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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 КОРПОРАТИВНАЯ СОБСТВЕННОСТЬ И КОНТРОЛЬ

CORPORATE OWNERSHIP & CONTROL

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Corporate Ownership & Control

Корпоративная собственность и контроль

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1

CORPORATE OWNERSHIP & CONTROL Volume 10, Issue 3, 2013, Continued - 1

CONTENTS

INTELLECTUAL CAPITAL MYTHS: COMMENTS ON LITERATURE REVIEW

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Michail Nerantzidis, Nikitas – Spiros Koutsoukis, Petros A. Kostagiolas, Zoi Karoulia CAPITAL BUDGETING TECHNIQUES EMPLOYED BY SELECTED SOUTH AFRICAN STATE-OWNED COMPANIES 177 J.H. Hall, T. Mutshutshu EXECUTIVE COMPENSATION AND BOARD OF DIRECTORS’ DISCLOSURE IN CANADIAN PUBLICLY-LISTED CORPORATIONS 188 Martin Spraggon, Virginia Bodolica, Tor Brodtkorb THE CAPITALISM OF TURBULENCES AND THE OVER-LIMITED LIABILITY OF THE TOO BIG TO FAIL CORPORATIONS: A PROPERTY ECONOMICS NOTE ON THE WORKING OF MORAL HAZARD 200 Octavian-Dragomir Jora, Radu Cristian Mușetescu, Mihaela Iacob THE IMPACT OF COMPANY-SPECIFIC AND EXTERNAL FACTORS ON CORPORATE RISK TAKING: THE CASE OF EGYPTIAN INSURANCE COMPANIES 210 Mohamed Sherif, Mahmoud Elsayed DOES STATUTORY AUDITORS MATTER GOVERNANCE? EVIDENCE FROM JAPAN

IN

Naoki Watanabel, Hideaki Sakawa

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BANK-DOMINATED

CORPORATE 226

Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1

INTELLECTUAL CAPITAL MYTHS: COMMENTS ON LITERATURE REVIEW Michail Nerantzidis*, Nikitas – Spiros Koutsoukis**, Petros A. Kostagiolas***, Zoi Karoulia*** Abstract The aim and purpose of this paper is to present the authors‟ viewpoints regarding three misguided beliefs concerning Intellectual Capital (IC); (i) IC definition, (ii) IC categorization and (iii) IC reporting framework. More specifically, due to the fact that general agreement on these aspects of IC does not exist, a review of the literature is provided and new pathways for future research are proposed. All in all, being one of the very few studies that provide an overview about some fuzzy issues, this paper, offers a significant added value to the research field of IC.**** Keywords: Intellectual Capital, Intangible Assets, Myth * Corresponding author, Department of Public Administration, Panteion University of Social and Political Sciences, 136 Syngrou Avenue, 176 71 Athens, Greece Email: [email protected] ** Department of Political Science and International Relations, University of Peloponnese, Corinthos, Greece *** Department of Archive and Library Science, Ionian University, Corfu, Greece **** A stimulus for this paper’s creation was two previous studies by Brickley and Zimmerman (2010) and Larcker and Tavan (2011).

1. Introduction The Intellectual Capital (IC) term was firstly introduced by Kenneth Galbraith in 1969 (Feiwal, 1975; Bontis, 1998: 67) “who believed that IC was more than pure intellect but including intellectual action” (Swart, 2006: 137). And, indeed, he had pointed that “I wonder if you realize how much those of us the world around have owed to intellectual capital you have provided over these last decades” (cited in Hudson, 1993: 1). Since Galbraith‟s remarks, researchers have persistently focused their attention on explaining further and expanding the simple concept of IC. The idea of transforming “knowledge and intangible assets into wealth - creating resources, both for companies and countries” (Bradley, 1997: 53). Admittedly, by “the transition from wealth based on natural resources to wealth based on brainpower” (Stewart, 1998: 56), theoretical and empirical studies on a wide spectrum of disciplines including economics, strategy, finance, accounting, HR and marketing have created a magnitude of definitions, of categorizations and reporting models of IC (Choong, 2008: 609). A magnitude that proves on the one hand the importance of IC awareness (Marr and Chatzkel, 2004: 224) and on the other the embryonic stage of this concept to give answers to some main issues. For the reasons mentioned above, the specific paper aims through a literature review of IC to

highlight three misguided beliefs on IC and in parallel to propose on future research in new pathways. The rest of the paper is organized as follows. Firstly, in the subsequent section, three common myths about IC are defined and the need for a wider recognition by the academic community is explained. Furthermore, the case of the non general agreement which exists on the: i) IC definition, ii) IC categorization and iii) IC reporting framework, is described. Finally, the inferences of the main findings are drawn and the vital points for further research are provided. 2. Myths and disbeliefs for Intellectual Capital 2.1. Myth 1: General agreement exists on the definition of “intellectual capital” Despite the numerous efforts to bring about an unbiased and widely accepted definition of IC, there is still some confusion as to how IC should be defined. There is still an abundance of definitions reflecting different perspectives, roles, component parts and viewpoints that justify the IC definition conglomeration (see table I). Indeed, a search on journal databases reveals the intense efforts of researchers to define the term of IC. However, the reader may face confusion as to which definition is more appropriate. A confusion that has “important implications both on the direction and

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 interpretation of research” (Brickley and Zimmerman, 2010: 236). At a starting point we quote two different terms that were used as synonymous by some researchers in order to indicate IC concept. Particularly a variety of terms such as “intangible assets”, and “knowledge assets”, are used with the same meaning of IC (Choong, 2008: 613; Lev, 2001) [1]. A separation which can easily create confusion to the researchers‟ on which term to use. Moreover, many authors wanting to venture into the identification and definition of intellectual capital in a managerial perspective (rather than an economic, accountant, or taxation perspective) prefer the concept of “resource” rather than the concept of “asset,” wanting to overcome issues associated to property and ownership (Kostagiolas, 2012: 7). Furthermore, one more indicative paradigm which enhances the lack of agreement on the definition of IC is the usage of different definitions even by researchers who were based on the same discipline. Particularly, Marr and Moustaghfir (2005) show several examples that demonstrate this paradox. Based on that, they proposed three dimensions (e.g. perspectives, roles and component parts) as a framework in order to facilitate future IC definitions. In our point of view, although this approach has many advantages, it cannot be a heuristic advice. We believe that the multiplication rule enumeration of this function could generate many combinations or else 147 different definitions which means that this approach suggests very narrow definitions. Our opinion comes in contrast to the above, as we think that a broad definition of IC could be more useful.

To better understand the “definition” of IC, one must look at the sphere of the concept, at those main parts that contribute to the development of this current new scientific field. For this reason, we think it is useful to have in mind the “Rubik‟s cube” concept in order to solve the puzzle of the IC definition. This means that the IC definition consists of numerous “cubies-elements”. However, the solution of this puzzle is to find the main faces that reflect each appropriate component part of IC. This optimal solution could act as a cornerstone for an appropriate and widely accepted definition by everyone who refers to the IC concept. In accordance with the above, a very broad definition that we propose is the following: “IC is the sum of human, structural/organizational and relational capital that positively influences an organization”. According to that, we focus on the main three IC categories that are adopted by the majority of researchers (more details are presented in the next section). The definitions of Sveiby (1997) and Edvinsson and Malone (1997) are moving in the same direction. All the previous discussed issues obviously mean that there is a malleable concept of IC and therefore confirms Bontis‟ (2001: 57) opinion who states that the IC definition “is still in its embryonic stage and there is no one willing to give up their own nomenclature” (Andriessen, 2004: 60). We find that the widely accepted definition of IC is a misconception [2] so we recommend that the aim is not a further production of IC definitions but to reach a consensus about a widely accepted one regardless of the discipline and roles of IC.

