Securities Laws, Control of Corruption, and Corporate Liquidity: International Evidence

• DOI: http://doi.org/10.1111/j.1467-8683.2010.00823.x
• Author: Naiwei Chen
• Date: 01 January 2011
• Published date: 01 January 2011

Securities Laws, Control of Corruption, and

Corporate Liquidity: International Evidence

Naiwei Chen*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Previous studies have reported the relationship between corporate governance and corporate

liquidity (cash holdings). Factors affecting corporate governance, such as securities laws and control of corruption, should

have bearing on corporate liquidity and its value. This study focuses on national-level predictors of cash holdings such as

securities laws and control of corruption and examines their impact on corporate liquidity, as well as its value from the

agency perspective.corg_8233..24

Research Findings/Insights: Using comprehensive dataon 47 countries from 1996–2007, this study demonstrates that when

benchmark variables are controlled, corporate liquidity is lower in countries with more effective securities laws or higher

control of corruption. In addition, cash can increase f‌irm value. This positive relation is more pronounced in countries with

effective securities laws or high control of corruption. Furthermore, excess cash can reduce f‌irm value in countries with

ineffective securities laws or low control of corruption as opposed to other countries; however, this value-reducing effect

can be mitigated or reversed when control of corruption or securities laws improve.

Theoretical/Academic Implications: This study establishes that securities laws and control of corruption, in addition to the

traditional cash determinants, play important roles in determining corporate liquidity and its value, and should therefore

not be ignored in future liquidity studies. In addition, securities laws and control of corruption reinforce each other in the

reduction of internal agency problems. Furthermore, this study provides empirical support for agency theory to explain

corporate cash holdings.

Practitioner/Policy Implications: Multinational f‌irms should consider the potential impact of different securities laws and

control of corruption of foreign countries in deciding the amount of cash to hold. Resultssuggest that f‌irms should decrease

target cash level in countries with more effective securities laws or higher control of corruption because investor protection

is stronger, and the agency problem is less severe. In addition, excess cash should not be held in countries with ineffective

securities laws or low control of corruption because these circumstances can reduce f‌irm value, unless these countries

substantially improve their control of corruption or securities laws. As for policy makers, caution has to be exercised when

improving securities laws or repressing corruption; the concurrent improvement of both is more effective for stronger

investor protection and better corporate governance.

Keywords: Corporate Governance, Corporate liquidity, Cash holdings, Securities laws, Control of Corruption

INTRODUCTION

The past decade has seen the growth of literature on

corporate liquidity (or cash holdings) as shareholders

question the major cash accumulation of large companies

such as General Motors and Ford in the 1990s (Opler,

Pinkowitz, Stulz, & Williamson, 1999). Early literature

focused on examining and determining which theory best

explained corporate liquidity: tradeoff theory, f‌inancing

hierarchy theory, or agency theory (Almeida, Campello, &

Weisbach, 2004; Bates, Kahle, & Stulz, 2009; Drobetz &

Gruninger, 2007; Opler et al., 1999). One of the major differ-

ences between these theories is their prediction of the

presence of optimal corporate liquidity. Tradeoff theory

states that optimal corporate liquidity results from a balance

of the marginal cost of corporate liquidity and the marginal

cost of shortage of corporate liquidity (Keynes, 1936).

Financing hierarchy theory claims that internal f‌inancing

is preferred over external f‌inancing to fund new invest-

ments because of the information asymmetry between

*Address for correspondence: Department of Finance,National Chung Cheng Univer-

sity, 168 University Road, Minhsiung, Chiayi, 62102, Taiwan. Tel: 886-5-2720411 ext

34213; Fax: 886-5-2720818; E-mail: f‌innwc@ccu.edu.tw

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Corporate Governance: An International Review, 2011, 19(1): 3–24

© 2010 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2010.00823.x

management and investors. Firms accumulate cash and

repay debt when they have a surplus of internal funds.

However, when they fall short of internal funds, cash is used

f‌irst, followed by debt, and, f‌inally, equity issuance to fund

new investments. Thus, corporateliquidity is determined by

changes in internal funds such that there is no optimal cor-

porate liquidity (Myers & Majluf, 1984; Shyam-Sunder &

Myers, 1999). Agency theory predicts that management

tends to hoard cash from windfall prof‌its to gain discretion-

ary power (Jensen, 1986). Since cash holdings involve the

agency cost of free cash f‌low, agency theory implicitly sup-

ports tradeoff theory over f‌inancing hierarchy theory in

explaining corporate liquidity (Chen, 2008). A strand of

recent liquidity literature examines the role of corporate

diversif‌ication in determining cash and its value. It is found

that diversif‌ication reducescash f‌low and investment oppor-

tunity risk and thus the precautionary demand for cash

(Duchin, 2010). In addition, diversif‌ication has bearing on

agency problems and thus affects the value of cash (Tong,

2009).

