Does governance matter for companies involved in real estate investment activities

Chapter One

INTRODUCTION

In this chapter we will give an executive summary the following subjects:
▪ Background of the study
▪ Motivation of the study
▪ Scope of the study
▪ Testable hypothesis
▪ Sample selection and sources of the data
▪ Methodology
▪ Organization of the study


CHAPTER ONE-INTRODUCTION

2

Chapter One

INTRODUCTION

1.1 Background

Separation of ownership and management is one of the characteristics of many modern
corporations 1 . Jensen and Meckling (1976) and Fama and Jensen (1983 a, b) argued that the
separation of ownership and control leaves managers with ample leeway to pursue their own
interests at the shareholders’ expense. Agency costs, therefore, arise when equity investors are not
involved in the management of corporations.

“Corporate governance’ as mechanisms devised to regulate the conduct of directors and management is

thus important in corporations to mitigate agency problem. Markets will reward companies with good
governance system. What does corporate governance exactly mean? Corporate governance comprises a
system of mechanisms through which owners of a corporation can monitor and reward the
corporation’s insiders and management, so to ensure that their capital funds are protected. In the
seminal article by Sheifer and Vishny (1997), the theory of corporate governance centers on three main
questions:

(i)

1

How do the suppliers of finance get managers to return some of the profits to them?

Coase’s (1937) theory of the firm which explains the underlying contractual view of firms is the foundation of
making most of the studies of corporate governance and firm performance. A corporation is made up of a nexus of
contracts, it difficult to fully specify ex-ante any ex-post contingencies in those contracts. Corporate governance,
therefore, becomes an important and critical issue in the modern theory of firm.


CHAPTER ONE-INTRODUCTION

(ii)

3

How do they make sure that managers do not steal the capital they supply or invest it in
bad projects?

(iii)

How do suppliers of finance control managers?

The corporate governance literature identifies seven major mechanisms, which can be divided into
two broad categories: internal monitoring and external control. The external control mechanisms
rely on parties outside the firm to monitor the performance of top management, which include the
debt policy, the managerial labor market, and the market for corporate control. The remaining four
corporate control mechanisms are instituted inside the firm, which include shareholdings of
managerial and institutions, large block-holders and the structure of board of directors. These
interdependent mechanisms aim to alleviate the agency problems between managers and
shareholders. Agrawal and Knoeber (1996) observed an optimal level of corporate governance
across a section of firms.

Quasi-rents 2 are common in real estate because of its unique characteristics such as asset
specificity, fixity by location, and complex valuation method. These are possible roots for the lack
of strict governance in real estate investments compared to investments in other asset types
(Sirmans, 1999). Ghosh and Sirmans (2002) empirically examine the governance in real estate
investment trust (REIT) in US. There are, however, limited studies that investigate corporate
governance in public property companies listed outside the US market.

Despite the Anglo-American influence of the practice and philosophy of corporate governance in
Singapore (Li, 1994), there are still apparent weaknesses in the structure and activities of
2

The payment that is received by a resource of production activity over the opportunity cost in the short run. According
to Zingales (1997), “The difference between the value of the product and the cost of the contracted manufacturer
presents a quasi-rent, and it needs to be divided ex-post.”


CHAPTER ONE-INTRODUCTION

4

Singapore’s corporations, which are not commonly observed in corporations in more developed
economies in the UK and the US. The high concentration of ownership and the weak take-over
market activities favor the owner-manager 3 structure in many public listed companies in
Singapore (Mak and Li, 2001). This structure provides weak corporate governance on managers.
The unique institutional characteristics and market environment in Singapore may offer a different
case for empirical tests of the theory of governance.

Land is scarce in Singapore. Many Singapore corporations own and invest in real estate as part of
their portfolio strategy. Although there are only 29 companies listed in property sector of the
Singapore Exchange (SGX). However, evidence shows that over 100 listed non-property
companies on SGX are highly property intensive with more than 20 per cent of property assets in
their total assets. 4 It is thus important to analyze how inherent characteristics in real estate
investment will affect the constitution of the corporate structure, and the potential governance
problems in a corporation. This study also investigates the relationship between corporate
governance system and performance of firms in Singapore.