Table 1. Indicative definitions of intellectual capital Author(s) Hall (1992: 136)

Term Intangible assets

Brooking (1996: 13) Edvinsson and Malone (1997: 44)

Intellectual capital Intellectual capital

Roos et al. (1997: 37) Sveiby (1997: 11)

Intellectual capital Intangible assets Intellectual capital Intangible assets Knowledge assets Knowledge assets Knowledge assets

Sullivan (1998: 4) Gu and Lev (2001) Bontis (2001: 41) Peloquin (2001: 6) SMR (2008: 3) Roos et al. (2005: 19) Source: Authors

Intellectual capital

Definition Assets which are obviously things which one owns, include intellectual property rights of: patents, trademarks, copyright and registered designs; as well as contracts, trade secrets and databases The combined intangible assets, which enable the company to function The possession of the knowledge, applied experience, organizational technology, customer relationships and professional skills that provide a company with a competitive edge in the market The sum of knowledge of its members and the practical translation if this knowledge into brands, trademarks and processes Invisible assets that include employee competence, internal structure and external structure The knowledge that can be converted into profits Intangibles are defined by their major drivers. Authors name R&D, advertising, IT and human resource practices as drivers knowledge assets are the crux of sustainable competitive advantage, the burgeoning field of intellectual capital is an exciting area for both researchers and practitioners The knowledge asset is the tangible representation of the corporations "know-how," and is prima facie proof of corporate competence A knowledge asset is defined as any collected information or knowledge held by the larger enterprise and used by anyone affiliated with the organization to help the organization achieve its goals All nonmonetary and nonphysical resources that are fully or partly controlled by the organization and that contribute to the organization‟s value creation

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 2.2. Myth 2: General agreement exists on the categorization schemes of “intellectual capital” The phenomenon of categorization stems from the ancient ages from the time of Aristotle (384-322 BC) who was the father of categorization since he loved making categories on just about everything. A simple definition of the term could be expressed as the act of distributing things (items) into classes or categories of the same type. But as noted in the previous section, a lack of conceptual clarity regarding IC definitions similarly extends to its categorizations. And this can be supported by the fact that different groups of researchers suggest numerous categorizations of IC (see table II). As characteristically stated by “Rudner (1966), the value of the categorization is associated with its ability to function as a heuristic advice, which is useful for the interpretation of substance” (Choong, 2008: 609). Consequently, based on the literature, one of the most commonly used categorization is the classification of IC into three broad categories:  human capital: which includes knowledge, experience, abilities, skills and staff creativity of an organization.  structural/organizational capital: which includes copyrights, brands, systems, knowledge artifacts, intellectual property, methodologies, and software. As Edvinsson stated “are all those things that remain in the organisation when the employees have left the building but cannot find in the balance sheet” (Roos et al., 2005: 19).  relational capital: which includes all the relationships held by an organisation with its clients, customers, consumers, suppliers, vendors, partners (Stewart, 1995; Edvinsson and Malone, 1997; Roos and Roos, 1997; Bontis, 1996,1998,2002;

MERITUM, 2002; Marr and Roos, 2005; White, 2007). Others adopt the same categorization but renamed the third category as customer capital instead of relational capital, but with the same meaning (Lloyd, 1996; Petrash, 1996; Sveiby, 1997; Stewart, 1997, 2001; Allee, 1999; Bontis et al., 2000; Huotari and Iivonen, 2005). It is worth mentioning that there is a group of researchers who come in conflict with the previous categorizations and adopt two categories:  human capital and  structural capital, respectively. Thence, structural capital is classified into two sub-categories that are customer capital and organizational capital, while organizational capital is divided into innovation and process capital (Edvinsson and Sullivan, 1996; Edvinsson, 1997; Zéghal, 2000; Bukh et al., 2001; Bontis, 2004). However, some other IC categorizations are also mentioned, such as:  human capital,  organizational capital and  social capital (Youndt et al., 2004). or  human capital,  internal capital and  external capital (Abeysekera and Guthrie, 2005; Guthrie et al., 2004). or even more  human capital,  social capital and  knowledge management (Rastogi, 2002). Last but not least, many other IC classifications are suggested that came in contrast to the scope of this paper, which is not to quote all the categorizations but to enhance and confirm the option that there is a myth about the existence of a commonly accepted IC one.

Table 2. An indicative list of the most accepted IC categorizations per researcher   

  

IC Categorization Human Capital Structural /Organizational Capital Relational Capital

Human Capital Structural/Organizational Capital Customer Capital  Human Capital  Structural Capital: i. Customer Capital, ii. Organizational Capital

Researcher(s) Stewart, 1995; Bontis, 1996,1998,2002; Edvinsson and Malone, 1997; Roos and Roos, 1997; Skyrme, 1998; Sánchez et al., 2000; Mouritsen et al., 2001; MERITUM Project, 2002; Carson et al., 2004; Chang and Birkett, 2004; Grasenick and Low, 2004; Leitner, 2004; Gallego and Rodriguez, 2005; Marr and Roos, 2005; Roos et al., 2005; Chu et al., 2006; Kong, 2007, 2008; White, 2007; Chen et al., 2009; Erickson and Rothberg, 2009; Ramírez, 2010; Seleim and Khalil, 2011; Komnenic and Pokajcic, 2012; Kostagiolas, 2012 Saint-Onge, 1993; Lloyd, 1996; Petrash, 1996; Roos and Roos, 1997; Stewart, 1997, 2001; Sveiby, 1997; Allee, 1999; Bontis et al., 2000; Brennan and Connell, 2000; Leliaert et al., 2003; Kannan and Aulbur, 2004; Huotari and Iivonen, 2005 Edvinsson and Sullivan, 1996; Edvinsson, 1997; Koening, 1997; Lank, 1997; Roos, 1998; Edvinsson and Stenfelt, 1999; Zéghal, 2000; Bukh et al., 2001; Zhou and Fink, 2003; Bontis, 2004

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1           

Human Capital Internal Capital  External Capital Organizational Capital Human Capital Social Capital Social Capital Human Capital Knowledge Management Human Capital Informational Capital Organizational Capital

