Multiple Large Shareholders and Corporate Risk Taking: Evidence from East Asia

• Author: Dev R. Mishra
• Published date: 01 November 2011
• DOI: http://doi.org/10.1111/j.1467-8683.2011.00862.x
• Date: 01 November 2011

Multiple Large Shareholders and Corporate

Risk Taking: Evidence from East Asia

Dev R. Mishra*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Prior literature suggests that weak external governance mechanisms negatively affect corporate

risk taking (CRT). However, strong internal governance is likely to mitigate the shortcomings of external governance. In a

sample of East Asian f‌irms, we examine whether the presence and voting power of multiple large shareholders (MLS)

beyond the dominant shareholder effectively manage internal governance and mitigate agency problems, as measured by

their effect on CRT.

Research Findings/Insights: In a sample of 1,686 f‌irms from nine countries, while the presence of a dominant shareholder

is associated with a lower CRT, the presence and voting rights of the MLS are strongly associated with a higher CRT.

Furthermore, the effect of the MLS on CRT is strongly positive in family dominated f‌irms (as opposed to non-family

dominated f‌irms).

Theoretical/Academic Implications: Weinterpret these f‌indings as evidence that in f‌irms featuring a dominant shareholder

with the power and incentives to extract private benef‌its of control by undertaking a conservative investment policy, the

power and presence of MLS improve internal governance by mitigating agency problems between the dominant share-

holder and minority shareholders and help promote a more optimal non-conservative investment policy.

Practitioner/Policy Implications: In countries where f‌inancial markets are still developing and in countries where the

dominant shareholder structures are widespread, the policy makers may encourage MLS structures in general and in the

privatization of state enterprises.

Keywords: Corporate Governance, Corporate Risk Taking, Large Shareholders, Investor Protection, Agency Costs

INTRODUCTION

Poor investor protection environments are breeding

grounds for extensive opportunities for corporate insid-

ers to expropriate shareholders (La Porta, Lopez-de-Silanes,

Shleifer, & Vishny, 2002; Leuz, Nanda, & Wysock, 2003) in

widely held f‌irms (Grossman & Hart, 1988; Jensen & Meck-

ling, 1976) and to expropriate minority shareholders in f‌irms

with concentrated control in the hands of a dominant share-

holder (Burkart, Gromb, & Panunzi, 1997; Shleifer & Vishny,

1986). Supporting these arguments, John, Litov, and Yeung

(2008) found that poor investor protection (poor external

governance) and higher agency problems (poor internal

governance) are signif‌icant sources of suboptimal low-risk

investment decisions by managers. Evidently, large share-

holders may mitigate the low risk-taking behavior of man-

agers through eff‌icient monitoring; yet, in f‌irms with a

dominant shareholder, “the large shareholder either directly

manages the f‌irm or internalizes the benef‌its from monitor-

ing managers, which aligns managerial interests with those

of the large shareholder” (Laeven & Levine, 2008:579). In

this paper, we examine the link between the presence and

power of multiple large shareholders (MLS) and Corporate

Risk Taking (CRT) to uncover the internal governance role of

the MLS and the extent to which the MLS affect the pursuit

of an eff‌icient risky investment policy. Prior literature on

MLS is limited but indicates that f‌irms with MLS have

higher values (Laeven & Levine, 2008; Maury & Pajuste,

2005) and a lower cost of equity capital (Attig, Guedhami, &

Mishra, 2008) compared with their counterparts with a

dominant shareholder. Furthermore, Attig, Ghoul, and

Guedhami (2009), using a sample of East Asian f‌irms,

uncovered that the effect of the MLS is more pronounced in

the situations in which f‌irms have higher agency problems,

in which they curb the diversion of the f‌irms’ resources

by playing a valuable monitoring role. Most East Asian

*Address for correspondence: Dev R. Mishra, University of Saskatchewan, Finance

and Management Science, 25 Campus Drive, Saskatoon, Saskatchewan, Canada S7N

4M5. E-mail: mishra@edwards.usask.ca

507

Corporate Governance: An International Review, 2011, 19(6): 507–528

© 2011 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2011.00862.x

countries have weaker institutions for protecting investors

(Attig et al., 2009); accordingly, we test whether CRT is a

signif‌icant function of MLS structures in East Asia.

The extensive corporate governance literature examines

the role of investor protection in mitigating agencyproblems

and in reducing the expropriation of minority shareholders

(e.g., La Porta, Lopez-de-Silanes, Shleifer, & Vishny, 1998; La

Porta et al., 2002; Lombardo & Pagano, 2002; Shleifer &

Wolfenzon, 2002). La Porta et al. (2002:1147) argued that

when their rights are better protected by the law, outside

investors are willing to pay more for f‌inancial assets such

as equity and debt. Theypay more because they recognize

that,with better legal protection, more of the f‌irm’s prof‌its

would come back to them as interest or dividends as

opposed to being expropriated by the entrepreneur who

controls the f‌irm. By limiting expropriation, the law raises

the price that securities fetch in the marketplace.

Consistent with this argument, the empirical literature f‌inds

that poor investor protection is associated with a negative

valuation effect (La Porta et al., 2002), poor market develop-

ment (La Porta, Lopez-de-Silanes, & Shleifer, 2006), a higher

cost of equity capital (Hail & Leuz, 2006), a lower CRT (John

et al., 2008) and a greater expropriation of minority share-

holders (La Porta, Lopez-de-Silanes, Shleifer, & Vishny,

2000).