1.2 Motivations of the Study

Governance plays an increasingly important monitoring role in today’s corporate activities.
Theoretical and empirical studies examining the agent-principal conflicts have been well published
in corporate finance literature. However, few of them have examined explicitly on the corporate
governance problems associated with real estate investment, and this study thus attempts to fill-in
the gap by using empirical data of listed companies in Singapore. There are four main motivations
for undertaking this study.

3
4

An individual who makes all major decisions directly and monitors all activities.
The data are based on the annual report of the financial year 2001 for each corporation.


CHAPTER ONE-INTRODUCTION

5

Firstly, cross-country differences in laws and their enforcement create different ownership
structure and government regulations, which may in turn affect in different ways how companies
are controlled and the processes by which the corporate controls are implemented. 5 Motivated by
the following comments by Sheifer and Vishny (1997, page 740), “Most of the available empirical
evidence (on corporate governance) comes from the United States…

More recently, there has

been a great surge of work on Japan, and to a lesser extent on Germany, Italy, and Sweden.
Unfortunately, except for the countries just mentioned, there has been extremely little research
done on corporate governance around the world.”

The question: “Do differences in institutional environment across countries affect the choice of
corporate governance practices?” will be examined in this study.

Secondly, based on the idea of Sirmans (1999) and Ghosh and Sirmans (2002), we believe that
quasi-rents caused by unique characteristics of real estate may create difficult governance
problems for firms with high concentration in real estate assets vis-à-vis other asset classes.
Alternative corporate mechanisms may be required to protect the equity holders’ interest in firms
with exposure to real estate markets. Studies of governance problems in Real Estate Investment
Trust (REIT) are well explored. However, the study of effects of real estate investment activities
on corporate governance in firms outside the US market is limited. Property companies listed on

SGX are not subjected to the same legal instructions of REIT, such as no free cash flow, lower
level of the ownership concentration, and no self-management of property assets. 6 In the absence
of these regulations, should more corporate mechanisms be installed to monitor the property
companies’ management in Singapore?
5

For example, Roe (1990), Li (1994), Sheifer and Vishny (1999 a, b) and others.
This self-management requirement is not applicable to REITs in the US and Australia, where internally-advised
structure is common for some REITs.
6


CHAPTER ONE-INTRODUCTION

6

Thirdly, owning and investing real estate is an important portfolio strategy of many Singapore
companies, and real estate constitutes a large proportion of corporations’ tangible assets in the
financial statements. There are only limited studies that test the governance problems in Singapore
(Phan and Mak, 1999; Mak and Li, 2001), and none of them look at how real estate investment
activities affect the effectiveness of the corporate governance of publicly listed firms. It is,
therefore, useful to empirically examine how inherent characteristics of real estate will influence
corporate structure, ownership structure, and also performance of publicly listed firms with
intensity property holdings.

Finally, cross-industry studies of the effectiveness of corporate governance are still lacking.
Sirmans (1999) argues that governance issues may be more problematic in real estate than in other
asset markets. However, there is still dearth of empirical evidence to support the hypothesis that
corporate governance is relatively less effective with firms involved actively in real estate
investment activities. This study compares the effectiveness of corporate governance for property

and non-property firms with high concentration of real estate investment assets. The findings will
have significant implications on whether non-real estate companies should divest their non-core
real estate assets, and outsource their real estate needs to professional real estate firms with
specialized industrial knowledge.

1.3 Scope of the Study

This study focus mainly on the governance issues associated with real estate investment activities.
Due to the small size of firms listed on the real estate sector of the SGX, which comprise only 29
firms at the time of the study, firms with high concentration of real estate assets, which is knows
as “property intensive companies” are also included in the empirical tests. The “property asset


CHAPTER ONE-INTRODUCTION

7

intensity” is measured by the proportion of property to total fixed assets held by a non real-estate
company. A 20 per cent cut-off point is used to define of “property intensive” non-real estate firms
in our sample. Based on this definition, non-real estate firms listed on the SGX can be divided into
two categories: property intensive firms and non-property intensive (other) firms.

Since property assets of non real estate firms are generally grouped into three subtypes: fixed
properties, investment properties and development properties, “property intensive” non-real estate
firms are further divided into two groups: firms that account real estate assets as a cost center, and
firms that take limited property market risk in holding investment and/or development properties.