Guthrie et al., 2004; Abeysekera and Guthrie, 2005

Youndt et al., 2004

Rastogi, 2002

Marr and Adams, 2004

Source: Authors

2.3. Myth 3: A consistent framework for reporting IC exists A large theoretical and empirical accounting literature examines the role of the “external reporting for the effective functioning of capital markets” (Healey and Palepu, 2001; Bozzolan et al., 2003: 544) and probably not unfairly as a considerable number of reasons have been referred. Particularly, accountants have published a plethora of those informative reasons, providing that IC disclosure (ICD) reduces i) information asymmetry (Lev, 2001; Luu et al., 2001; Pike et al., 2002), ii) cost of capital (Leadbetter 2000; Lev, 2001; Luu et al., 2001), iii) cost of debt (Sengupta, 1998), and iv) the risk of the insider trading (Leadbetter, 2000) (Nerantzidis, 2013). For this purpose, academics, practitioners and authorities have developed various models of ICD (Roos et al., 2005: 292-310): 1. the model proposed by the MERITUM project; 2. the Danish Disclosure initiative; 3. the ARCS intellectual capital report; 4. the Triple Bottom Line (TBL) framework; 5. the Balanced Scorecard model; and 6. the Skandia model. Even if a common feature that appears in all these models is the use of indicators (may contain those related to: knowledge transfer, research management, customer satisfaction, etc.), there is still not a common framework in their design. However, there are many exploratory (and parallel complementary) theories of voluntary ICD such as the positive accounting theory, the legitimacy theory and finally the stakeholder theory (Guthrie et al., 2004: 283-284; Abeysekera and Guthrie, 2005: 155; Beattie and Thomson, 2006: 2) that strengthen the efforts of researchers for more unified research “working for an overarching framework for IC and value creation” (Ross et al., 2005: 319) [3]. Undoubtedly, content analysis appears to be the most refined “instrument in order to quantify and measure comparative positions and trends in reporting” (Guthrie et al., 2004: 285). As Krippendorff (1980: 21) mentions, content analysis is a “research technique for making replicable and valid

inferences from data according to their context” (Bozzolan et al., 2003: 548). And this can be supported by the fact that a considerable number of IC researchers have used that method to examine ICD (Guthrie and Petty, 2000; Brennan, 2001; Abdolmohammadi, 2005; Bozzolan et al., 2006; Striukova et al., 2008; Brüggen et al., 2009; Taliyang and Jusop, 2011; Branswijck and Everaert, 2012). However, the question that firstly has to be answered is whether we could refer to the existence of a widely accepted model of IC reporting. Definetely not always, and this is propably a consequence that comes from the first myth. A vicious circle that was generated exactly by the shortage of a concensus on IC definition, extended with the second myth, and finally leads to the lack of an established IC reporting framework (Nerantzidis, 2013). The magnitude of everything mentioned above can be transmitted by the phrase of Henry James (1982: 130) “The whole situation works in a kind of inevitable rotary way - in what would be called a vicious circle”. Consequently, all these demonstrate the fact that we cannot talk about an “ideal” ICD index (Nerantzidis, 2013). Precisely, the theoretical background regarding the construction of an ICD index is weak. First of all, there is no theory to guide us neither to the categories [4] that an index can be classified nor to the items [5]. Secondly, there is a lack of a common practice according to i) the unit of analysis and unit of measurement ii) the volume of disclosure (see Beattie and Thomson, 2006: 9, 12) and iii) the type of corporate reports used in order to examine ICDs (see Striukova et al., 2008: 302). However, there are some empirical evidences that clarify some “vaguenesses”. For instance, the debate between manual and electronic searching for IC information tilts in favor of the first (see Weber, 1990). Beyond these, we believe that the most common practice, the one that uses a unique weighting for both the categories and the items, means no weight at all (see Nerantzidis, 2012: 12; Nerantzidis, 2013). “Overall, the selection rules applied are admittedly, to some extent, arbitrary. But this is a common concern for all studies” (Florou and Galarniotis, 2007: 983) on ICD (e.g. Marr 2005;

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1

Branswijck and Everaert, 2012). As Beattie and Thomson mentioned (2006: 2) both transparency and share meanings could be the cornerstone for the development of a common accepted model of ICD; a model that can enhance interpretation and comparison of findings across studies (Nerantzidis, 2013).

3. Conclusion(s) “We need to do anomaly-seeking research, not anomaly-avoiding research” Christensen (2003: 18) The analysis presented above identified a lack of consensus on some major issues about IC. For this reason, we suggest that a broader definition emanating from the most accepted categorization could act as an explanation of IC puzzle(s). A proof of our suggested concept is presented in the following illustration:

Figure 1. The intellectual capital framework

Source: Authors

Notes 1.

2.

3.

4.

Kok (2007: 184) mentions that despite the fact that “many authors use the term “intellectual asset” and “intellectual capital” interchangeably, there are subtle differences between the meanings of two”. The same conclusion was reached by Nerantzidis et al. (2012: 2) in the scientific field of corporate governance. A minor debate exists between researchers‟ opinion about the representative theories that explains the IC disclosure. Especially, Abeysekera and Guthrie (2005: 155) mention the political economy of the accounting theory and the legitimacy theory (Guthrie et al., 2004: 283-284) refer to stakeholder theory and legitimacy theory, while Beattie and Thomson (2006: 2) present the positive accounting theory, the legitimacy theory and the stakeholder theory. For instance, Abeseykera and Guthrie (2005: 156) classified 45 intellectual capital items into three categories (external capital, human capital and internal capital) while Taliyang and Jusop (2011: 117) classified 39 intellectual capital items into four categories (structural capital, human capital, relational capital and general items).

5.

6.

It is worth mentioning that a considerable number of researchers classified the intellectual capital items not only in main categories but also in sub-categories with a major variability (see Abeseykera and Guthrie, 2005; Bozzolan et al., 2003). Christensen (2003: 18).

References 1. 2.

3. 4. 5.

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6. 7.

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10. 11.

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CAPITAL BUDGETING TECHNIQUES EMPLOYED BY SELECTED SOUTH AFRICAN STATE-OWNED COMPANIES J.H. Hall, T. Mutshutshu Abstract An analysis of the prior literature revealed few studies on the capital budgeting practices of stateowned companies (SOCs). The goal of this study was therefore to investigate the capital budgeting techniques employed by decision-makers in South African state-owned companies. The results indicated that the NPV and IRR techniques were used by 43% of respondents (the NPV was slightly more popular). WACC emerged as the preferred discount rate for capital budgeting purposes. In considering project risk, state-owned companies seem to prefer sensitivity analysis. It is thus recommended that academics emphasise the importance of NPV as a primary capital budgeting technique. Keywords: Net Present Value (NPV), Internal Rate of Return (IRR), Capital Budgeting Techniques, Weighted Average Cost of Capital (WACC) * Department of Financial Management, University of Pretoria, Pretoria, 0001, Republic of South Africa Tel.: +27 12 420 3389 Fax: +27 12 420 3916 E-mail: [email protected] ** Chief Advisor: Economic Regulation and Financial Planning, ESKOM, Republic of South Africa

1. Introduction In recent decades, capital budgeting has attracted much interest, and there has been copious research on the topic. Many of these studies have been conducted on private sector businesses (the term “private sector” is used in this context to refer to businesses that are not owned by the government), and the samples used in these studies have often been drawn from local stock exchanges. However, in the United States (US) and Canada, two studies by Burns and Walker (1997) and Chan (2004) respectively are examples of capital budgeting studies on government-owned utilities. In the South African context, scrutiny of the financial academic literature revealed no studies published on the capital budgeting practices of South African state-owned firms, although a number of studies on the capital budgeting practices used by South African private sector firms have been conducted, for example, by Hall (2000), Hall (2001), Gilbert (2003), Du Toit and Pienaar (2005), Correia and Cramer (2008) and Hall and Millard (2010). The main purpose of this study was therefore to address the knowledge gap regarding the absence of research on capital budgeting techniques used by state-owned companies. This study thus sought to determine which capital budgeting techniques are employed by decision-makers in state-owned companies in South Africa, and to investigate the methods these entities use to determine the weighted average cost of capital (WACC).

