Do Controlling Shareholders’ Expropriation Incentives Imply a Link Between Corporate Governance and

Firm Value? Theory and Evidence

Kee-Hong Bae, York UniversityJae-Seung Baek, Hankuk University of Foreign StudiesJun-Koo Kang, Nanyang Techonological UniversityWei-Lin Liu, Nanyang Techonological University

1

Corporate governance and firm value

Examine the relation between governance and firm value change during crisis period.– Johnson, Boone, Breach, and Friedman

(2000), Mitton (2002), Lemmon and Lins (2003), Baek, Kang, and Park (2004)

– Firms with poor corporate governance suffer more during economic crisis period in the Asian region.

2

Why poor governance firms suffer more?

Expropriation hypothesis– Johnson, Boone, Breach, and Friedman

(2000)

Information hypothesis– Rajan and Zingales (1998)

Risk hypothesis

Overreaction hypothesis3

Research question

Reevaluate the validity of expropriation hypothesis against other possibilities.

The novelty of our approach– The prediction of expropriation

hypothesis during recovery period is exactly opposite to that during crisis period.

4

A simple model of expropriation

The change in firm value during the crisis is negatively (positively) re-lated to the manager’s expropriation power (his equity ownership in the firm).

The change in firm value during the recovery period is positively (nega-tively) related to the manager’s ex-propriation power (his equity owner-ship in the firm). 5

During the crisis period, controlling shareholder allocates less capital to investments, resulting in a smaller amount of investable capital avail-able when the recovery arrives.

The limited amount of initial in-vestable capital produce, on a per dollar investment basis, a large in-crease in firm value.

6

Expropriation vs. Information

Relation between the governance quality and firm

value change

Crisis period Recovery period

ExpropriationHypothesis

Positive Negative

InformationHypothesis

Positive Positive or no relation

7

Data

Korean sample (for main analyses)– 608 non-financial firms listed on the

Korean Stock Exchange (KSE) during 1996-1999.

Additional evidence using– Asian sample: 598 firms from seven Asian

countries during Asian crisis– Latin sample: 302 firms from four Latin

countries during 2001 Argentine crisis

8

Method

OLSDependent variable– Firm performance (BHRs, accounting

profits)

Independent variables– Governance variables– Firm risk– Contrarian effect– Firm characteristics

9

Governance variables

Disparity between voting rights and cash flow rights by controlling share-holders (defined as owner-managers and their family members)– Log of (voting rights / cash flow rights)

Equity ownership by controlling shareholders

10

Firm risk and contrarian effect

Market beta using two-year daily stock returns

Residual variance

Past holding period return (HPR)

11

Control variables

Log of total assets and its squareLeverageBusiness group (top 30) dummyForeign ownership and ADR dummyFinancial investment in affiliated firmsTobin’s qCash flowIndustry dummy

12

13

14

15

16

17

Robustness tests

Alternative governance measures– Sum of block ownership by all

shareholders– Largest managerial block ownership– Largest nonmanagerial block ownership

Alternative performance measure– Accounting profitability

Alternative crisis and recovery period18

Does governance matter on net?

Governance variables are not related to holding period return over the en-tire cycle, down and up.

Controlling shareholders’ propping behavior? (Friedman, Johnson, and Mitton (2003)– Propping activities during recovery may

improve firm value and lead to large re-bounds in the stock prices.

19

Endogeneity issue and event study

The effect of corporate governance on firm values during the recovery period is not free from the endogeneity problem.

We consider exogenous events during the 1997-1998 period and examine the relation between the change in firm value due to such events and a set of governance variables. 20

21

22

23

Further tests

Sample of seven East Asian countries during 1997 Asian currency crisis.

Sample of four Latin American coun-tries during 2001 Argentine crisis.

24

25

26

27

ConclusionThe fundamental premise of law and finance literature is the importance of investor protection in preventing the expropriation of minority investors (LLSV, 2000).

Our evidence shows that investor expropriation is indeed the main channel through which corporate governance affects firm value.

28