1.4 Testable Hypothesis

The following testable hypotheses are formulated in this study:

1) The substitution hypothesis, which states that since alternative mechanisms exists, the
relatively lower reliance on one mechanisms will not adversely affect the effectiveness of total
governance mechanisms, is firstly investigated;

2) Since real estate investment has its specific characteristics, such as asset specificity, fixity by
location, and complex valuation method, the governance may be more problematic in real
estate than in other type industries. Therefore, real estate investment must be a significant
determinant for some particular governance practices to eliminate the conflicts between
owners and management;

3) CEO organizational control can be increased by adding more executive directors on the board,
owning more equity, and serving in the position for a longer period. Therefore, the


CHAPTER ONE-INTRODUCTION

8

discretionary power of the CEO is entrenched. This study also investigates that entrenchment
hypothesis of the CEO control power;

4) Shareholder voting hypothesis, which states that directors’ decision control power in the
nomination process as the directors’ voting rights increases by owning more common stocks
of the firm, is also tested in following studies.

5) There are two perspectives in the literature for studying the relationship between governance
mechanisms and firm performance. One perspective explores the relationship based on the
assumption that certain governance system is optimal for all firms, that firms that conduct it
will have higher performance or value; an alternative view is that although governance

mechanisms are endogenously determined, there is unlikely to establish significant
relationship between those monitoring mechanisms and firm value. This study tries to provide
further evidence as to whether an endogenously determinants in the governance mechanisms
will have possible effects on firm performance in Singapore market;

6) The hypothesis of the institutional impact on the corporate governance—institutional
characteristics would influence the level of the performance of various corporate governance
mechanisms

1.5 Sample Selection and Sources of the Data

Firms listed on the Singapore Exchange (formerly known as the Stock Exchange of Singapore)
(SGX) are used as the sample of this study. There are 386 firms listed on the main board and 106
firms listed on the SGX-SESDAQ as at end of 2001. Based on these 492 firms, we sieve out firms
that meet the following criteria for our empirical analysis purposes:


CHAPTER ONE-INTRODUCTION

9

1) The firms must have been listed on the SGX for at least two years by end of 2001;

2) There are annual reports for the firms;

3) Only Singapore dollar denominated stocks are selected; and

4) Annual report of the firms must contain information of chairman and CEO or its equivalence,
such as the managing director or president.

Based on the above criteria, 228 sample listed firms are selected in this study, which includes 20
firms listed on the property sector of the SGX.

Cross sectional financial statements and firm-specific data for the 228 sample firms for the
financial year ended in 2001 were collected. The financial data on net income, fixed asset, total
assets, total debt, market capitalization, and total number of common stocks were collected from
the computer database, Datastream®, at the department of real estate of the National University of
Singapore. Corporate governance data such as the number of independent directors, characteristics
of CEO, shareholdings of large blockholders and management were extracted mainly from annual
reports of the sample companies.

1.6 Methodology

Three quantitative methodologies that include the simultaneous equations system, binary response
regression model, and classical linear regression model are used in this study to empirically test
the corporate governance hypotheses. These models empirically test the significance of various
corporate governance mechanisms. They also evaluate the effectiveness of governance


CHAPTER ONE-INTRODUCTION

10

mechanisms between listed property companies, listed property intensive non-real estate
companies and other companies.

1.6.1 Simultaneous Equations System

The issue of endogenity among governance mechanisms has been extensively discussed in the
corporate governance literature. As those mechanisms are jointly determined, there is a two-way

causal relationship between the governance variables. To deal with the endogeneity of the
mechanisms, this study tests the internal and external corporate governance mechanisms proposed
by Agarwal and Knoeber (1996) using a simultaneous equations system technique. Two-stage
least squares (2SLS) approach is used to estimate the significance of various governance
mechanisms, and at the same time, test the feed-back effects and bi-directional causality of the
governance mechanisms.

1.6.2 Binary Response Regression Model

The leadership structure of the board is considered by corporate governance literature as an
important governance mechanism. 7 It can be defined using a binary dummy variable that has a
value of either one, if the same person in the board serves as both CEO and chairman; or zero, if
there is a dual leadership structure. A binary response regression model is employed to find the
determinants for the dual leadership structure in the board. This study uses the logit model to
explain the likelihood of firms adopting a binary leadership structure in the management.