The specific objectives of this study were to answer the following questions: What capital budgeting techniques do stateowned companies use in the evaluation of capital budgeting projects? What, if any, discount rate is used for capital budgeting purposes? How is the discount rate that is used in the capital budgeting process calculated? How, if at all, do these institutions account for risk in the capital budgeting process? Apap and Masson (2005) observe that information on the capital budgeting techniques applied by publicly traded utilities is useful not only to the management of these utilities, but also to investors. Hence, the current study sought to add to the body of knowledge by identifying the capital budgeting practices applied by decision-makers in South African state-owned companies. In.addition, a determination of the cost of equity of state-owned companies that do not have the benefit of the stock exchange to determine proxies and betas holds some potential for new understanding on capital budgeting practices. The lack of academic research in this field thus far presented an opportunity for new learning. The opportunity to add new knowledge should also be seen against the backdrop of the massive investment drive in South Africa to catch up with the backlog caused by previous underinvestment, and by unprecedented economic growth in the last decade. This study‟s results can also be compared to those of

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previous studies. In addition, the recommendations from the results of this study will assist management, decision-makers and government in using sound capital budgeting techniques in their investment programmes. The article is set out as follows: a literature review involves a synthesis of the current literature available, both internationally and locally, on the topic of capital budgeting, and addresses particularly the issues of cash flow determination, capital budgeting techniques, the determination of the discount rate and the incorporation of risk in the capital budgeting process. This is followed by a discussion of the research design and methods. Thereafter the empirical results and analysis are discussed. Finally, conclusions and recommendations for further studies are provided. 2. Literature Review The literature review in this study explores the choice of capital budgeting techniques available, including the incorporation of risk in the capital budgeting process, as found in both international studies and local South African studies. 2.1 Determination of cash flows The determination of cash flows is consistently considered to be one of the most important and complex stages of the capital budgeting process. In their survey of Taiwanese firms, Haddad et al. (2010) found that approximately half of the respondents considered project definition and cash flow determination the most difficult aspects of the capital budgeting process. Bennouna et al. (2010) point out that previous studies indicated that Canadian firms did not determine cash flows properly in their capital investment analysis. However, in their research, Bennouna et al. (2010) found that an overwhelming percentage of the firms (91.5%) in their study correctly computed net present value (NPV) or internal rate of return (IRR) on a cash flow basis, rather than accounting income. A large proportion treated inflation, interest expenses and other financial costs correctly. In the South African context, Hall (2000), Brijlal and Quesada (2009) and Hall and Millard (2010) found that their respondents from private firms regarded project definition and cash flow estimation as the most important and difficult stages of the capital budgeting process. The estimation of cash flows is based on a combination of methods, in particular, subjective management estimations with consensus of expert opinions, and quantitative methods (Hall, 2000; Hall and Millard, 2010). A matter for concern was the significant number of respondents who used only subjective management estimates, who were not able to say how their cash flows were determined, or who

did not make any adjustments for inflation (Hall, 2001). 2.2 Capital budgeting techniques Capital budgeting techniques can be divided into the academically superior discounted cash flow techniques, such as NPV, IRR and the modified internal rate of return,(MIRR), and non-discounted cash flow methods, such as the payback period (PBP) and accounting rate of return (ARR). Financial theory advocates using the NPV rather than the IRR, because the IRR may give incorrect results when projects are mutually exclusive (Ryan and Ryan, 2002; Du Toit and Pienaar, 2005; Bennouna et al., 2010). The findings of prior international and South African studies on the choice of capital budgeting techniques are discussed below. A review of international studies reflects a constructive increase in the adoption of discounted cash flow techniques over time (Burns and Walker, 1997; Arnold and Hatzopoulos, 2000; Ryan and Ryan, 2002; Graham and Harvey, 2002; Truong et al., 2008; Bennouna et al., 2010; Baker et al., 2011; Kester and Robbins, 2011). Furthermore, it is encouraging to note the increased preference for the NPV over the IRR technique in the capital budgeting process (Ryan and Ryan, 2002; Truong et al., 2008; Baker et al., 2011). However, it is still a matter of some concern that a significant number of firms continue to use non-discounted cash flow techniques, in particular, PBP (Graham and Harvey, 2002; Brounen et al., 2004; Chan, 2004; Apap and Masson, 2005; Haddad et al., 2010; Kempe and Meyer, 2011). The appeal of the PBP was found to be the simplicity of its computation and ease comprehension, and it is often used to supplement discounted cash flow techniques (Burns and Walker, 1997; Leon et al., 2008).The size of a project and the size of a firm were found to be two factors that influence the adoption of capital budgeting techniques (Payne et al., 1999; Kester and Robbins, 2011). A considerable amount of research had been done on the topic of capital budgeting in developed countries, but developing countries have not received the same amount of coverage in respect of research on the topic (Brijlal and Quesada, 2009). A review of earlier South African studies shows mixed results regarding the use of capital budgeting techniques, as both discounted cash flow and non-discounted cash flow techniques being used, in some cases with a preference for non-discounted cash flow techniques (Hall, 2000; Gilbert, 2003). Lack of knowledge of discounted cash flow techniques was cited as a possible reason for this phenomenon (Gilbert, 2003). However, Gilbert‟s (2003) finding was in contrast with Hall‟s finding that South African decision-makers were academically well-qualified (Hall, 2001; Hall and Millard, 2010).

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However, over time, it appears there has been an increase in the popularity of discounted cash flow techniques, especially amongst large firms, although small and medium businesses still seem to prefer the rather crude PBP method (Du Toit and Pienaar, 2005; Correia and Cramer, 2008; Brijlal and Quesada 2009; Olawale et al., 2010; Viviers and Cohen, 2011). Some studies using South African data show a clear preference for using the IRR rather than the NPV (Du Toit and Pienaar, 2005; Correia and Cramer, 2008), whereas other studies show a preference for the NPV over the IRR (Brijlal and Quesada, 2009; Hall and Millard, 2010). As has been reported in international studies, South African studies found that local companies tended to use a number of different techniques (Napier, 2000; Gilbert, 2003). Furthermore, the size of the business and the size of the capital budget were also factors in the choice of capital budgeting techniques – decision-makers in listed companies seem to prefer discounted cash flow techniques, whereas decision-makers in smaller businesses seem to opt mainly for PBP (Hall, 2000; Correia and Cramer, 2008; Brijlal and Quesada, 2009). To conclude, from a South African point of view, there is evidence of a positive trend towards the adoption of discounted cash flow methods, particularly the NPV (Correia and Cramer, 2008). Financial considerations are an integral part of the investment decision, but other qualitative factors also play a role in the decision-making process. Nonfinancial (qualitative) factors are playing a growing and more significant role in the capital budgeting process (Hall and Millard, 2010). The following reasons have been cited for this phenomenon in the South African context, amongst others: employee safety (Hall, 2000), the continuity of existing product lines (Hall, 2000), legal requirements (Du Toit and Pienaar 2005), strategic factors (Du Toit and Pienaar, 2005), environmental considerations (Du Toit and Pienaar, 2005; Viviers and Cohen, 2011), keeping up to date with technological developments (Du Toit and Pienaar, 2005), and increased government regulation (Hall and Millard, 2010). 2.3 Determination of the discount rate The cost of capital is a key parameter in the capital budgeting process. Although previous studies have indicated that Canadian firms used subjective judgement to determine the discount rate (Payne et al., 1999), later studies have shown a positive trend in that WACC was used by a substantial number of respondents (Bennouna et al., 2010; Ryan and Ryan, 2002; Baker et al., 2011). Canadian municipalities, however, used the cost of debt as their discount rate (Chan, 2004). For publicly traded utilities in the United States, Apap and Masson (2005) found that over half of the respondents used WACC.

