Variation in Corporate Governance and Firm Valuation – an International Study

• Date: 01 December 2016
• Author: Linda Yu,Steve Z. Fan
• DOI: http://doi.org/10.1111/irfi.12096
• Published date: 01 December 2016

Variation in Corporate Governance

and Firm Valuation –an

International Study

STEVE Z. FAN AND LINDA YU

College of Business and Economics, University of Wisconsin–Whitewater, Whitewater,

WI, USA

ABSTRACT

In this paper, we investigate the types of f‌irms that are likely to deviate from

common practice in corporate governance of their home countries and exam-

ine how the deviation is correlated with f‌irm value. Our results show that f‌irms

with higher institutional holdings, lower insider holdings, and higher sales

growth are more likely to deviate from common practice in civil law countries,

whereas, in common law countries, especially in the USA, f‌irms with lower

institutional holdings, higher insider holdings, and lower sales growth are

likely to deviate from common practice. We document a strong positive corre-

lation between governance deviation and f‌irm value in civil law countries.

This relationship is robust to different testing and sample selection methods.

The results, however, are mixed for US f‌irms and not signif‌icant in other

common law countries. Using the deviation from common practice as a proxy

of f‌irm-level impact on corporate governance, our results provide evidence

that f‌irm-level effect matters in governance quality and the effect varies across

countries.

JEL Codes: G30; G32; G34

I. INTRODUCTION

Corporate governance has been an extensively studied topic, especially in recent

years. The common understanding is that corporate governance depends on

both country-level and f‌irm-level characteristics. Country-level characteristics,

including laws, regulations, investor protections, and f‌inancial and economic

development, have been suggested to play a signif‌icant role in determining

governance structure (La Porta et al. 1997, 1998, 1999, 2000, 2002; Doidge

et al. 2007). Some studies f‌ind that country-level characteristics have a dominant

effect on f‌irms’governance. For instance, Doidge et al. report that country

characteristics explain much more of the variance in governance ratings than

do f‌irm characteristics. While countries matter for corporate governance, there

is still debate about whether f‌irm-level characteristics play a signif‌icant role in

corporate governance.

© 2016 International Review of Finance Ltd. 2016

International Review of Finance, 16:4, 2016: pp. 525–563

DOI: 10.1111/irf‌i.12096

Theoretically, a f‌irm’s controlling shareholder chooses a corporate gover-

nance structure to maximize his or her welfare. On the one hand, better

governance would reduce the shareholder’s ability to retrieve private benef‌its.

Adoption of a governance attribute presents a cost to the f‌irm’s controlling

shareholder. On the other hand, better governance decreases the cost of exter-

nal f‌inancing and, in turn, increases f‌irm value. The controlling shareholder’s

welfare would increase through his or her holdings in the company. Therefore,

adoption of a governance attribute has both costs and benef‌its. In an ideal

world, the controlling shareholder will choose an optimal governance structure

for which the marginal benef‌it of adopting an attribute equals the marginal

cost. However, in practice, it is diff‌icult, if not impossible, to achieve such

structure, as theory predicts. Firm-level governance attribute selection is

inf‌luenced by many factors beyond the trade-off mechanism. For example,

many countries have mandatory requirements for public f‌irms. Whether or

not these mandatory requirements facilitate an optimal governance structure,

selection of these mandatory attributes should not be considered as a result of

the trade-off (or f‌irm-level) effect.

In addition, after widespread corporate governance failures (such as Enron

and Xerox), the public have put considerable pressure on legislators and public

f‌irms to respond with more strict regulations and laws as well as better

governance practices. Under such pressure, legislators and f‌irms are likely to

react in a way that focuses on alleviating a crisis, even temporarily. Bruno and

Claessens (2010) argue that country reforms may not be the optimal public

policy design to address corporate governance failures. Further, a f‌irm’s

governance structure may be inf‌luenced by its country’s business culture or

normal practice. Even though some attributes may not be optimal for a specif‌ic

f‌irm, the f‌irm may adopt it simply because other f‌irms have it or because it is

normal to have it.