7

Agrawal and Knoeber (1996), Mak and Li (2001) treated the leadership structure of the board as one of governance
mechanisms and introduced this variable into their simultaneous equations system.


CHAPTER ONE-INTRODUCTION

11

1.6.3 Classical Linear Regression

The classical linear ordinary least squares (OLS) regression is also used to test the relationship
between corporate governance and firms’ performance, which is represented by the Tobin q

measure. Different corporate governance variables are included in three independent OLS models
to separate the effects of different corporate governance variables. The White’s test is used to test
the heteroscedasticity in the model, when governance mechanisms are jointly included to explain
the variations in firm performance. Finally, by comparing the results from both OLS and 2SLS
estimations, we can isolate the problem of endogeneity between governance mechanisms and firm
performance, and evaluate how these determinants affect the explanatory relationship between the
corporate governance and firm performance.

1.7 Organization of the Study

The remainder of this study is organized as follows.

Chapter One describes the background, motivations and scope of the study. The testable
hypotheses, the data sources and the empirical methodologies are also included in this chapter.

In Chapter Two, relevant corporate governance literature is reviewed, which is followed by
discussions of the knowledge and findings of current research in the subject.

Chapter Three provides an overview of the institutional environment and the corporate governance
system in Singapore. The regulatory framework relating to corporate control, accounting standards,
and various corporate governance initiatives are described in this chapter.


CHAPTER ONE-INTRODUCTION

12

The process of data collection and the sources of data are described in Chapter Four. This chapter
sets up the definitions of various variables. The summary statistics of these variables, which
include the Spearman correlations between the variables are also presented.

Chapter Five discusses the steps and the techniques in the model building. Firstly, the
simultaneous equations system is applied to test the endogenous relationships among the
governance mechanisms; Secondly, a dummy dependent variable model is used to test the
determinants of the board’s leadership structure. Next, the linear relationships between the
corporate governance and firm performance are estimated. Two regression techniques: the OLS
regression and the 2SLS regression, are employed to empirically test the relationships between the
governance mechanisms and firm performance and to examine the effects of endogeneity of the
determinants.

The empirical results are analyzed in Chapter Six, which includes the evaluation of the model
fitness, and the significance of the testable hypotheses. Differences in the results of the OLS and
the 2SLS regressions on firm performance and various corporate governance mechanisms are also
discussed.

Chapter

Seven

concludes

the

study.

Contributions

of

this

research

are

discussed.

Recommendations for further studies are presented, and limitations of this study are also
highlighted.


Chapter Two

LITERATURE REVIEW

In this chapter we will cover the following subjects:
▪ The theory of firm
▪ What is corporate governance?
▪ What constitutes corporate governance?
▪ The endogeneity issue
▪ Governance literature on real estate investment
▪ Corporate governance literature on Singapore Market

This literature review chapter sets up the framework for the theory of the corporate governance. It covers the
following questions: What causes the governance issue? What is the definition of the theory of corporate
governance? What constitutes the corporate governance? The empirical analyses of the corporate
governance are also presented. As well as the importance of the study of the governance issue in real estate
investment and the pervious studies on the corporate governance in Singapore market are described.

CHAPTER TWO-LITERATURE REVIEW

14

Chapter Two

LITERATURE REVIEW

2.1 The Theory of Firm
The research into the causality of corporate governance is invariably dependent on the emergence
and the form of business organization of a corporation of firms. An understanding of the nature of
the firm is essential in studying the question of why corporate governance matter. There are many
definitions of a firm in the economic and legal literature. These definitions have been used in
neoclassical economic theories that explain the transaction cost and principle-agent relationships.

The classical theory of firm is introduced by Coase (1937). In his seminar paper, he suggested that
the introduction of the firm was mainly because of the existence of marketing costs. There are
costs incurred when operating in a market. Forming an organization and allowing entrepreneur to
directly allocate the resources can reduce some marketing costs. He also emphasized that an
entrepreneur must exert efforts to reduce cost in operations. He must attempt to obtain factors of
production at a price lower than that attained in the open market transaction; otherwise it will not
make economic sense for the firm to exist. He also pointed out that writing a contract is itself
costly. The contract should only state the limits to the powers of an entrepreneur. Within these
limits, he can therefore have the flexibility to deploy the factors of production.

