Financial decisions and ownership structure as control mechanisms of agency problems: evidence from Italy

Pages531-563
DOIhttps://doi.org/10.1108/CG-01-2017-0014
Published date13 February 2018
Date13 February 2018
AuthorFabrizio Rossi,Robert Boylan,Richard J. Cebula
Subject MatterCorporate governance,Strategy
Financial decisions and ownership
structure as control mechanisms of
agency problems: evidence from Italy
Fabrizio Rossi, Robert Boylan and Richard J. Cebula
Abstract
Purpose The purpose of this study is to investigate the relationship between financial decisions and
ownership structure by using the control contests on a sample of Italian listed companies.
Design/methodology/approach The analysis adopts a balanced panel data set of 984 firm-year
observations for the period of 2002-2013, with estimation using a generalized method of moments.
Findings The results appear to confirm both the hypotheses of the alignment of interests and the
entrenchment effect. The entrenchment and alignment effects are not found to be alternatives but
rather are found to co-exist. The presence of a coalition of minority shareholders acts as a tool to
control agency costs, particularly when the coalition is instrumental in the contestability of corporate
control.
Practical implications These findings suggest that minority shareholders may have a larger impact
than previously identified by strategically aligning with other shareholders to form coalitions. This study
provides several practical implications. First, dividend payout is not necessarily a good instrument to
control and monitor agency costs. This is because the payout can be used to expropriate benefits from
the minority shareholders. Second, high ownership concentration does not always reduce agency costs.
Third, a non-collusive coalition can be more useful in the monitoring of agency costs than other tools,
such as the debt level.
Originality/value This study shows that there is considerable value to the firm when individual
blockholders come together in a contestable environment and become instrumental in making business
decisions. The results support the contention that contestability is an excellent deterrent to dampen the
expropriation of benefits to minority shareholders. This study also provides evidence that cash holding
can be a good substitute for dividends and debt in the effort to limit agency costs.
Keywords Ownership structure, Debt, Cash holding, Contestability contests, Payout dividend, GMM
Paper type Research paper
1. Introduction
Capital structure and dividend policy are key issues in corporate finance (Modigliani and
Miller, 1958, 1961; Myers, 1984; Myers and Majluf, 1984), and they are often integral to
dealing with the agency issues articulated by Jensen and Meckling (1976). Rozeff (1982)
and Easterbrook(1984) suggest that managers might selfishly engage in low-risk projects
rather than higher-risk/return projects preferred by stockholders. They also suggest that
management may prefer lower dividends to minimize having to finance new projects by
issuing new capital. New capital increases transaction costs and the scrutiny of
management as part of the external financing process. Jensen and Meckling (1976) argue
that the allocation of the funding sources of equity and debt affect agency costs arising
from the separation of ownership and control, and that these agency costs increase when
management’s share of ownership decreases. Dividends and debt can be good control
mechanisms to mitigate conflicts between managers and shareholders (or between majority
Fabrizio Rossi is Adjunct
Professor of Economics
and Business Organisation
at Universita degli Studi di
Cassino e del Lazio
Meridionale, Cassino, Italy.
Robert Boylan and
Richard J. Cebula are both
based at Jacksonville
University, Jacksonville,
Florida, USA.
JEL classif‌ication – G32, G34,
G35
Received 12 January 2017
Revised 25 June 2017
22 September 2017
Accepted 15 January 2018
The authors wish to thank both
the editor, Gabriel Eweje, and
two anonymous referees for
their helpful suggestions and
comments that improved this
study.
DOI 10.1108/CG-01-2017-0014 VOL. 18 NO. 3 2018, pp. 531-563, © Emerald Publishing Limited, ISSN 1472-0701 jCORPORATE GOVERNANCE jPAGE 531
and minority shareholders). Debt forces the firm’s managers to pay fixed amounts of money
for the repayment of the loan, and dividends may limit management’s use of the cash in a
discretionary manner (Jensen and Meckling, 1976; Jensen, 1986).
More recently, several studies have investigated cash holding as a means of establishing
and monitoring agency costs. Cash holding is a powerful tool available to managers
(controlling shareholders) and may potentially be abused, especially in countries with a low
level of shareholder protection (Blanchard et al., 1994; Opler et al., 1999; La Porta et al.,
2000; Dittmar et al, 2003; Kalcheva and Lins, 2007; Mikkelson and Partch, 2003; Ozkan and
Ozkan, 2004; Bigelli and Sa
´nchez-Vidal, 2012).
Most of the studies in the literature have investigated common law countries, which have
higher protection of shareholders and debt holders (La Porta et al., 1999), and only a
modest number of studies has examined civil law countries, which are known to be more
bank-based, with more family-controlled firms and have a lower level of protection for
shareholders and creditors. Recently, some studies have emphasized on the role that
multiple large shareholders can assume in mitigating agency problems. However, only a
modest number of studies has investigated the impact that coalitions between
blockholders, beyond the largest single shareholder, may have on corporate financial
decisions and, in particular, whether the coalition is an effective tool to limit the opportunistic
behavior of the largest shareholder through the control and monitoring of agency costs.
Using a panel data of 984 firm-year observations during the period of 2002-2013, this study
investigates a sample of listed Italian companies. The results seem to confirm both the
hypotheses of the alignment of interests and the entrenchment effect. The entrenchment
and alignment effects are not found to be alternatives but rather are found to co-exist. The
presence of a coalition of blockholders acts as a tool to control agency costs, particularly
when it is instrumental in the contestability of corporate control. These findings also provide
evidence that cash holding can be a good substitute for dividend and debt in control and
monitoring of agency costs.
