Corporate Governance and Regulation: Can There be Too Much of a Good Thing?

1. Corporate Governance and Regulation: Can There be Too Much of a Good Thing? Valentina Bruno, American University Stijn Claessens, IMF and University of Amsterdam Conference on Contemporary Issues of Firms and Institutions Chinese University, Hong Kong December 14-15

2. Motivation of the study • What matters most in CG practices is still subject to debate and empirical questioning • E.g., is the CEO/Chairman split important? • Gompers, Ishii & Metrick (2003), Bebchuk et al. (2004), Core et al. (2006) differ in important ways • Relationship of companies’ CG practices with country legal system is of practical/policy interest • Determines role of government • Existing studies: Klapper and Love (2004), Durnev and Kim (2005)

3. Motivation of the study • Increased global de-listing, going private (equity) • Raises questions on appropriateness of some CG rules for listed corporations, US and globally • Renneboog et al. (2006), Leuz (2003), Boot et al. (2006) • Current debate on excessive regulation in US • “One factor contributing to the loss of U.S. public market competitiveness is the growth of U.S. regulatory compliance costs and liability costs” (Interim report of the committee on U.S. capital markets regulation, Nov. 2006)

4. What we do • Study detailed company-level CG practices and general country-level CG rules • Study association of CG practices, country-level CG rules and interactions between practices and country rules with performance to understand: • What are the most important CG channels? • What is the impact-magnitude of these channels? • Is there substitution or complementarity between company-level CG practices & country-level CG rules? • Does CG matters differently by industry type of firms?

5. How we extend the current literature • Better indexes of corporate governance • Third party, cross-checked • Good cross-country coverage • 23 countries, with variety in rules/practices • Interaction country and company CG • Are not independent (laws, substitutes, complements) • Focus on the channels and their magnitude • Use detailed governance indicators • Take into account monotonic and non-monotonic associations • Importance of CG for external financing and size • Show channels, with less causality issues

6. Underlying theoretical foundations - Graphical representation - marginal $ benefit marginal cost GOV

7. Underlying theoretical foundations - Graphical representation - marginal $ benefit marginal cost GOV

8. Underlying theoretical foundations - Graphical representation - marginal $ benefit marginal cost GOV

9. Underlying theoretical foundations - Graphical representation - marginal $ benefit marginal cost GOV An increase in investor protection is not necessarily associated with an increase in firm value since it can be that marginal costs > marginal benefits (e.g., SOX)

10. Roadmap • Motivation • Contribution and differences from the existing literature • Dataset and construction of the corporate governance indicators • Standard empirical methodology (1) • Empirical methodology (2), assuming no monotonic relations • Robustness • Conclusions

11. Data • Company-level data on CG practices from Institutional Shareholder Services (ISS) • Country-level data on investor protection from LLSV, Djankov et al. (2007), and International Country Risk Guide (ICRG) • Financial data, Worldscope & COMPUSTAT • Firm performance is Tobin’s Q, market to book • Sample: 5857 company-year observations, 23 countries from developed economies • Period: 2003-2005 • Usual firm control variables (size, capital intensity, etc)

12. Company-level CG indicators • BOARD COMMITTEES: nomination, compensation, audit and governance • Two Indices: Existence (COMM1) or independence (COMM2). Range: 0-4 • BOARD ENTRENCHMENT (BCF): no poisons pills, no staggered, no supermajority for mergers or charter amendments (Range: 0-4) • BOARD INDEPENDENCE: dummy = 1 if majority of independent members, 0 otherwise (INDEP1) or boardindependence, no former CEO on the board, separated CEO/Chairman (INDEP3, Range: 0-3) • COMPANY TRANSPARENCY: auditors ratified at AGM, fees paid to auditors strictly audit fees, no related party transactions for the CEO (TRANSP, Range: 0-3)

13. Country-level CG indicators • LLSV anti-director index (legal protection of minority shareholders) • Self-Dealing Index (private enforcement mechanisms) • International Country Risk Guide (Law and Order Tradition of a country) • We create: • INV_PROT1= LLSV+ICRG • INV_PROT2= LLSV+ICRG+Self Dealing • INV_PROT3= LLSV * ICRG

14. Empirical methodology (2) WE DIVIDE COMPANIES INTO 4 GROUPS: • Hi Hi: companies with high (above median) country CG and high company CG • Hi Lo: companies with high country CG, but low (below the median) company CG • Lo Lo: companies with both low country and company CG • Lo Hi: base case (low country CG, high company CG) CONTROLS: size, assets tangibility, cross-listing (ADR), investment intensity, leverage, growth opportunities METHODOLOGY: country random effects, with time and industry dummies, standard error clustered at country level

15. Results (2)

16. Results (2)

17. Results (2)

18. Results (2)

19. Results are robust • Different sample choices (include financial companies, reduced sample US, 2005 only) • Consider laws (de-jure) as well as enforcement (de-facto) • Consider additional control variables, overall governance score • ROA, MTB • Different econometric specifications (dummy or continuous variables)

20. Results are robust (cont’d) • Companies adjust to country? Mandatory vs. flexible corporate governance? We filter out the country effect. STEP 1: a. Compute the within-country averages for each indicator. b. Take the difference (company indicator – country average), e.g., (COMM1 – country average COMM1) • Positive values indicate higher than the average governance standards c. Then, separation in 4 groups (HH, HL, LH, LL) Less concern on country effect on company corporate governance

21. Results are robust (cont’d) STEP 2: • where companies with high country CG and higher than the average company CG, etc. • “Too much of a good thing” is confirmed. • Relevance of COMM1, COMM2 and INDEP1 is confirmed

22. Corporate Governance, External Financing Dependence, and Size • EXT_DEP is Rajan & Zingales (1998) external financing dependence measure • SIZE is the (log of) median size of companies • i= company, k=industry, t=year • The U.S. is the benchmark Methodology: OLS, with country, industry and time dummies, standard errors clustered at country level

23. Results • CG practices signal commitment to investors • Bigger companies benefit more from CG

24. Conclusions • Not everything equally matters: • Board committees and board independence matter more • CG as monitoring and signalling device • Especially for companies in highly financial dependent industries • Effects between company and country CG • Country can not overcome weak company

25. Conclusions • Possible over-regulation • Too much country regulation can hurt good firms, leading to lower valuation • Costs of too much regulation direct & indirect • Direct more an issue for small firms • Indirect, through reduced flexibility for firms, reducing degrees of freedom, investment & efficiency of operations • Policy implications: evaluate CG-rules • Tougher regulation does not necessary imply higher valuation/performance • Avoid less listings/de-listings, going private