Many researchers build their studies based on the work of Coase’s. Jensen and Mechkling’s work
(1976) is one of the examples. They looked at a firm as a nexus of a set of contracting
relationships among individuals. They gave the definition of the agency relationship as a contract

CHAPTER TWO-LITERATURE REVIEW

15

in which a principal can engage an agent to perform some services on his behalf. The ex-ante
made contract is usually treated as a necessary instrument to ensure agents to align their interests
with principals’. However such contract can never make a complete forecast of the ex-post
divergence. In order to eliminate the aberrant activities of the agent, principal must establish
appropriate incentives and monitoring mechanisms. Both of those activities are also costly. The
authors summarized the costs of the agency relationship as 1) the monitoring expenditures, 2) the
bonding expenditures, and 3) the residual loss. Such concept of agency costs just makes a room for
governance in a firm.

In 1980, Fama further extended the work on the theory of the firm. He claimed that the classical
agency theory fail to explain the functions of a large modern corporation, where the control of the
firm is in the hands of managers who are separated from the firm’s security holders. The author
believed that this separation of security ownership and control can be an efficient form of
economic organization within the “set of contracts” perspective. According to Jensen and
Meckling’s theory, the entrepreneur is not only a manager, but also a residual risk bearer. However,
in the modern corporation, the separation of management and risk bearers exists. So, Fama pointed
out that when looking at the risk bearing from the viewpoint of the portfolio theory, the risk
bearers are likely to spread their wealth across many firms, and not interested in directly
controlling the management of any individual firms. This efficient distribution of risk causes a
large degree of separation of security ownership from control of a firm. As a consequence, big
agency problems rise in a modern corporation.

Grossman and Hart (1986) come up with an alternative definition of firm, which states that a firm
is a collection of the assets that it owns. Base on this theory, they classified the contractual rights
into two categories, which are specific rights and residual rights. Moreover, they define the
ownership as the purchase of the residual rights. Since it is impossible to prepare a comprehensive

CHAPTER TWO-LITERATURE REVIEW

16

contract ex-ante, the purchase of the residual rights is both meaningful and valuable. The authors
claimed that it is meaningful because the ownership based on this purchase confers the right to
make decisions in all contingencies unspecified by the initial contract; it is valuable because these
residual rights can be important in bargaining the size of the ex post surplus as well as its
distribution. Their incomplete contracting model creates a room for ex-post governance and
because of the separation of contractual rights there may be incentives to optimally allocate the
ownership among the firm.

Rajan and Zingales (1998) put the theory of firm forward based on the concepts created by
Grossman and Hart. They define the firm both in terms of the unique assets and in terms of the
people who have an access to these assets. This definition expands the theory of firm by
incorporating the theory of power in organizations. It explicitly recognizes that a firm is a complex
structure that cannot be instantaneously replicated. In their paper, Rajan and Zingales interpreted
the power within a firm, the role it plays and the origination of the firm. They suggest that access
can be a better mechanism than ownership because the power from having access may be more
contingent on a specific investment than the power of ownership. The ownership of physical assets
is no longer the only source of power within a firm. This view of the firm well explains a variety
of institutional arrangements as well as highlights the role played by an internal organization in
enhancing the value of the firm.

Although there are different views about the concept of a corporation, there is a common element
among the corporate structure. That is when people enjoy the benefits of this business organization;
they must pay for their loss of control. Investors lose control over the use of their capital;
managers lose control over their sources of funding. The loss of control gives rise to conflicts

between equity holders and managers. Therefore, mechanisms that eliminate the conflicts become
more valuable to the corporations.

Those mechanisms constitute the major part of the


CHAPTER TWO-LITERATURE REVIEW

17

governance, which is more and more considered by individual investors, funds, banks, and other
financial institutions.

2.2 What is Corporate Governance?
The firm’s security holders are diversified across many of firms and they may not take a direct
interest in the management of a particular firm. The ex post deviations from the contract set-up
may also incentive a manager to consume more on the job than what has been agreed in his
contract. These central questions arise:

(i)

How do the suppliers of finance get managers to return some of the profits to
them?

