In other words, the
collateralizing shareholders bear lower risk than other minority shareholders and thus
have higher risk tolerance on the future fortunes of the firm. When the controlling
shareholders have higher risk tolerance, they may take risky investment projects and
expose minority shareholders to greater risk. The agency costs and moral hazard
resulting from controlling shareholders’ share collateralization create ethical problems
toward the minority shareholders.
The Relation between Firm Performance and Controlling Shareholders’ Share
Collateral
We argue that controlling shareholders’ share collateral raises agency cost and
moral hazard problems including earnings management, direct stock price
manipulation, and selection of risky investment projects. These ethical problems
will hurt firm performance and expose the firm to financial distress.
The effect of controlling shareholders’ share collateral on firm performance
depends on the use of the funding from share collateral. The funding from
controlling shareholders’ share collateral could be for personal use such as gaining
control or for corporate use such as financing firms’ projects. Basically, only when
corporate debt is not available or too expensive to use, the controlling shareholders
controlling shareholders finance the firms’ projects through their share collateral, the
controlling shareholders have to share the benefits from the projects with other
shareholders but bear the risk of the projects themselves. Hence, the use of funding
from controlling shareholders’ share collateral can be regarded as a positive signal to
the value of the firms’ projects leading to a higher firm performance. On the other
hand, it can also be a sign of desperation implying that the firm cannot raise corporate
debt for projects. However, if the funding from controlling shareholders’ share
collateral is for personal use instead of corporate use, the firms do not benefit from the
funding but suffer associated agency cost or moral hazard. Therefore, when the
funding of controlling shareholders’ share collateral is not for corporate use, the firm
performance should be poorer due to the severe ethical problems of agency costs and
moral hazard.
Anecdotal evidence (The Commercial Times, October 7, 2000) indicates that the
controlling shareholders in Taiwan pledge their shares as collateral to exaggerate their
control rights rather than to finance the firms’ projects. Therefore, we expect
controlling shareholders’ share collateral in Taiwan will be negatively related to firm
performance.
Sample and Variable Definition
controlling shareholders’ collateralized shares with the sample of listed firms in
Taiwan. The data on collateralized shares held by directors, ownership of directors,
debt ratio, R&D ratio, market value of equity, and stock returns are collected from the
Taiwan Economic Journal (TEJ) database. Since TEJ began to report the proportion
of collateralized shares owned by directors in 1998, our sample period covers a 6-year
period of 1998-2003. Financial firms, utility firms, and state-owned firms are
deleted from the sample. Firms with missing data on controlling shareholders’ share
collateral or other variables are also discarded. Finally, our sample consists of 2766
firm-year observations.
Our variables are explicitly defined as follows.
1). RETM: market-adjusted annual stock return; RETM is used to measure firm
performance.
RETMit=Rit - Rmt,
Rit is the stock return of firm i at year t.
Rmt is the market return at year t. Market return is measured by the TSE (Taiwan
Stock Exchange) stock index which is a value-weighted market index.
2). COLLATERAL: percentage of shares that is held by directors of the firm and is
collateralized to financial institutions; COLLATERAL is used to measure controlling
COLLATERALit= directors by owned shares ns institutio financial at ized collateral directors by owned shares ,
COLLATERALit is the percentage of shares that is held by directors of the firm i
and is collateralized to financial institutions at the end of year t.
3). DEBT: debt-to-asset ratio,
DEBTit= it it assets Total s liabilitie Total ,
Total liabilitesit is the total liabilities of firm i at the end of year t.
Total assetsit is the total assets of firm i at the end of year t.
4) R&D: ratio of R&D expenses to net sales,
R&Dit= it it sales Net expenses D & R ,
R&D expensesit is the R&D expenses of firm i at year t.
Net salesit is the net sales of firm i at year t.
5) LogMV: the logarithm of market value of the firm’s outstanding shares. LogMV is
a proxy for firm size.
LogMVit=log(Pit×Number of shares outstandingit),
Pit is the stock price of firm i at the end of year t.
Number of share outstandingit is the number of shares outstanding of firm i at the
end of year t.
OWNERSHIPit= g outstandin shares of number directors by owned shares ,
7) INDUSTRY: industry dummy variable. INDUSTRY is 1 for electronic firms; 0
otherwise.
