Foreign Direct Investors as Change Agents: The Swedish Firm Experience

• Author: Kathy S. Fogel,Kevin K. Lee,Johanna Palmberg,Wayne Y. Lee
• DOI: http://doi.org/10.1111/corg.12035
• Published date: 01 November 2013
• Date: 01 November 2013

Foreign Direct Investors as Change Agents:

The Swedish Firm Experience

Kathy S. Fogel*, Kevin K. Lee, Wayne Y. Lee, and Johanna Palmberg

ABSTRACT

Manuscript Type: Empirical

Research Question: Prior studies examine corporate governance either at the f‌irm level, with limited attention paid to

societal culture and norms, or at the nation-state level, with limited attention paid to the management practices of f‌irms. In

this study we examine the impact on the corporate governance of Swedish f‌irms brought about by foreign investors. We

argue that in countries like Sweden with strong culturally embedded norms and control exercised by dominant domestic

shareholders, control-seeking foreign investors can act as agents of change to improve f‌irm performance through more

eff‌icient capital utilization and labor productivity.

Research Findings: We f‌ind that the entry of foreign equity investors over the years 1992–2008 surrounding Sweden’s

formal admission to the European Union in 1995 enhanced the f‌inancial performance of large publicly traded, domestic

owner-controlled f‌irms in Sweden. The heightened performance of Swedish f‌irms was not simply a result of cross-border

portfolio investments by institutions as the literature on shareholder activism implies. Rather, signif‌icant advancements in

f‌irm performance occurred only when an increase in voting participation by foreign direct investors was coincident with a

decrease in the excess voting power of the largest domestic shareholder, which gave foreign equity investors a critical

“voice” in the management of the f‌irm.

Theoretical Implications: Informal institutions inf‌luence corporate governance by aligning corporate goals with socially

acceptable outcomes. Corporate governance practices, if culturally embedded, cannot be easily displaced even when the

gains in economic eff‌iciency are large. Corporate owners stand to benef‌it from the maintenance of the status quo and may

not welcome radical changes that can lead to a “creative destruction” of their market power and political dominance.

Foreign portfolio investors who focus solely on cash f‌low rights of the f‌irm cannot effectivelychange decision making in the

boardroom. Foreign direct investors, who actively seek voting shares and control rights, will have the utmost potential to

effect change in corporate governance by advocating for new corporate priorities and objectives at board meetings.

Keywords: Corporate Governance, Foreign Direct Investors, Informal Institution, Business Culture

INTRODUCTION

An extensive literature on institutional economics

establishes a causal link between a country’s formal

institutions and its economic success (Acemoglu, Johnson,

& Robinson, 2001; Botero, Djankov, La Porta, &

Lopez-de-Silanes, 2004; Djankov, La Porta, Lopez-de-Silanes,

& Shleifer, 2002; La Porta, Lopez-de-Silanes, Shleifer, &

Vishny, 1998, 2000; North, 1990). A well-functioning legal

system that protects private property rights and reduces

transaction costs in arm’s-length exchanges, as well as inves-

tor protection laws that enable capital to f‌low from those

who have it to those who need it, supports the birth and

expansion of innovative f‌irms (Beck, Levine, & Loayza, 2000;

Henrekson & Johansson, 2009; Johansson, 2010; Wurgler,

2000). Disclosure and fraud deterrence encourage broad

equity market participation by external investors and

informed price discovery improves capital allocation to the

most productive f‌irms (Morck, Yeung, & Yu, 2000).

But as North (1990) observes, “informal institutions” can

play an equally important role. The tacit rules of the game –

social values, cultural norms, as well as traditions, facilitate

communication and mutual understanding in societies that

establish trust, consensus, and national/ethnic identity

among strangers. Informal constraints on behavior, which

do not take the form of legal statutes, and misconduct not

resulting in specif‌ic monetary or criminal penalties, can

nonetheless effectively shape and inf‌luence economic per-

formance and stability.1

*Address for correspondence: Kathy S. Fogel, Sam M. Walton College of Business,

University of Arkansas, Fayetteville, AR 72701, USA. Tel: +1-479-575-5301; E-mail:

kfogel@walton.uark.edu

516

Corporate Governance: An International Review, 2013, 21(6): 516–534

© 2013 John Wiley & Sons Ltd

doi:10.1111/corg.12035

In this paper, we make the case that foreign investors are

not as deeply invested in maintaining the status quo of local

host countries and can have different priorities, business

cultures, and practices that ref‌lect their home country’s

informal institutions. Cross-border investments can change

the informal rules of the game that reorients corporate gov-

ernance, and thereby, impact f‌inancial eff‌iciency and f‌irm

value. Further, globalization can decrease the cost of capital

by reducing information asymmetry and associated agency

costs; improve the f‌inancial f‌lexibility of domestic f‌irms by

increasing the pool of potential investors and f‌inancing

opportunities; and expand cross-border f‌lows of knowledge

and technology. An inf‌lux of foreign investors can be

expected to improve f‌irm performance (Oxelheim &

Randøy, 2003; Stultz, 1999).

Sweden is a unique setting for the study of corporate

governance in advanced economies. On the one hand, La

Porta et al. (1998, 2000) rank Sweden far above other coun-

tries on rule-of-law; and Durnev, Errunza, and Molchanov

(2009), rank Sweden’s transparency f‌ifth out of 69 countries.