(ii)

How do they make sure that managers do not steal the capital they supply or
invest in bad project?

(iii)

How do suppliers of finance control managers? 8

Principal-agent problems arise from the separation of ownership and control between corporate
outsiders and insiders. Considering this inherent conflict, there may be checks and balances on
managerial behavior. Although economists and legal experts have raised concerns on the corporate
governance, and its use as a defense of shareholders’ interests, there is no universally accepted
definition of what the term corporate governance is defined.

8

Sheifer and Vishny (1997)


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18

Traditionally, corporate governance has been concerned with the issues of the exercise of choice
and the creation of opportunities, and how choices and opportunities impact on institutions’
decision-making and accountability (Bird and Waters, 1987). Shleifer and Vishny (1997), however,
consider corporate governance as an instrument that assures the suppliers of finance to
corporations of getting a return on their investment. Robert and Nell (2001), present the definition
of corporate governance as a relationship among various participants in determining the direction
and performance of corporations.

In Organization for Economic Co-operation and Development’s (OECD) definition, corporate
governance structures are seen as mechanisms for making decisions that have not been specified
by contract between principals and agents. Since it is costly to set up a comprehensive contract on
exact tasks for the latter, Zingales (1998) defined the corporate governance as a complex set of

constraints that shapes the ex-post bargaining over the quasi-rents generated by a firm. Within his
definition, the corporate governance is considered as corporate authorities’ allocation which
affects the process through quasi-rents distribution. Those authorities are include ownership,
capital structure, managerial incentive schemes, takeovers, boards of directors, pressure from
institutional investors, product market competition, labor market competition, organizational
structure, etc.

In summary, two conditions have made corporate governance critical to a firm. Firstly, agency
problems exist in any form of business organization, as long as the interests between principals
and agents differ. Secondly, because complete contracts are technologically infeasible, future
contingencies are hard to describe and foresee.


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19

2.3 What Constitutes Corporate Governance?

Broadly speaking, the principles of corporate governance can be explained from two perspectives.
From a corporation’s perspective, corporate governance is about maximizing value subject to
meeting the corporation’s financial, other legal and contractual obligations. From a public policy’s
perspective, corporate governance is about ensuring accountability in the exercise of power and
patronage by firms. Both perspectives provide a framework for corporate governance that reflects
an interplay between internal incentives (which define the relationships among the key players in
the corporation) and external forces (notably policy, legal, regulatory, and market)), which together
govern the managerial behavior.

The roots of investigating the characteristics of the internal and external features can be traced
back to at least Berle and Means (1932), who argued that management ownership in large firms is

insufficient to create managerial incentives for value maximization.

Agrawal and Knoeber (1996) summarized the total internal and external factors into seven control
mechanisms. The external mechanisms that discipline the firm’s performance include the
production market competition, the market for corporate control, and the debt covenants. The
internal contents consist of the shareholdings of managers, institutions, and large block-holders,
and the use of outside directors.

2.3.1 External Forces

Hart (1983) proposed the idea that the competition in the product market reduces managerial slack.
The managerial slack is the outcome of the separation of ownership and control in a firm, and this
separation gives the managers an opportunity to pursue their own objectives. The manager’s goals


CHAPTER TWO-LITERATURE REVIEW

20

on growth maximization or effort minimization may be in conflict with the profit or market value
maximization goals of the firm. However, the author pointed out that when a firm operates in a
market, it will face the competition from other firms in the same industrial, and the competition
makes the performance of different firms interdependent. Given this interdependency, when the
cost of the firm is falls, other firm’s cost are also likely to be low. The managers are only allowed
a partial reduction in the slack. Thus, the competition in the product markets is a necessary but not
enough form of discipline on managers. Competition in capital markets also plays an important
role in eliminating the managerial slack.

Corporate control of firms is always considered as an important component of the capital market.
Economic evidence indicates that corporate control in the capital market benefit shareholders and

society, and it has strong influence of the corporate organization form.

The market for corporate

control is often referred to as the takeover market, which is defined as a market in which
alternative managerial teams compete for the rights to manage the corporate resources (Jensen and
Ruback, 1983).