Private sector European firms reportedly determined the cost of equity by using the Capital Asset Pricing Model (CAPM) (Brounen et al., 2004), whilst an overwhelming majority of Australian firms also used the CAPM to determine the cost of equity and used the target weights to determine the WACC (Truong et al., 2008). However, less than 15% of Indonesian companies reported using the CAPM to determine the cost of equity, despite the high rate of adoption of discounted cash flow techniques (Leon et al., 2008). In the South African context, the results are mixed in that, although studies show a positive trend for the adoption of CAPM in listed firms (Correia and Cramer, 2008) and the Brijlal and Quesada (2009) study shows a low adoption rate of WACC. In conclusion, international studies show a preference for the use of WACC and CAPM as tools in the capital budgeting process. South African results on the use of WACC and CAPM were mixed and not consistent, but the majority of respondents appeared to use the WACC and the CAPM in evaluating capital budgeting projects. 2.4 The incorporation of risk in the capital budgeting process There are a number of methods to incorporate risk in the capital budgeting process. These are a scenario analysis, the certainty equivalent method, sensitivity analysis, simulation analysis and decision tree analysis. In addition, firms can adjust their discount rate or their cash flows to adjust for risk in the capital budgeting project. Sensitivity analysis has proved to be very popular as a risk analysis tool amongst firms internationally (Brigham and Pettway, 1973; Graham and Harvey, 2002; Leon et al., 2008; Bennouna et al., 2010; Haddad et al., 2010). The next most popular technique to incorporate risk was found to be an adjustment to the discount rate and cash flows by means of simulation and scenario analysis (Ryan and Ryan, 2002; Chan, 2004; Bennouna et al., 2010; Kester and Robbins, 2011). The level of management education and leverage levels of decision-makers were identified as key determinants in the choice of risk analysis techniques (Graham and Harvey, 2002; Baker et al., 2011). Results from South African studies suggested that there was large a gap between theory and practice regarding risk analysis, finding little use of quantitative methods of risk adjustment in the capital budgeting process (Hall, 2001; Gilbert, 2003). Where risk analysis was performed, sensitivity analysis was the preferred technique for incorporation in the capital budgeting process (Hall, 2001). However, more recent studies have found a strong preference for sensitivity analysis (Correia and Cramer, 2008; Hall and Millard, 2010). The increase in the use of quantitative techniques could be attributed to “an increasingly uncertain world where risk factors have to be

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 incorporated in any financial decision” (Hall and Millard, 2010). However, a high level of use of subjective (non-quantitative) methods of risk adjustment in smaller businesses still prevails (Brijlal and Quesada, 2009). Du Toit and Pienaar (2005) suggest that the high level of use of the PBP method (over 40%) could be attributed to the use of this method as a risk measure, because it provides an assessment of the period required to recover the capital spent. The findings of previous studies appear to suggest that sensitivity analysis is the prominent measure for risk assessment, followed by the adjustment of the discount rate and cash flows. The review on capital budgeting practices reveals a gap between what is considered theoretically sound and what is actually applied in practice by decision-makers. Baker and Fox (2002) describe this as “an uncomfortable gap between investment appraisal models in literature and current practice.” There is an obvious split between the two, although there are clear signs that the gap is narrowing, as academically sound capital budgeting practices are gaining momentum and are increasingly being brought into the workplace. The next section addresses the research design and methods used iIn order to achieve the objectives of this study. 3. Research Method In this section, the population, questionnaire, collection of data, responses and analysis techniques used in this study are discussed. The population for this study consisted of South African state-owned companies involved in the execution of infrastructural projects and state-owned companies that provided such companies with funding. Given the limited number of such organisations in South Africa, the approach adopted in the study was to include all entities that met the identified requirements. Therefore, sampling was not required. There were 14 state-owned companies that fitted the profile. The primary data were collected by means of a survey based on structured questionnaires. The questionnaire consisted of 31 questions structured in such a way that information on the state-owned company as an entity, the decision-makers‟ profile, their choice of capital budgeting method, the way they calculate WACC, as well as the incorporation of risk in the capital budgeting process, was obtained. The questionnaires were distributed to the chief financial officers (CFOs) or their equivalent in the organisations by means of electronic mail. The email was preceded by a courtesy telephone call to give a high-level briefing on the study to the individual who was being approached. The data collection questionnaire took the form of an interactive Excel spread sheet with dropdown menus to save participants time, and to ensure

the accuracy of the results. Upon receipt, the data were consolidated manually into one sheet. The data were analysed using the statistical functions in the Excel spread sheet, and the results were presented by means of descriptive statistics. 4. Empirical Results and Analysis The results of the study provide a unique insight into the capital budgeting processes of state-owned companies, an important sector of the South African economy on which no previous studies on these processes could be found. Although the sample included 14 state-owned companies, only six responded, despite several attempts to achieve a higher return rate. Issues of confidentiality were cited as the greatest concern to those who did not return the research instrument, despite assurances that the responses would be treated with the strictest confidentiality and that no particular state-owned company would be associated with the data. Some state-owned companies had been subject to extensive negative media coverage regarding their capital programmes, which may be a contributing factor in their reluctance to participate in the study. The completed questionnaires received from the six state-owned companies that responded were all of a usable quality. This is predominantly the result of the fact that the respondents were willing to engage with the researcher where further clarification was required. Therefore, the overall response rate was approximately 42%. 4.1 Company profile

and

decision-maker’s

The state-owned companies represented in the responses operate in various sectors of industry. However, for reasons of confidentiality, given the small number of respondents, the sectors cannot be identified here. The data collection instrument was directed at the CFOs of the organisations or their equivalent, who were e-mailed the questionnaire. All except two respondents indicated that they were chartered accountants (CAs) in various positions who played an advisory role in capital budgeting decisions. The CFOs were ultimately responsible for the final capital budgeting decisions. With regard to the CFOs‟ age profile, half of the responding companies had CFOs between the ages of 40 and 49, and a third of the CFOs were below the age of 40. All these CFOs were CAs[SA], and one had a master‟s degree. Of the CFOs, 83% had been with their companies for less than four years, and only one had been with the company for more than nine years. The extent of the fixed assets managed by the state-owned companies and the revenue they generate are a reflection of the strategic importance of these

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entities in the delivery of essential services to the country. Only one company manages assets of less than R5bn; two companies manage fixed assets of between R11bn and R50bn; the other three have assets greater than R50bn. The results on the size of the companies‟ capital budget are presented in Table 1. The annual

capital expenditure by these state-owned companies is substantial: more than 50% of the companies spend less than R10bn on their capital projects annually, but 33% spend between R10bn and R50bn. This could be attributed to the fact that in the last few years, some state-owned companies have embarked on substantial infrastructure expansion projects.

