Investor protection, managerial entrenchment, and cash holdings: Cross‐country evidence

• DOI: http://doi.org/10.1111/infi.12343
• Date: 01 December 2019
• Published date: 01 December 2019

DOI: 10.1111/infi.12343

ORIGINAL ARTICLE

Investor protection, managerial entrenchment, and

cash holdings: Cross-country evidence

Henrique Castro Martins

Pontifícia Universidade Católica do Rio

de Janeiro −PUC-Rio, Rio de Janeiro,

Brazil

Correspondence

Henrique Castro Martins, Pontifícia

Universidade Católica do Rio de Janeiro

−PUC-Rio, 225 Marquês de São Vicente

St., Gávea, Rio de Janeiro, RJ 22451-900,

Brazil.

Email: hcm@iag.puc-rio.br

Funding information

Conselho Nacional de Desenvolvimento

Científico e Tecnológico (CNPq);

Coordenação de Aperfeiçoamento de

Pessoal de Nível Superior (CAPES)

Abstract

We investigate whether investor protection (i.e. shareholder

protection and creditor rights) is associated with how

entrenched managers set corporate cash holdings. Our

sample covers more than 6,000 firms from 29 countries

(roughly 16,000 observations during 2010–2013). We find

that the entrenchment–cash holdings association is sensitive

to the level of shareholder protection but not to the level of

creditor rights. Moreover, we find that the way shareholder

protection shapes this association depends upon how

managers become entrenched. When managers become

entrenched through ownership, shareholders consent to

their preferences to hold more cash, whereas, when

managers become entrenched through CEO duality, share-

holders force them to disgorge cash. We interpret our

findings as evidence that shareholders agree to increase cash

when managers are aligned with them by ownership but

prefer to decrease cash when they are not aligned, whereas

creditors do not influence entrenched managers’cash

holdings decisions.

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INTRODUCTION

This study investigates the association between managerial entrenchment and corporate cash holdings

and whether this relationship is moderated by investor protection (e.g. shareholder protection and

creditor rights). In a perfect market, cash holdings decisions should be irrelevant (Opler, Pinkowitz,

Stulz, & Williamson, 1999), companies can always find external funding, and no opportunity costs are

incurred for keeping low levels of cash. Nevertheless, previous literature shows that companies make

cash decisions under information asymmetry (Dittmar & Mahrt-Smith, 2007; Opler et al., 1999),

International Finance. 2019;1–17. wileyonlinelibrary.com/journal/infi © 2019 John Wiley & Sons Ltd

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financial constraints (Kyröläinen, Tan, & Karjalainen, 2013), and agency costs of managerial

discretion (La Porta, Lopez-de Silanes, Shleifer, & Vishny, 1998), potentially increasing the demand

for cash, for either precautionary reasons or flexibility. Moreover, some companies make cash

decisions in legal environments with poor investor rights (Dittmar, Mahrt-Smith, & Servaes, 2003;

Kalcheva & Lins, 2007; Pinkowitz, Stulz, & Williamson, 2006; Yung & Nafar, 2014), which also

affects cash preferences through agency costs.

Previous literature analyses these cash holdings determinants (e.g. agency costs of managerial

entrenchment and investor protection) separately but neglects their connection in explaining cash

decisions. The only exception is the study of Kalcheva and Lins (2007), who investigate shareholder

protection and managerial entrenchment as co-determinants of cash holdings. Our study, however,

builds upon theirs by introducing the creditor rights dimension and including chief executive officer

(CEO) duality as an alternative measure of entrenchment. Moreover, previous literature generally

assumes agency costs exist due to either the absence of governance mechanisms preventing agency

costs at the firm level (Dittmar & Mahrt-Smith, 2007; Elyasiani & Zhang, 2015; Faulkender & Wang,

2006; Opler et al., 1999; Ozkan & Ozkan, 2004), or the absence of country-level factors ensuring

shareholder protection (Dittmar et al., 2003; Yung & Nafar, 2014). Thus, unlike previous studies, we

assume that cash holdings decisions are affected by the agency costs of managerial entrenchment, firm-

level governance mechanisms, and the protection of shareholders and creditors. Importantly, we

analyse managerial entrenchment apart from the absence of governance mechanisms.

This study analyses 6,168 companies from 29 countries between 2010 and 2013, with over 16,000

firm-year observations. Using panel data and the generalized method of moments (GMM), our results

suggest that entrenched managers are associated with more cash holdings, supporting Jiang and Lie

(2016). We also find this association to be sensitive to the level of shareholder protection but not to the

level of creditor rights. More interestingly, we find that the way shareholder protection moderates

entrenched managers’preferences depends upon the entrenchment proxy. When entrenched managers

are aligned through ownership, shareholders consent to their preferences to hold more cash; however,

when entrenched managers are not aligned, shareholders force them to disburse cash. We believe this

result to be a novel contribution to the cash holdings–governance debate.

Our study makes the following contributions. First, Schiehll and Martins (2016) recently suggested

that corporate governance scholars have focused on the effects of firm- and country-level governance

on firm performance but paid less attention to more strategic decisions, such as cash holdings. We focus

on the latter. Second, we separate managerial entrenchment from (the absence of) governance

mechanisms and from shareholder protection and creditor rights, allowing us to build on different

managerial entrenchment perspectives than those of Florackis and Ozkan (2009) and Sheu and Lee

(2012) and to use governance mechanisms as control variables. Our study specifically adds to this

literature by analysing (1) managerial entrenchment (using manager-related variables); (2) firm-level

corporate governance mechanisms; and (3) country-level governance protecting shareholders and

creditors, as different elements influencing cash holdings.

More importantly, we use not only the seminal investor (e.g. shareholder and creditor) protection

indexes of La Porta et al. (1998) but also recent indexes from Guillén and Capron (2016), Spamann

(2010), and the World Bank's Doing Business Project. This approach provides a complete dataset of

information on country-level protection and allows for the analysis of shareholder protection as a

separate component from creditor rights. This separation is central to our study because shareholders

and creditors are protected by different laws and have different securities rights (La Porta et al., 1998)

and also because, as shown in the next section, shareholders, creditors, and managers have different

financial policy preferences (Dittmar et al., 2003; Jensen & Meckling, 1976; Myers, 1977). As Yung

and Nafar (2014) argue, previous literature mainly investigates the role shareholders play in firms’

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