Manne (1965) is one of the researchers who recognize the critical role of the market for corporate
control. The causality of this control mechanism is the existence of a high positive correlation
between corporate managerial efficiency and the market price of the company shares. The author
interpreted that if the market price of the corporation’s common stock is low, and if a group of
individuals or another corporation believes it could manage the corporation more efficiently, it has
the incentive to purchase the corporation and increase its value from an improved management. If
the purchase were to occur, it is likely that the new owners would fire the management, because
they believe that it is the poor management that causes the corporation’s suboptimal performance.
Consequently, the threat of a takeover installs a scheme for the market for corporate control, which


CHAPTER TWO-LITERATURE REVIEW

21

enforces competitive efficiency among corporate managers, and thereby protects the interests of
the small and non-controlling shareholders.

The findings of Grossman and Hart (1980), Jarrel, et al (1988), Jensen and Ruback (1983), Jensen
(1988), and Instefjord (1999) also indicate that the market for corporate control induces wealth
creation in various ways. Which include a reduction in wasteful bankruptcy proceedings, a more
efficient management of corporations, protections for non-controlling corporate investors, an

increased mobility of capital, and a more efficient allocation of resources.

Jensen’s (1986) free cash flow theory indicates that takeover is an imperfect mechanism for
companies, where management has access to significant discretionary cash flows. The
management will be reluctant to use outside capitals, which will otherwise subject them to the
monitoring of the capital market. Since the existence of free cash flow has negative implications
for takeover activity, Jensen advocates debt creation, which comes with mandating interest
payments, as a good alternative control to minimize the agency conflict. The threat of the failure to
make debt service payments serves as an effective force that motivates the management of the firm
to be more efficient.

Shleifer and Vishny (1997) also discussed the debt contracts as a specific governance arrangement.
They said the defining feature of debt that transfers the control rights to creditors reduces agency
cost. These controls prevent a manager from investing in negative net present value projects, and
on the other hand force him to sell assts that are worth more in alternative use.

However, Jensen, Shleifer and Vishny also emphasize that while debt contracts may be beneficial
in reducing the agency problem; increased leverage also has its associated costs. Firstly, debtors
may prevent firms from undertaking new projects, because debt covenants restrict them from


CHAPTER TWO-LITERATURE REVIEW

22

raising additional funds. Secondly, bankruptcy may also increase costs. Because of these costs,
debt contracts may not always have positive control effects. Therefore, an optimal debt-equity
ratio, as suggested by Jensen at a point where the marginal costs of debt just offset the marginal
benefits, should be adopted by firms.

While the external forces of corporate control are powerful instruments in disciplining managers
and ensuring that they will behave corresponding closely to shareholders’ wishes. However these
mechanisms alone cannot solve the whole problems of corporate governance. Whidbee (1997)
finds that the effectiveness of external control mechanisms is weak in some industrial sectors. For
example, the market for corporate control through hostile takeover is rare in the banking industry.
The majority of bank acquisitions are friendly rather than hostile. In this situation, alternative
monitoring mechanisms like internal incentives and monitoring mechanisms assumes an important
role.

2.3.2 Internal Monitoring and Incentives

In its narrowest sense, corporate governance can be viewed as a set of arrangements internal to the
corporation that defines the relationship between managers and shareholders. At the center of this
system is the board of directors, so the key internal governance mechanism is the rules for
selecting the directors. Since the most important right adhered to the shareholders is the right to
select the board of the directors, ownership structure should be the foundation of the internal
arrangements. Since both ownership structure and board composition constitute a major part of
internal mechanisms that reduces the agency problems in companies, an extensive theoretical and
empirical research that investigates determinants of ownership structure and board composition
has been conducted in recent years.


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23

2.3.2.1 Determinants of Managerial Ownership and the Link between Ownership
and Performance

The ownership structure is measured by the allocation of shares among insiders and outsiders

(Jensen and Meckling, 1976). Agency problems arise when there is a potential conflict of interest
between corporate managers and dispersed shareholders, and when managers do not have an
ownership interest in the firm. Jensen and Meckling divide stockholders into two groups—an
inside shareholder who manages the firm as well as has exclusive voting rights, and the outside
shareholders, who have no voting rights. They also show how the allocation of shares among
insiders and outsiders can influence the value of the firm.