While empirical evidence does not favor any particular

theory, the agency view has been the focus of recent liquid-

ity research. The majority of these studies have examined

how cash and its value are related to corporate governance

and agency problems (Chen, 2008; Dittmar & Mahrt-Smith,

2007; Harford, Mansi, & Maxwell, 2008; Huang & Zhang,

2008; Kalcheva & Lins, 2007; Pinkowitz, Stulz, & William-

son, 2006; Tong, 2009). This is mainly because corporate

cash holdings are the most liquid assets and account for a

large portion of total assets. Hence, any changes in agency

costs resulting from corporate governance should be

ref‌lected in corporate cash holdings. Additionally, insiders

or management can more easily hold cash for discretionary

purposes because of its liquid nature (Dittmar & Mahrt-

Smith, 2007; Dittmar, Mahrt-Smith, & Servaes, 2003). For

the same reason, cash holdings are susceptible to changes

in outside environments and thus serve as a good basis for

studying the relationship between corporate governance

and institutional variables. In particular, corporate gover-

nance has been the center of attention in recent f‌inance lit-

erature because of several corporate scandals and f‌inancial

crises. Investigating corporate liquidity from the agency

perspective should shed some light on how to improve

governance mechanisms, especially through enhancements

of institutional environments.

According to agency theory, management tends to hoard

cash whenever possible to build up the resources under

their control (Jensen, 1986). When corporate governance is

poor and investor protection is weak, the agency problem

within the f‌irm tends to worsen (Dennis & McConnell, 2003;

Shleifer & Vishny, 1997). Management or insiders of such

f‌irms are more likely to accumulatecash to pursue their own

interests at the cost of outside investors. In contrast, in the

presence of good corporate governance and strong investor

protection, the agency problem is less severe. Under such

circumstances, management should be less likely to hoard

cash for discretionary purpose because excess cash can be

disgorged by empowered investors (Dittmar et al., 2003;

Harford et al., 2008; Kalcheva & Lins, 2007; La Porta, Lopez-

de-Silanes, Shleifer, & Vishny, 2000a, 2000b, 2002; Pinkowitz

et al., 2006). In addition, while tradeoff and f‌inancing

hierarchy theories predict that f‌irms should hold more cash

in anticipation of greater growth/investment opportunities

because of costlyexternal f‌inancing, particularly when f‌inan-

cial markets are less developed, agency theory provides a

more subtle explanation of the relationship between cash

holdings and growth/investment opportunities. Based on

agency theory, when f‌irms are poorly governed and agency

problems are more severe, management is less inclined to

hoard cash in response to greater growth/investment

opportunities because other factors not driven by value

maximization are in play. In contrast, when f‌irms are well-

governed and agency problems are less severe, management

has more incentive to hoard cash to take advantage of the

approaching greater growth/investment opportunities for

value maximization. Thus, transaction cost and precaution-

ary motives for holding cash are stronger (weaker) when

agency problems are less (more) severe (Dittmar et al., 2003).

Furthermore, since excess cash is more likely to be wasted by

management when f‌irms are poorly governed and the

agency problem is severe, excess cash should reduce f‌irm

value. In contrast, when corporate governance is good and

management and investors’ interests are more aligned, the

cash hoard is reserved solely for value maximization, and

excess cash should create f‌irm value (Dittmar & Mahrt-

Smith, 2007).

This study aims to revisit corporate liquidity from the

governance and agency perspective by examining whether

and how corporate liquidity and its value are related to

securities laws and control of corruption in order to expand

existing literature on corporate liquidity. The documented

relationship between corporate governance and corporate

liquidity imply that factors affecting corporate governance,

such as securities laws and control of corruption, have

impact on corporate liquidity (Dennis & McConnell, 2003).

Since securities laws and control of corruption are country-

specif‌ic and governance-related, they should have an over-

riding impact on corporate governance and f‌inancial

decisions, including cash policy. This research question has

never been addressed before and is worth exploring

to provide new insight into corporate governance and

liquidity.

Previous liquidity studies examined how corporate

liquidity is related to corporate governance in a single-

country setting using f‌irm-specif‌ic variables, such as divi-

dend payout policy,ownership structure, managerial control

rights, board composition, executive compensation, and

governance index (Gompers, Ishii, & Metrick, 2003; Harford

et al., 2008; Ozkan & Ozkan, 2004). Results of these studies

show that some corporate governance variables play little or

no role in determining corporate liquidity and its value. For

example, Opler et al. (1999) examine US f‌irms and found no

evidence to support agency theory as an explanation for

corporate liquidity. In addition, the effects of corporate gov-

ernance variables are inconsistent in some cases. For

example, f‌irms with poor corporate governance (e.g., lower

managerial ownership) in the US hold less cash than other

f‌irms, likely because they dissipate cash faster by using it to

engage in value-decreasing activities such as mergers and

acquisitions (M&A) (Harford et al., 2008). In contrast,

Drobetz and Gruninger (2007) f‌ind that managerial owner-

ship is inversely related to corporate cash holdings in Swiss

4CORPORATE GOVERNANCE

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