8) EM : the measurement of earnings management measured by absolute value of
abnormal accruals. Abnormal accruals are accruals that can be manipulated and is
typically used as the measure of earnings management. This paper applies absolute
values of abnormal accruals as a measure of earnings management. This measure is
suggested by Warfiled et al. (1995) and Bartov (2000). Accruals are the difference
between net income and cash flow from operations. Accruals consist of
discretionary and non-discretionary accruals. We use a modified Jones (1991) model
to estimate expected or nondiscretionary accruals for each two-digit industry code for
each year from 1998-2003. Abnormal or discretionary accruals are measured by
subtracting normal accruals from total accruals.3
Empirical Results
Table 1 reports the descriptive statistics of the variables. On average,
market-adjusted annual stock return is 5.71%. 19.9% of shares owned by directors is
collateralized at financial institutions. Directors own 24% of the outstanding shares
sample is electronic firms. The earnings management level is about 0.102 on
average. Table 2 shows the correlation coefficients among the variables and
indicates that the magnitudes of the correlation coefficients are all smaller than 0.359
(the correlation coefficient between INDUSTRY and R&D). The magnitudes of
correlation coefficients imply that our independent variables are not highly correlated
to cause multi-collinearity problem. We also apply VIF (variance inflation factor) to
examine the collinearity among independent variables in Table 3.
--- TABLES 1 2 3 about here ---
We employ the following regressions to investigate the relationship between firm
performance (earnings management) and controlling shareholders’ share collateral.
RETM = 0 + 1 COLLETERAL + 2 DEBT + 3 R&D + 4 logMV + 5 OWNERSHIP + 6 INDUSTRY + (1) EM = 0 + 1 COLLETERAL + 2 DEBT + 3 logMV + 4 OWNERSHIP
+ 5 INDUSTRY + (2) From the correlation coefficients in table 2, we know that our independent
variables are not highly correlated to one another. In table 3, we further investigate
the VIF of each independent variable in the regressions to see if collinearity problem
that there is no severe collinearity among the independent variables.
Table 3 reports our regression results between firm performance and controlling
shareholders’ share collateral. We use Newey-West (1987) test to adjust for
heteroscedasticity and autocorrelatoin. Table 3 shows that controlling shareholders’
share collateral is highly and negatively related to firm stock return with coefficient=
0.352 and Newey-West t-value= 3.659. Table 3 also indicates that controlling shareholders’ share collateral is significantly positively related to the level of earnings
management with coefficient and Newey-West t-value are 0.025 and 2.581,
respectively. With the data in Taiwan, the empirical results confirm our argument
that the controlling shareholders’ share collateral would raise ethical problems and
increase agency costs leading to poor firm performance.
Concluding Remarks and Suggestions
Shareholders can pledge their shares as collateral for funding from the capital
markets. Minority shareholders who have no control over the firms will bear all the
related risk and benefits from their share collateral themselves. On the other hand,
the controlling shareholders with their control power over the firm can earn benefits
from their share collateral and transfer the risk of share collateral to the creditors and
to the minority shareholders. However, controlling shareholders’ share collateral is
controlling shareholders on the minority shareholders and the ethical problems on the
creditors and minority shareholders due to controlling shareholders’ share collateral
should attract the attention of the government and all the participants of the capital
markets.
A major source for the ethical problems related to controlling shareholders’ share
collateral is the deviation of cash flow rights and control rights. To alleviate the
ethical problems, we can do at least two things: one is to reinforce the corporate
governance mechanism; the other is to reduce the deviation of the cash flow rights
and the control rights resulting from the controlling shareholders’ share collateral.
To reinforce the corporate governance mechanism, the controlling shareholders’ share
collateral should be monitored by the exchange and the related information should be
truthfully revealed to the public. To reduce the deviation of cash flow rights and
control rights associated with controlling shareholders’ share collateral, the voting
rights of the collateralized shares should be limited. We suggest that similar to
treasury stocks collateralized shares should not be honored with voting rights. When
a shareholder collateralizes his shares for funding, his voting rights of the
collateralized shares should be removed. That is, the controlling shareholders may
lose control over the firm when collateralizing shares. Once the controlling
shareholders. In this case, the controlling shareholders would not expropriate the
minority shareholders, but instead they would favor the minority shareholders.
Knowing the potential ethical problems of controlling shareholders’ share collateral
can protect the interest of the creditors and minority shareholders and thus facilitates
Footnotes
1
Controlling shareholders are shareholders able to control the composition of the
board of directors. Typically, controlling shareholders are also top managers. La
Porta, Lopez-de-Silanes, and Shleifer (1999) define shareholders own at least 10% of
votes through a control chain as controlling shareholders. On the other hand, a
minority shareholder is exactly what it sounds like: an individual or organization who
holds shares in a corporation but does not control a majority of the votes. In
companies that are widely-held, a 10% shareholder can be a controlling shareholder.