Following Jensen and Meckling paper, studies in the determinants of managerial ownership and
the link between ownership and firm value have expanded rapidly in both the theoretical and the
empirical fronts.

Based on the theory of principal-agent, managerial ownership is well known as an important
component of the ownership structure. There is an extensive theoretical literature explaining the
empirical link between managerial ownership and firm performance. However, the interpretations
in these studies remain ambiguous. The role of insider ownership is complex. While it aligns the
interests of managers and shareholders and thus enhances performance, it also creates managerial
entrenchment, which adversely affects performance.

Morck et al. (1988) find evidence of a significant nonmonotonic relationship, when estimate a
piecewise-linear relation between the fractions of shares owned by corporate insiders and Tobin's
Q, using cross-section data of 371 fortune 500 firms in 1980. The Tobin’s Q fist increases as
insider ownership increases up to 5%, then falls as ownership increases to 25% and increases


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24

again slightly at a higher ownership level. McConnell and Servaes (1990) examine a larger set of
Fortune 500 firms than those examined by Morck et al. and they find a significant curvilinear

relation between Tobin’s Q and managerial ownership, with an inflection point at between 40%
and 50% ownership. Hermalin and Weisbach (1991) analyze 142 NYSE firms and find that
Tobin’s Q rises with ownership up to a stake of 1%. The relationship is negative in the ownership
range of 1-5%, and it becomes positive again in the ownership range of 5-20%. It turns into a
negative region when ownership level exceeds 20%.

Kole (1995) compares the results in the recent studies that use different management stock
ownership data and he shows that differences in firm size can account for the differences in the
results of those studies. Holderness et al. (1999) analysis the relationships using a comprehensive
cross section of 1,500 publicly traded U.S. firms in 1935 and compare the results with those using
a modern benchmark of more than 4,200 exchange-listed firms for 1995. The shape of the
performance-ownership relation in 1935 is similar to the pattern identified by Morck et al.
However, the pattern was weaker in the 1995 samples. These studies generally interpret the
positive relation at low levels of managerial ownership as evidence of incentive alignment,
whereas the negative relationship at high levels of managerial ownership as evidence that
managers become ‘entrenched’ and can indulge in non-value-maximizing activities without being
disciplined by diversified shareholders.

In contrast, Demsetz (1983) argues that the ownership structure of the firm that ‘emerges is an
endogenous outcome of competitive selection of an equilibrium organization of the firm that
balances various cost advantages and disadvantages’. Therefore, Demsetz points out that there is
no relationship between ownership structure and profitability. Demsetz and Lehn (1985) provide
additional evidence to support Demsetz’s conclusion. They investigate the accounting profit rate of
511 U.S. companies in 1980 on different measure of ownership concentration, and find no


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25

significant correlationship. Himmelberg et al. (1999) extend the cross-sectional results of Demsetz
and Lehn (1985) using panel data and show that managerial ownership is explained by key
variables in the contracting environment. In other words, after controlling both for observed firm’s
characteristics and firm’s fixed effects, they cannot find a relationship between changes in
managerial ownership and firm performance.

Lauterbach and Vaninsky (1999) empirically examine the effect of ownership structure on firm
performance of 280 Israeli firms. They separate the sample firms into family firms, firms
controlled by partnerships of individuals, concern controlled firms, and firms where blockholders
have less than 50% of the vote. The results show that owner-manager firms are less efficient in
generating net income than firms managed by a professional (non-owner) manager, and that family
firms run by their owners perform (relatively) the worst.

Associated with the ownership structure, the board of director is also an important internal device
in the agency literature to provide monitoring functions to resolve, or at least mitigate, agency
conflicts between management and shareholders.

2.3.2.2 The Determinants of Board Composition and Board Effectiveness

The agency theory describes a significant role of the board of directors in the organizational and
governance structure of typical large corporation. Fama and Jensen (1983a) discuss the role of
market and organizational mechanisms in eliminating the agency conflicts and better aligning
management interests with equity holders or residual claimants, who are largely diffused. Among
the most important organizational controls is the board of directors. The board is considered to
have three main missions in a firm, which includes providing advice and counsel to management,
serving as disciplinarian, and acting in crisis situations.