Corporate Governance and Firm Value: The Case of Venezuela

• DOI: http://doi.org/10.1111/j.1467-8683.2008.00680.x
• Author: Urbi Garay,Maximiliano González
• Date: 01 May 2008
• Published date: 01 May 2008

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Corporate Governance and Firm Value:

The Case of Venezuela

Urbi Garay and Maximiliano González*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: We examine the relationship between corporate governance and f‌irm value, and evaluate the

relatively understudied governance practices in Venezuela.

Research Findings/Results: We construct a corporate governance index (CGI) for publicly-listed f‌irms that is free of

self-selection and self-reported bias and f‌ind that its mean value is below the emerging market average in general, and

below the Latin American average in particular.This weak investor protection environment makes Venezuela a good setting

to study how corporate governance practices affect f‌irm value. We show that an increase of 1 per cent in the CGI results in

an average increase of 11.3 per cent in dividend payouts, 9.9 per cent in price-to-book, and 2.7 per cent in Tobin’s Q. These

f‌indings are robust after considering the potential endogeneity of our regression variables.

Theoretical Implications: Results contrast to those reported in the US due to the higher interf‌irm variations in CGI. Our

f‌indings are consistent with the theoretical models that relate good corporate governance practices to higher investor

conf‌idence, and with the agency model of dividend payout. Furthermore, we conjecture that our results are generalizable

mainly to other countries where investor protection is low.

Practical Implications: Two direct insights to policy makers and practitioners follow from our analysis: f‌irst, managers in

weak investor protection environments could differentiate their f‌irms adopting corporate policies to improve their gover-

nance structure; and second, our measure of governance practices gives investors a quantitative tool to better assess

Venezuelan f‌irms.

Keywords: Corporate governance rating/index, corporate performance, South America

INTRODUCTION

More companies in a growing number of countries are

increasingly attempting to adopt better corporate

governance practices. In the case of Latin America, the

Andean Development Corporation (Corporación Andina de

Fomento – CAF) recently presented an outline for a corporate

governance Andean Code (CAF, 2005). Furthermore, the

larger companies of the region, especially those that belong

to the f‌inancial sector, are in the process of adopting other

international codes of best corporate governance practices,

such as the Sarbanes-Oxley Act and the Principles of

Corporate Governance developed by the Organization for

Economic Co-operation and Development (OECD, 1999). It

is not diff‌icult to predict that the success or failure of these

initiatives will depend on the real impactthat they may have

on the f‌inancial performance and market valuation of the

companies that adopt them.

La Porta, López-de-Silanes, Shleifer and Vishny (1997,

1998, 2000a) show that the legal framework that f‌irms and

investors face differs signif‌icantly around the world, in

part, because of differences in legal origin. They argue that

investors are less protected in French Civil Law countries,

compared with countries from the Common Law origin.

All countries in Latin America have the same legal origin,

which is French Civil Law. They also f‌ind that Latin

American countries perform even worse than the average

French Civil Law countries in terms of investor rights, and

argue that this helps explain the low level of f‌inancial

development and the small size of stock exchanges of these

countries. Chong and López-de-Silanes (2007) conf‌irm

these f‌indings for a more recent period. Furthermore,

according to Djankov, La Porta, López-de-Silanes and

* Address for correspondence: Suite 11629, 6910 N.W.50 Street, Miami, FL/33166. Tel:

571339 4999 (ext. 3369); Email: mgf@adm.uniandes.edu.co

194 CORPORATE GOVERNANCE

Volume 16 Number 3 May 2008 © 2008 TheAuthors

Journal compilation © 2008 BlackwellPublishing Ltd

doi:10.1111/j.1467-8683.2008.00680.x

Shleifer (2008) Venezuela exhibits one of the worst scores

in terms of investor protection.

The weak investor protection inherent in many Latin

American countries offers an opportunity for f‌irms to dif-

ferentiate themselves from the rest and to send strong and

credible signals to attract investors by self-adopting good

corporate governance practices and policies, thus partially

compensating investors for the weak legal environment

in which these f‌irms operate. Klapper and Love (2004)

and Durnev and Kim (2005) show that corporate gover-

nance provisions matter more in countries with weak legal

protection.