In dispersed ownership f‌irms (Berle & Means, 1932), weak

investor protection (i.e., weak external corporate gover-

nance, institutional monitoring, and securities legislation)

increases the instances of expropriation of the f‌irms’

resources by managers because the dispersed minority

shareholders have little ability to monitor the managers. This

ineff‌icient link between the f‌irm and its owners increases the

possibility of concentrated ownership and the presence of

dominant owners with non-trivial cash f‌low rights in the

f‌irm’s ownership structure (Burkart, Panunzi, & Shleifer,

2003; Morck, Wolfenzon, & Yeung, 2005; Stulz, 2005).

Accordingly, recent literature has reported overwhelming

evidence of controlling large shareholders in f‌irms around

the world, for example, in 27 wealthy countries (La Porta,

Lopez-de-Silanes, & Shleifer, 1999), Western Europe (Faccio

& Lang, 2002), East Asia (Claessens, Djankov, & Lang, 2000)

and the USA (Holderness, 2009). These studies report that

the dominant shareholder, by using pyramids, cross-

holdings and dual class share structures, often holds sub-

stantially higher voting rights in relation to his/her rights to

dividends. The same research also provides signif‌icant evi-

dence of MLS, beyond the dominant shareholder, holding

signif‌icant dividend and voting rights in f‌irms from these

countries.

Firms with a dominant shareholder are often subject to

substantial expropriation of other minority shareholders,

especially in economies with poor investor protection, as

evidenced by lower f‌irm values (Claessens, Djankov, Fan, &

Lang, 2002; La Porta et al., 2002), higher costs of equity

(Chen, Chen, & Wei, 2009; Guedhami & Mishra, 2009), the

poor informativeness of reported earnings and higher earn-

ings management (Fan & Wong, 2002; Haw, Hu, Hwang, &

Wu, 2004; Leuz et al., 2003) and the poor quality of f‌inancial

reporting (Fan & Wong, 2005). One way the dominant share-

holder (like managers) maybe instrumental in reducing f‌irm

value is by investing in suboptimal, low-risk investment

projects or empire-building but value-destroying corporate

diversif‌ication. The possibility that a dominant shareholder

(or managers in a dispersed ownership f‌irm) may make

conservative investment decisions is raised in a number of

studies. First, Morck, Yeung, and Yu (2000) argued that

informed risk arbitrage is lower in countries with weaker

investor protection. Two recent studies corroborate this con-

jecture: Durnev, Morck, and Yeung (2004), by f‌inding that

poor investor protection is characterized by a lower level of

informed risk arbitrage, poor resource allocation, and low

productivity growth, and John et al. (2008), by f‌inding that

poor investor protection is associated with a poor invest-

ment policy and that the f‌irms in poor investor protection

environments record lower CRT and weaker growth rates.

Additionally, Paligorova (2010) documented a lower risk-

taking tendency in f‌irms featuring a dominant shareholder

that did not hold the largest equity stake in several f‌irms,

and they add that this tendency is greater in countries with

weaker shareholder rights and stronger creditor rights. All

of these f‌indings suggest that the dominant shareholder gen-

erally has incentives and the power to choose conservative

investment strategies and more so in poor shareholder pro-

tection regimes.

Why does (or does not) the dominant shareholder have

incentives to pursue a suboptimal low-risk (optimal, high-

risk) investment strategy? Consider a manager without an

equity stake in the f‌irm he/she manages. Such a manager’s

earnings depend on his/her employment. The employment

risk faced by such a manager can be reduced by achieving

a lower earnings volatility through diversif‌ication

(Amihud & Lev, 1981; May, 1995); thus, s/he has incentives

to pursue a conservative investment policy. In cases in

which the f‌irm is controlled by a dominant shareholder

with a substantial equity stake, such an agency problem

(i.e., between the manager and shareholders) may be alle-

viated. However, if the dominant shareholder does not

hold ownership in a diversif‌ied portfolio of businesses

(Paligorova, 2010), has the desire to transfer control to

future generations in the family (Anderson, Reeb, & Mansi,

2003), or has a gap between his/her controlling power and

ownership stake in the f‌irm (Laeven & Levine, 2009), then

s/he may have incentives to pursue a conservative invest-

ment policy. In other words, such a dominant sharehold-

er’s interests conf‌lict with those of other minority

shareholders, such that s/he has incentives to appoint

and persuade managers to fulf‌ill her/his self-interests.

However, does the unanimous power of the dominant

shareholder to pursue a conservative investment policy

continue to prevail in f‌irms with MLS? If so, do the MLS

have incentives to pursue a high-risk investment strategy

as opposed to the low-risk strategy of the dominant share-

holder? The importance of this research question is echoed

by recent f‌indings that approximately one-third of the

f‌irms in Western Europe (Faccio & Lang, 2002; Laeven &

Levine, 2008) and by the current study that approximately

one-half of the f‌irms in East Asia (excluding Japan) have

more than one large shareholder in their ownership struc-

tures. Yet, it is unclear how the corporate risk-taking ten-

dency is affected if a f‌irm has more than one large

shareholder (i.e., MLS) with substantial voting rights.

508 CORPORATE GOVERNANCE

Volume 19 Number 6 November 2011 © 2011 Blackwell Publishing Ltd