Table 1. Annual capital expenditure by state-owned companies Annual capital expenditure

%

Less than R10bn

50%

R10bn - R50bn R51bn - R100bn R101bn - R200bn More than R200bn

33% 17% 0% 0% 100%

The sections below deal with the responses of the six state-owned companies on their capital budgeting processes, namely the stages of their capital budgeting decisions, their capital budgeting techniques, cash flow estimation methods, riskadjustment techniques and qualitative considerations.

4.2 Stages process

in the capital

budgeting

The questionnaire sought to determine the importance that the state-owned companies attached to the various stages of the capital budgeting process, from “project definition to post- implementation review. Furthermore, the respondents were asked to rate the complexity of each stage of the capital budgeting process. Table 2 reflects the results.

Table 2. Capital budgeting stages: importance and complexity Capital budgeting stage

Most important

Most complex

Project definition and cash flow estimation Analysis and selection

22% 22%

40% 0%

Implementation Post-implementation review

56% 0%

60% 0%

100%

100%

Project implementation was considered the most important and complex stage of the capital budgeting process. This result is contrary to findings of previous studies discussed in the literature review, where the cash flow estimation stage was consistently rated as one of the most important and risky activities in the capital budgeting process. This finding on the importance and complexity could be attributed to the fact that state-owned companies have to compete with the private sector for the necessary human resources skills. Furthermore, maintaining the physical capacity to execute largescale infrastructure projects has proven to be difficult for the state-owned companies. This in turn could be attributed to the fact that there is an acknowledgement that the increase in the demand for goods and services

has not been matched by growth in the executing capacity of these companies. The importance attached to the implementation stage by the respondents in the state-owned companies could also be attributed to the pressure exerted on government to deliver goods and services to the general population. In contrast to the findings of previous studies, 40% of the respondents considered the project definition and cash flow estimation stages to be the most complex stages of the capital budgeting process. The complexity of cash flow estimation could be the result of the significant cost overruns of major infrastructural projects experienced by the stateowned companies.

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Considering the size of the projects in monetary value, it is of concern that none of the respondents rated the post-implementation review of the projects as either important or complex. Only half of the respondents reported doing any form of postaudits. Hall and Millard (2010:90) observe that this stage is important for learning from experience and ensuring the transfer of knowledge in an organisation. It is also important to prevent potentially costly errors. Given the increased negative media coverage of infrastructural projects by state-owned companies, it is expected that in future this stage of the capital budgeting process will receive a greater deal of attention and will achieve a higher level of importance.

4.3 Cash flow estimation methods As indicated in Table 1, the project definition and cash flow estimation stages were ranked the second most complex stages of the capital budgeting process. When asked to respond on how the companies determined the cash flow requirements of the projects, the respondents indicated that they used a combination of techniques and did not rely on one technique only. Table 3 reflects the results of the responses.

Table 3. Cash flow estimation methods Cash flow estimating methods

%

Management estimates Expert opinions Quantitative methods Previous experience Other

13% 27% 13% 33% 13% 100%

Previous experience was the most popular technique adopted for estimating cash flows. This finding may suggest that errors in the process of estimating cash flows may occur if the previous experience was not modified to take into consideration the actual cash flows during the project. The mitigating factor for this risk is that, as indicated, the respondents used more than one technique to determine cash flows. It was reassuring to observe that more than 50% of the respondents used formal techniques (excluding the use of management subjective estimates and previous experience) for cash flow estimation. Previous studies reported a high use of subjective management judgement and a lack of

quantitative methods for this integral component of the capital budgeting process, despite the fact that substantial sums were concerned. 4.4 Capital budgeting techniques The respondents were asked to indicate their preferred capital budgeting techniques. As with the cash flow estimation techniques, the respondents indicated a preference for more than one capital budgeting technique. One respondent indicated that the company‟s investment committee required the results of all the techniques mentioned, with the exception of real options. Table 4 reflects the preferred capital budgeting techniques.

Table 4. Preferences for capital budgeting techniques Preferences for most used capital budgeting technique

%

Net present value (NPV) Internal rate of return (IRR)

25% 17%

Modified internal rate of return (MIRR) Profitability index (PI)

8% 17%

Payback period (PBP) Return on investment (ROI)

17% 8%

Real options Other

0% 8% 100%

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It was disappointing to observe that only 25% of the state-owned companies preferred to use the NPV method. If the primary use of IRR is included, this brings the total for the NPV and IRR techniques to 42%. In cases where the NPV was not the most preferred technique, 15% of the respondents indicated that the NPV technique was used as a secondary technique to support the primary technique. Overall, there is a significant use of discounted cash flow techniques for capital budgeting decisions. The preference for using the NPV over using the IRR supports financial theory, which advocates using the superior NPV rather than the IRR technique, as the IRR may give incorrect results in the case where multiple projects being assessed are mutually exclusive (Bennouna et al., 2010). In contrast to the study on listed South African companies where Hall and Millard (2010) found that there was no significant difference between the preference for the NPV and the IRR, the results of this study found a significant preference for the NPV compared to the IRR among the respondents from the state-owned companies. The IRR and PBP techniques received an equal and significant rating of 17% use each. This is consistent with previous studies, which observed that the use of the IRR and PBP techniques remain high, although there has been an increase in the popularity of the NPV technique. It is likely that the continued use of the IRR and PBP techniques is attributable to the fact that these measures are easy to calculate and understand. The MIRR, return on investment (ROI) and Other techniques also received an equal rating of 8%. Although the real options technique was not the respondents‟ preferred technique, two state-owned companies indicated that they used it as a secondary technique. This result is in contrast to the findings of previous studies, which reported the emergence of the use of real options as a capital budgeting technique in engineering-driven, construction and large industrial businesses that had substantial capital investments and high risk levels (Triantis and Borison, 2001; Verbeeten, 2006; Baker et al., 2011). The insignificant use of the real options technique by state-owned companies could be attributed to pressure

to increase the capacity to meet rising demands for their services – the situation on the ground means that it is not a realistic option to abandon projects once a decision has been made and communicated. This may also be the reason for the significant cost overruns on projects undertaken by state-owned companies. Where the NPV and IRR were used, the respondents were asked which of the two they preferred. In their responses, 66% indicated a preference for the NPV technique. Whilst the popularity of NPV and IRR is significant and encouraging, the fact that they are not equally used is a concern, given that the decision-makers responsible for the capital budgeting process from a financial point of view were all CAs and were in a position to influence senior management to use theoretically sound techniques. In addition, the equal popularity of the IRR, profitability index - PI and PBP is a concern, given the academic qualifications of the decisionmakers. The concern in this regard must also be seen in the light of the fact that approximately 83% of the CFOs are below the age of 50, and are expected to be familiar with any recent developments in the field of capital budgeting. Therefore, there is room for improvement in the use of theoretically sound techniques and the correct determination of cash flows in the capital budgeting processes of state-owned companies in South Africa. 4.5 Determining the discount rate An important consideration in the use of the NPV is the discount rate that is being applied. Where the respondents indicated that they used the NPV technique, they were requested to indicate what discount rate they used. All the respondents indicated that they used WACC. Furthermore, 83% indicated that they used the CAPM to determine the cost of equity, and one respondent indicated that it used a proxy of the rate from a listed entity. In other words, the state-owned company based its cost of equity on the cost of equity of a listed company in a similar industry. The results on the ways in which cost of equity is determined are set out in Table 5.