Compared to Anglo-Saxon countries, Sweden provides rela-

tively poor minority shareholder protection (La Porta et al.,

1998, 2000). Agnblad, Berglöf, Högfeldt, and Svancar (2001)

note, however, the absence of evidence that minority share-

holders in Sweden are exploited. The def‌iciency in formal

laws that protect minority shareholders is more than offset

by high standards of legal enforcement and accounting.

On the other hand, among advanced economies, Sweden

represents an extreme case where corporate ownership and

control is highly concentrated(La Porta, Lopez-de-Silanes, &

Shleifer, 1999). Corporate law and the Swedish Corporate

Governance Code explicitly favor f‌irms with strongmajority

owners and enable private owners to establish and maintain

control of listed f‌irms through pyramidal ownership struc-

tures and dual-class shares. Many other countries, especially

in Europe, allow similar ownership structures. But few

countries permit pyramid structures, vote-differentiated

dual-class shares, and cross-holdings, to be used jointly.

Moreover, even among countries that allow dual-class

shares, the proportion of f‌irms that use dual-class shares is

higher in Sweden than any other country in Europe

(Bennedsen & Nielsen, 2004; Faccio & Lang, 2002).

External events and attenuation in economic nationalism

triggered the abolition of restrictions on foreign ownership

and an attitudinal change in legal support for control-

enhancing mechanisms. The resulting entry of foreign

equity investors over the years 1992–2008 surrounding Swe-

den’s formal admission to the European Union in 1995

improved the f‌inancialperformance of large publicly traded,

owner-controlled f‌irms in Sweden.2

The implications of our signif‌icant f‌inding are twofold. In

contrast to prior literature, cross-border investments over

this distinct 17-year sample period were not motivated by

the exceptional performance of Swedish f‌irms. On the con-

trary, the notable decline in per capita GDP and standard of

living of Sweden relative to OECD countries in the two

decades following its peak in the early 1970s ref‌lected the

underperformance of Swedish f‌irms. Signif‌icant mean

reversions in the performance of Swedish f‌irms during this

sample period – utilizing return on assets, return on equity,

and earnings per share as proxies, are inconsistent with

momentum driven, return-chasing behavior by foreign

investors.

Importantly, we show that the enhanced performance of

Swedish f‌irms was not simply a result of cross-border port-

folio investments by institutions as the literature on share-

holder activism implies. Gillan and Starks (2003) f‌ind that

foreign institutional investors play an important role in

monitoring management and prompting changes in corpo-

rate governance practices worldwide; Ferreira and Matos

(2008), that foreign institutional ownership is positively cor-

related with the value and performance of f‌irms outside of

the United States; and Aggarwal, Erel, Ferreira, and Matos

(2011), that foreign investors were able to change corporate

governance mechanisms and outcomes. These studies,

however, must contend with a signif‌icant endogeneity

issue.3Appropriate inferences about the impact of cross-

border investments by foreigners on f‌irm performance will

require satisfactory controls for self-selection bias – the

incentive of foreigners to concentrate their investments in

high performing f‌irms.

Our research design avoids the endogeneity issue entirely.

Foreign equity investors in Swedish f‌irms over this 17-year

sample period were predominantly institutional. Signif‌icant

advancements in f‌irm performance occurred only when

there was an increase in participationby foreign direct inves-

tors coincident with a decrease in the excess voting power of

the largest domestic shareholder that gave foreign equity

investors a critical “voice” in the management of the f‌irm.

Neither an increase in foreign participation nor a decrease in

excess voting power of the largest domestic shareholder

alone was suff‌icient. Further, we f‌ind that the participation of

control-seeking domestic equity investors did not appear to

have the same effect. There was no signif‌icant change in f‌irm

performance from declines in the excess voting power of the

largest domestic shareholder that resulted from an increase

in participation by control-seeking domestic investors.

Foreign direct equity investors, primarily from the United

States and the United Kingdom, can assume leading roles as

change agents in reducing the unproductive deployment of

capital and labor.

Table 1 shows a dramatic increase in foreign ownership

and voting participation in Swedish f‌irms from the early

1990s through 2008 following a deregulation of capital

markets in the 1980s and elimination of restrictions on

foreign ownership in 1992 as preconditions for its admission

into the European Union. The percentage of ownership and

voting rights declined over the 17-year sample period 1992–

2008 and, as a result, the excess voting power of the largest

domestic shareholder. There was a concurrent fall in the use

of dual-class shares by Swedish f‌irms as well.

Table 1 suggests that the large inf‌lux of foreigners may

serve as one of the possible channels to stimulate GDP

growth and a rise in overall market capitalization and equity

share issuance. Specif‌ically, Sweden experienced a greater

than average of OECD GDP per capita growth over the

period 1994–2010. Improvements in individual f‌irm perfor-

mance from the entry of foreign direct equity investors start-

ing in 1992, which preceded the admission of Sweden into

the European Union in 1995, had a positive long-term effect

on the overall economy. The reversal in Sweden’s economic

performance since 1992 was signif‌icant. Until the early

FOREIGN DIRECT INVESTORS AS CHANGE AGENTS 517

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