We know relatively little about the potential impact that

the adoption of corporate governance practices may have on

company value in Latin America (see Chong and López-de-

Silanes, 2007, for a recent review of this evidence). Measur-

ing this effect is important for the region because the success

or failure of implementing good corporate governance prac-

tices may be greater if the market rewards those companies

that adopt them. In the case of the US, the empirical evi-

dence shows either no effect or an economically small effect.1

Black (2001) argues that perhaps these weak results in the

US arise because the variation in f‌irm governance is small

given that the minimum quality of corporate governance,

which is set by law and by norms, is very high in that

country.On the other hand, interf‌irm governance variation is

found to be much larger in Venezuela.This should not come

as a surprise, as a country with weaker laws and norms

offers a wider range for governance differences between

f‌irms and, therefore, the potential for stronger results on

the effects of governance on f‌irm value. Furthermore, even

though Venezuela is the fourth largest economy in Latin

America (after Brazil, Mexico, and Argentina), relatively

little is known about corporate governance practices in this

country. In sum, Venezuela represents a very strong case

study.

We evaluate the current state of corporate governance

practices in Venezuela by constructing a corporate gover-

nance index (CGI) for all f‌irms listed in the Caracas Stock

Exchange (CSE) as of the end of 2004 and comparing the

results to other emerging and Latin American countries.

We then evaluate whether f‌irm dividend payout policies,

price-to-book multiple, and Tobin’s Q (TQ) are related to our

CGI. By undertaking a single country-study approach, we

attempt to perform a straightforward empirical test that has

the advantage of avoiding some of the potential econometric

problems involved in cross-country studies such as the

omitted variable bias and the usually high across-f‌irm

heterogeneity.

In general, we f‌ind a positive and strong relation between

our index of corporate governance and the payout ratio,

price-to-book multiple, and TQ for f‌irms in Venezuela. From

the composition of the index, we f‌ind that the subindexes on

ethics and conf‌licts of interest, composition and perfor-

mance of the board of directors, and shareholders’ rights

explain much of the cross-sectional difference in payout

ratio; on the other hand, the subindex regarding ethics and

conf‌licts of interest can explain much of the results when

price-to-book and TQ are used as dependent variables.

These results add to the growing literature that supports

the idea that in countries with relatively low investor pro-

tection, good corporate governance practices and policies

could be used as an eff‌icient mechanism for f‌irms that want

to distinguish themselves to attract investors. Although our

results are tentative given the small size of the CSE, they

passed a series of robustness checks thatattempted to tackle,

among other potential problems, the issue of endogeneity, a

common concern found in this literature.

Our paper is similar to Black (2001) and Judge, Naoumova

and Koutzevol (2003) who tested the relation between cor-

porate governance and f‌irm value in Russia, a transition

economy characterized by weak investor protection. Both

papers have a small sample and Russia, like Venezuela, is

also a country that scores low in terms of investor protection

and exhibits a high interf‌irm variation in corporate

governance practices. Our paper is also related to recent

country studies done in Latin America2and especially with

Garay and González (2005), who also studied the case of

Venezuela.

The evidence reported in this paper is important not only

for Venezuela but also for other emerging markets in the

process of attempting to improvetheir corporate governance

practices. The evidence we show here adds to the growing

literature worldwide that indicates that f‌irms can differenti-

ate themselves by adopting better corporate governance

practices and policies. That is, even in a weak investor pro-

tection environment, f‌irms can increase their market value

by adopting good corporate governance measures.

The rest of the paper is organized as follows: f‌irst, we

review the growing literature on corporate governance and

market valuation, concentrating on recent papers that are

based on Latin America. Second, we construct a CGI for

Venezuela and compare it with other emerging economies

and, more importantly, to other Latin American countries.

Third, we present the data and conduct our econometric

analysis testing the relation between a f‌irm’s dividend

payout ratio, price-to-book, and TQ, and our CGI. Fourth,

we perform a number of robustness checks to our main

f‌indings. In the last section we present the conclusions and

policy recommendations, as well as its potential practical

applications and suggestions for future studies.

LITERATURE REVIEW

Many def‌initions of corporate governance stress the poten-

tial conf‌licts of interest between insiders (managers, boards

of directors, and majority shareholders) and outsiders

(minority shareholders and creditors) of the company. The

set of internal and external mechanisms to balance these

conf‌licts of interest is what it is usually known as corporate

governance.

The effect that a set of good corporate governance prac-

tices may have on f‌irm’s value is, however, an empirical

question. Recently, different studies, trying to measure

quantitatively the quality of corporate governance, have

created indexes based on legal, accounting, and f‌irm-level

f‌inancial information. Gompers, Ishii and Metrick (2003)

construct a CGI based on 24 governance rules for 1,500

large US f‌irms, and show that f‌irms with higher corporate

governance scores had higher f‌irm value.

La Porta et al. (1997) study a sample of 49 countries and

conclude that countries with legal systems based on Civil

CORPORATE GOVERNANCE AND FIRM VALUE 195

Volume 16 Number 3 May 2008© 2008 TheAuthors

Journal compilation © 2008 BlackwellPublishing Ltd