However, in companies that are concentrated, a 10% shareholder can still be a
minority shareholder.
2
In fact, directors are not exactly the same as controlling shareholders. In Taiwan, it
is difficult to define the ultimate controlling shareholders due to complicate control
chain and token sharehodlers. Hence, we follow Kao, Chiou, and Chen (2004) to
use “director” as a proxy variable for “controlling shareholder”.
3
Since direct stock price manipulation is illegal and risky investment project is
difficult to observe, we simply test the relation between controlling shareholders’
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TABLE 1 Descriptive statistics
Descriptive statistics for stock performance, controlling shareholders’ share collateral, and other firm characteristics of firms listed in Taiwan over the period of 1998-2003. N Mean Standard deviation Minimum Maximum RETM 2766 0.057 0.661 -1.300 6.589 COLLATERAL 2766 0.199 0.264 0.000 1.000 OWNERSHIP 2766 0.240 0.139 0.000 0.971 DEBT 2766 0.415 0.163 0.025 0.865 R&D 2766 0.019 0.036 0.000 0.545 MV 2766 16616 67939 49 1472848 INDUSTRY 2766 0.310 0.462 0 1 EM 2766 0.102 0.126 0 1.092
RETM: market-adjusted annual stock return.
COLLATERAL: percentage of shares that is held by directors of the firm and is collateralized to
financial institutions. The minimum ownership of controlling shareholders equals to 0 because some directors, for example independent directors, do not own any shares of the firms.
DEBT: debt-to-asset ratio.
R&D: ratio of R&D expenses to net sales.
MV: the market value of the firm’s outstanding shares. Unit: in million NT dollars. OWNERSHIP: percentage of shares owned by directors.
TABLE 2 Correlation analyses
Correlation coefficients among stock performance, controlling shareholders’ share collateral, and other firm characteristics of firms listed in Taiwan over the period of 1998-2003. P-values are reported in the parentheses.
COLLATERAL OWNERSHIP DEBT R&D LogMV INDUSTRY
RETM -0.116 (<.0001) 0.039 (0.038 ) -0.074 (<.0001) 0.002 (0.904) 0.185 (<.0001) 0.079 (<.0001) COLLATERAL -0.250 (<.0001) 0.344 (<.0001) -0.156 (<.0001) -0.067 (0.000) -0.167 (<.0001) OWNERSHIP -0.163 (<.0001) -0.022 (0.247) 0.056 (0.003) -0.020 (0.304) DEBT -0.224 (<.0001) -0.211 (<.0001) -0.146 (<.0001) R&D 0.174 (<.0001) 0.359 (<.0001) LogMV 0.316 (<.0001)
TABLE 2 continued
RETM: market-adjusted annual stock return.
COLLATERAL: percentage of shares that is held by directors of the firm and is collateralized to financial institutions. DEBT: debt-to-asset ratio.
R&D: ratio of R&D expenses to net sales.
MV: the market value of the firm’s outstanding shares. Unit: in million NT dollars. OWNERSHIP: percentage of shares owned by directors.
TABLE 3
Regression analyses between firm performance (earnings management) and controlling shareholders’ share collateral
The relation between stock performance (earnings management) and controlling shareholders’ share collateral conditioning on other firm characteristics. In the parentheses are Newey-West t-values are calculated using Newey-West test.
Dependent variable: RETM Dependent variable: EM Variance Inflation Factor Intercept -0.525 (-4.192) 0.089 (1.606) 0.000 COLLATERAL -0.352 (-3.659) 0.225 (2.581) 1.217 DEBT -0.106 (-0.906) 0.109 (9.056) 1.221 R&D -1.564 (-2.549) 1.198 LogMV 0.241 (6.191) -0.009 (-3.451) 1.153 OWNERSHIP 0.065 (0.633) 0.031 (3.782) 1.086 INDUSTRY 0.169 (1.356) 0.050 (12.198) 1.263 N 2766 2766 R2 4.78% 8.96% Pr>F <0.0001 <0.0001
RETM: market-adjusted annual stock return.
EM: the absolute value of abnormal accrual as measure of earnings management.
COLLATERAL: percentage of shares that is held by directors of the firm and is collateralized to
financial institutions.
DEBT: debt-to-asset ratio.
R&D: ratio of R&D expenses to net sales.
MV: the market value of the firm’s outstanding shares. Unit: in million NT dollars. OWNERSHIP: percentage of shares owned by directors.