Table 5. Determination of the cost of equity Determination of the cost of equity Proxy of other private entity

% 17%

Estimated figure Capital asset pricing model (CAPM)

0% 83% 100%

All the state-owned companies indicated that where WACC was used government bonds were used as a proxy for the risk-free rate. In determining the beta, 50% indicated that they used the betas of listed

peer companies, and the other 50% used published sources (17%) and own determined betas (33%), as indicated in Table 6.

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Table 6. Determination of beta Determination of beta Published source

% 17%

Own determined beta Other (benchmarked against peers)

33% 50% 100%

Of the respondents, 67% indicated that they used published sources for determining the market risk premium while 83% indicated that they used long-term targets of debt and equity in their consideration of WACC. All respondents also indicated that they used discount real cash flows with a real discount rate or, alternatively, nominal cash flows with a nominal discount rate. Furthermore, half of the respondents had only one company-wide discount rate, whilst the other half used different discount rates for various subsidiaries, divisions and projects. The approaches used by the decision-makers of the state-owned companies in their use of WACC appeared to be sound, as the correct theoretical precepts were generally used. 4.6 Qualitative considerations for capital projects Given the nature of infrastructure projects undertaken by state-owned companies and their mandates, emanating from their shareholder‟s (government)

priorities, it is understandable that considerations other than quantitative factors would play a significant role in the capital budgeting processes of these companies. One respondent observed that in the consideration of the capital budgeting techniques, the outcome of the quantitative calculation could be completely overridden by statutory or regulatory considerations. Previous studies found that non-financial (qualitative) factors play a growing and significant role in the capital budgeting process of firms in the private sector (Hall and Millard, 2010). The respondents were asked how they would rank the importance of quantitative factors against qualitative factors in the decision-making process on capital projects. A total of 56% of the state-owned companies responded that quantitative factors play a role in the decision-making process of their capital budgeting decision, whilst qualitative factors were cited by 44% of the respondents. Table 7 sets out what the state-owned companies considered to be the most important qualitative considerations.

Table 7. Qualitative considerations Most important qualitative considerations

%

Political influences Environmental factors Service delivery considerations Employment creation Government regulations

0% 29% 29% 7% 28%

Other

7% 100%

Environmental factors, service delivery considerations and government regulations received an equal rating of 29%. Some of the respondents leave a significant footprint on the environment, such as considerable levels of carbon dioxide (CO2) emissions and the consumption of scarce natural resources such as water. It is, therefore, not surprising that environmental factors are an important consideration. The significant rating given to this consideration is also a reflection of the pressure that financiers of some of these projects have brought to bear on these

state-owned companies. Some conditions imposed as part of the funding agreements stipulate that considerations of the environment should be given a high priority, and this should be reflected in the technologies used in the projects. There has been a strong focus on service delivery in the country, with the sentiment that not enough has been done to improve the lives of many in the lower living standard measure (LSM) groups, as is manifested in failing and dilapidated infrastructure and capacity limitations. Poor service delivery has indeed resulted in public protests. It is, therefore,

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expected that service delivery considerations would be given a significant ranking, given the mandates of the state-owned companies to deliver essential services in South Africa. Given the levels of poverty and unemployment in South Africa and the priority of government to increase employment, it is surprising that state-owned companies did not rank the employment creation considerations higher. With their relatively large capital budgets, the state-owned companies are in a position to influence levels of employment, not only in the construction of infrastructural projects, but also in the continued operation of these assets. The low priority given by the state-owned companies to “employment creation” is also in glaring contrast to the call by government to create employment opportunities. In terms of other considerations, the respondents indicated that the continued delivery of their services would sometimes outweigh any

financial considerations to the point that they would be justified in investing in and operating projects at a loss if they had to. Considering that some of these state-owned companies are monopolies and suppliers of last resort, this rationale is understandable, because the specific sector and its service delivery capacity could collapse if they did not provide the service. Whilst the creation of shareholder wealth may be the overriding consideration in capital budgeting in the private sector, the results from this study indicate that imperatives other than the creation of shareholder wealth play a more significant role in the capital budgeting decisions of state-owned companies. 4.7 Risk budgeting

considerations

in

capital

The respondents were requested to indicate the techniques they used dealing with risk in the capital budgeting process. Table 8 outlines the responses.

Table 8. Risk adjustment techniques Risk-adjustment techniques

%

Scenario analysis (i.e. base case, worst case, best case forecasts) Certainty equivalent method Sensitivity analysis

38% 0% 38%

Simulation analysis (e.g. Monte Carlo Simulation) Decision-tree Analysis Other

12% 12% 0% 100%

All the respondents indicated that they included risk considerations in their capital budgeting process and used more than one technique for risk considerations. Scenario analysis and sensitivity analysis received an equal rating of 38%, while simulation and decision-tree analysis received a lower rating of 12%. Hall and Millard (2010) observed that sensitivity analysis is not a risk-measuring technique, but tests the sensitivity of the project to variables that

may influence the project. The appeal of this technique is attributed to its simplicity and costeffectiveness. Only two respondents used real options as a secondary technique to deal with risk in the capital budgeting process. The respondents were also asked which method they used to incorporate risk in the capital budgeting process. Table 9 outlines the responses.

Table 9. Methods to incorporate risk adjustments Methods to incorporate risk adjustments

%

Risk-adjusted discount rate Adjustment to cash flows

20% 60%

Certainty equivalent units Other

0% 20% 100%

It is clear that the most popular method is the adjustment to cash flows to incorporate risk in the process. Adjustment to the discount rate and Other

methods received a 20% rating each. As far as other methods are concerned, the respondents indicated that they would adjust the technical assumptions of the