This study seeks to contribute to the literature in several ways. First, this study considers
cash holding not only as a proxy for agency costs, and therefore as a source of
opportunistic behavior by majority shareholders, but also as a substitute for debt and
dividend policy in controlling and monitoring agency cost problems. In countries such as
Italy, shareholder activism (Shleifer and Vishny, 1986) may be ineffective because many
firms have ownership control concentrated in a small number of shareholders, who can
decrease the agency cost by monitoring management and can implement tactics to
expropriate minority shareholders using the amount of debt, the dividend policy and the
level of cash holdings. Excess cash, in the absence of growth opportunities, should be
returned to minority shareholders in the form of a dividend rather than being used
discretionarily. Improper financial decisions could camouflage behavior to increase the
private benefits of control for the largest shareholder(s).
Second, this study investigates the significance of how multiple blockholders form
coalitions. The findings suggest that multiple blockholders may have a more significant
impact than previously believed, when they in fact form coalitions. These coalitions were
likely formed with the prurient goal of self-interest but have a positive impact on the firm
through the reduction of agency costs. This study also investigates the positive impact of
contestability with different modeling techniques relative to what is typically found in the
literature. This study incorporates contestability measures in the form of ownership structure
and also in terms of voting power.
Third, this study investigates the relationship between ownership structure and financial
decisions (i.e. debt, dividend policy and cash holding), which can represent agency cost
proxies and can be used alternatively or complementarily to limit opportunistic behavior of
majority shareholders. The Italian stock market is characterized by firms with a high ownership
PAGE 532 jCORPORATE GOVERNANCE jVOL. 18 NO. 3 2018
concentration and therefore a higher probability of opportunistic behavior by the largest
shareholders. Italian companies are likely to experience higher agency costs than common
law countries that have better protection of minority shareholders and creditors. Italy is a
country with a lower level of shareholder protection than most common law countries (La Porta
et al., 1999; World Bank Group, 2013a, 2013b). A country like Italy, where there is a high
ownership concentration, a high degree of separation between ownership and control and a
prevalence of pyramidal groups (Bianchi et al., 2001), provides an excellent setting in which
the control mechanisms of corporate governance used to mitigate the conflict between
majority and minority shareholders that causes Type II agency problems (Villalonga and Amit,
2006) and tends to increase the private benefits of control can be analyzed. Italy, in particular,
is well known for being a bank-oriented country, where businesses rely mainly on bank debt to
finance investments and the number of listed companies is comparatively lower than in most
other common law countries (e.g. UK and USA). Most of the private wealth is invested in the
family business, and this may reduce the ability to diversify equity portfolios. In this context, the
controlling shareholder may influence the firm so as to use risk-averse tactics, which preserve
capital for future generations rather than higher risk tactics, which would maximize the present
value of the firm and are in the best interest of minority shareholders. The tendency for Italian
firms to have concentrated ownership may increase risk aversion, especially where most of the
founder wealth is invested in the family business. This circumstance could fuel the
phenomenon of wealth preservation, the so-called “creative destruction”, which may cause
the owner to refrain from investing in risky projects or might influence the owner to make sub-
optimal investments to preserve the accumulated wealth (Morck et al., 2000). In such
circumstances, the entrenchment effect may prevail over the alignment of interests effect
between the majority and minority shareholders.
Finally, in Italy, according to Consob data (2014), the Italian debt level is higher than the
debt level in the Eurozone. The ratio of financial debt to net equity of Italian listed companies
at the end of 2013 (110 per cent) was significantly greater than that in the Eurozone (70 per
cent). Despite experiencing a decline in bank loans during the crisis period, Italian
companies are among the most indebted and the most financially vulnerable in Europe.
Although major listed companies have experienced a reduction in liquidity and a decline in
self-financing, debt financing remains the main channel for coverage of financial needs
(Commissione Nazionale per le Societa
` e la Borsa, 2014). Furthermore, compared to
common law countries, Italy has a low protection of creditor rights (La Porta et al., 1999)
with a score – whose value ranges from 0 to 12 – of 2, against a score of 5 and 4 for Spain
and France, respectively (World Bank Group, 2013c). The use of excess debt could be
more targeted at the expropriation of minority shareholders rather than as an agency
monitoring tool (Faccio et al, 2010). According to this hypothesis, debt would be used to
increase resources for purposes not in line with the maximization of value, but for large
stockholders, they can extract the private benefits of control through “tunnelling” (Johnson
et al., 2000). Bank debt also avoids entering equity markets for financing, which dilute
control (Pindado and de la Torre, 2011). In other words, debt becomes a tool to acquire
resources while protecting the non-majority controlling shareholders from potential
takeovers and, at the same time serves, increasing the private benefits of control through
opportunistic behavior.
The remainder of this study is organized as follows. Section 2 of this study discusses related
literature and provides hypothesis development. Section 3 describes the sample and
survey methodology. Section 4 presents the estimation results and a discussion of the
empirical findings, and Section 5 provides closing observations.
2. Literature review and hypothesis development
Jensen (1986) argues that debt and dividends could be good substitutes for monitoring the
behavior of managers, but the positive effects of debt are not infinite, and it is necessary to
VOL. 18 NO. 3 2018 jCORPORATE GOVERNANCE jPAGE 533

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