It is important to recognize that it is not easy to measure true f‌irm-level

effects on corporate governance. Most research measures f‌irm-level governance

using an index, which is the sum of the number of attributes adopted by a

f‌irm (Aggarwal et al. 2009; Bebchuk et al. 2009; Bruno and Claessens 2010),

termed an equal weighted sum (EWS) index. This conventional index includes

not only f‌irm-level effects but also country-level effects, such as mandatory

attributes and attributes considered as country norms. Some studies recognize

the non-f‌irm-level portion of the conventional index measure. For instance,

Chhaochharia and Laeven (2009) developed an index to minimize country-

level inf‌luence from f‌irm-level corporate governance. They def‌ine the

attributes that are adopted by all f‌irms in a country as country-level impact.

The additional attributes adopted by a f‌irm beyond these mandatory attributes

are considered f‌irm-level governance.

In this study, we take a different approach to identify f‌irm-level effect on cor-

porate governance. Our argument is simple. We consider two f‌irms in a country

with the same conventional EWS index: One f‌irm’s governance structure consists

of less commonly adopted attributes, while the other f‌irm’s governance structure

International Review of Finance

© 2016 International Review of Finance Ltd. 2016526

consists of more commonly adopted attributes. Compared with the other f‌irm,

the governance structure with less common attributes is more likely determined

by f‌irm characteristics than by country characteristics and/or country norms. In

other words, a more unique governance structure is more likely determined by

f‌irm-level characteristics. We developed an index to measure how unique a f‌irm’s

governance structure is in its home country and use this index as a measure of

f‌irm-level efforts in shaping a f‌irm’s governance structure. We call this the corpo-

rate governance deviation (CGD) index. Using this index, we study what types of

f‌irms tend to adopt a different governance structure and how the deviation is

associated with f‌irm value.

Af‌irm can achieve a different governance structure through two ways: (i)

adopting more or fewer governance attributes than others or (ii) choosing

attributes different from others. The f‌irst component can be measured by the

EWS index. The CGD index is designed to capture the second component. The

idea behind the CGD index is that, if a f‌irm adopts a rarely adopted attribute or

does not adopt a commonly adopted attribute, a higher weight is assigned to

the f‌irms’CGD index. It is worth noting that the EWS index is an absolute mea-

sure, while the CGD index is a relative measure (deviation from common practice

of a country). In general, these two are correlated. One would have to control for

the EWS index when studying the impact of the CGD index. Therefore, the CGD

index should be considered as a measure to detect the governance structural

difference for f‌irms with similar EWS indexes (a detailed discussion is presented

in the next section).

In this study, we test the following hypotheses:

H1: Deviation irrelevant hypothesis: The CGD index does not provide

any signif‌icant additional information over the EWS index. In other words,

the CGD index is highly (or nearly perfectly) correlated with the EWS index.

Under this hypothesis, we should not observe any signif‌icant correlation

between the CGD index and f‌irm characteristics or f‌irm value after controlling

for the effect of the EWS index.

H2: Deviation for good hypothesis: Deviation is associated with high

governance quality. Under this hypothesis, we should observe that f‌irms with

a higher CGD index usually have f‌irm-level characteristics that are positively

correlated with governance quality. We also would expect a higher CGD index

to be associated with higher f‌irm value.

H3: Deviation for bad hypothesis: Deviation is associated with low

governance quality. Under this hypothesis, we should observe that f‌irms with

a higher CGD index usually have f‌irm-level characteristics that are negatively

correlated with governance quality. We also expect a higher CGD index to be

associated with lower f‌irm value.

To conduct our study,we use the Institutional Sharehold er Services (ISS) global

corporate governance quotient database. The ISS data reports 44 common

Variation in Corporate Governance and Firm Valuation

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