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project which feed into the capital budgeting considerations, such as the rate of use of the assets or the operating levels of the assets. The significant use of sensitivity analysis is consistent with the findings of previous South African studies cited in the literature review. However, previous studies found that where respondents did adjust for risk, they preferred an adjustment of the discount rate rather than an adjustment of the cash flows. This contrasts with the findings of the current study. The empirical findings of this study reveal contrasts with findings of previous studies on the capital budgeting practices of private sector firms. The implications of these differences are discussed in the conclusion to this study. 5. Conclusion and recommendations The purpose of this study was to determine the capital budgeting techniques employed by selected South African state-owned companies involved in major infrastructure projects. Despite the significant number of studies both locally and internationally on the capital budgeting techniques employed by private entities (and government utilities internationally), there is no evidence of such a study on state-owned companies in the South African context. In terms of the objectives set out for this study, the results of this study have established that stateowned companies use various techniques for capital budgeting purposes, with relatively little use of discounted cash flow techniques as the primary determinants of capital projects. The NPV and IRR techniques were used by 43% of respondents, and the NPV was slightly more popular than the IRR. The continued use of inferior capital budgeting techniques may be attributed to the ease of calculating and understanding these methods. The substantial weight attached to quantitative considerations (approximately 44%) by state-owned companies could also be a factor that contributed to the use of non-discounted cash flow techniques. WACC emerged as the preferred discount rate for use in the capital budgeting purposes. The CAPM was the most popular technique for determining the cost of equity. In their consideration of risk in projects, state-owned companies preferred to use sensitivity analysis, despite its not strictly being a risk measurement technique. There are a number of recommendations that could be made on the basis of the results of this study: Firstly, whilst all the respondents indicated that they were CAs, it is disappointing that only 25% reported that they used the NPV as a primary technique of capital budgeting. This may imply that academics need to emphasise the importance of using the NPV as a primary capital budgeting technique at teaching institutions for current learners and to

discourage the use of inferior techniques such as the PBP. Secondly, the limited use of new developments in capital budgeting techniques such as real options was disappointing. This is especially true given the nature (major infrastructure) and value of the projects undertaken by state-owned companies. Once again, the responsibility for change may lie with academics who need to foreground these techniques to ensure that learners are familiar with them. Furthermore, for professionals already in the field, professional financial qualification institutions should make learning about new developments in the field of finance a compulsory requirement for continued membership of their institutions. Thirdly, the use of sensitivity analysis as a risk technique is a matter of common concern among international companies, local companies and stateowned companies. Once again, the intervention of academics and professional qualification institutions is required to promote the replacement of this technique and to encourage the uptake of more accurate techniques such as simulations. Lastly, the study also points to areas that may present further knowledge gaps in the area of capital budgeting for state-owned companies which require further research. Further research in capital budgeting techniques could include state-owned companies that are not only involved in major infrastructural projects. This would increase the size of the sample and the number of responses. Whilst capital budgeting practices in private sector firms have been researched extensively over many years, and development trends can be traced, it would be beneficial to observe the trends and developments regarding capital budgeting in state-owned companies over an extended period. To conclude, the aim of this study was to research the capital budgeting techniques used by selected South African state-owned companies. The results provide useful insight into the techniques used by these companies. At the same time, this study also highlights the possibility of further research in other aspects of capital budgeting by state-owned companies. References 1.

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EXECUTIVE COMPENSATION AND BOARD OF DIRECTORS’ DISCLOSURE IN CANADIAN PUBLICLY-LISTED CORPORATIONS Martin Spraggon*, Virginia Bodolica**, Tor Brodtkorb*** Abstract This article contributes to the growing body of literature exploring the important role that information transparency plays in strengthening the national corporate governance regime. We review the 2007 amendments to the Canadian reporting legislation with the particular emphasis on sections pertaining to executive compensation and boards of directors. Taking into consideration the specificities of the „comply-or-explain‟ system in Canada, we seek to uncover the extent to which publicly-listed firms comply with these newly amended standards of corporate governance reporting. Based on a comparison of 403 proxy circulars issued in the post-amendment period, we identified important cross-firm variations in the type and format of disclosed information on executive compensation and corporate boards of directors. In order to address the problems that inter-organizational disclosure discrepancies generate for governance researchers and analysts, we provide several recommendations on how Canadian publicly-traded companies can improve their reporting practices. Keywords: Board of Directors, Canada, Compliance, Corporate Governance, Disclosure Legislation, Executive Compensation * Ph.D., Associate Professor of Strategic Management, American University of Sharjah, School of Business and Management, Department of Management P.O. Box 26666, Sharjah, United Arab Emirates Tel.: (971) 6 515 2585 Fax: (971) 6 558 5065 E-mail: [email protected] ** Corresponding author. Ph.D., Associate Professor of Strategy and Corporate Governance, American University of Sharjah, School of Business and Management, Department of Management P.O. Box 26666, Sharjah, United Arab Emirates Tel.: (971) 6 515 2308 Fax: (971) 6 558 5065 E-mail: [email protected] *** LLM, Assistant Professor of Business Law and Ethics, American University of Sharjah, School of Business and Management, Department of Management P.O. Box 26666, Sharjah, United Arab Emirates Tel.: (971) 6 515 2729 Fax: (971) 6 515 558 5065 E-mail: [email protected]

1. Introduction The recurrent worldwide incidence of financial scandals and corporate failures and the consequent loss of significant amounts of investors‟ capital has undermined public trust in regulatory institutions, and placed the corporate governance practices of publiclytraded firms under the spotlight (Ben-Amar and Zeghal, 2011; Spraggon and Bodolica, 2011). The United States (US) government and stock market authorities responded by tightening the national governance regime in order to force listed companies to disclose more specific and detailed data to the outside community (Broshko and Li, 2006). Strict

reporting standards have been introduced by the Securities and Exchange Commission (SEC) to scrutinize governance practices of organizations, to increase managerial responsiveness to shareholders‟ interests, and to reduce the instances of corporate resource misallocation. The American „rule-based‟ system, which stipulates mandatory compliance with established governance legislation (Healy and Palepu, 2001), influenced significantly the regulatory developments in neighboring Canada. Due to a large number of Canadian cross-listed companies on the US stock exchanges, the Ontario Securities Commission (OSC) developed requirements similar to the SEC-adopted

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governance codes, in order to secure closer reporting alignment and decrease discrepancies across the two markets. However, considering the multiple peculiarities of the Canadian institutional context in contrast to the American one (Bodolica and Spraggon, 2009), it was decided that a more flexible „principlesbased‟ approach would be maintained in corporate Canada. Under this system, publicly-traded companies have a choice to either comply with established disclosure regulations or explain how they achieve the same governance objectives through alternative means (Burke, 2002; Steeno, 2006). The most significant advancements in the Canadian governance legislation occurred in 2005 with the issuance of two major reporting guidelines for companies traded on the Toronto Stock Exchange (TSX): National Policy (NP) 58-201 (Corporate Governance Guidelines) and National Instrument (NI) 58-101 (Disclosure of Corporate Governance Practices) (Lando et al., 2005). The main purpose of the NP 58-201 is to provide issuers with general corporate governance guidance, to delineate a set of best practices in the field, and to discuss fundamental principles that publicly-listed firms are expected to incorporate in their corporate governance practices (OSC, 2005b). The NI 58-101 builds on the principles outlined in the NP 58-201 to specify the actions that the issuers are recommended to undertake to improve their corporate governance configuration and to require specific disclosure of governance practices that were adopted by the firms (OSC, 2005a). Despite the non-mandatory nature of the actions prescribed in these disclosure guidelines (MacAulay et al., 2009), both regulations were introduced so that a higher level of uniformity in reporting standards of Canadian companies could be achieved. In light of the dismal economic situation in the world, this corporate governance legislation in Canada has recently been undergoing several amendments to enhance the transparency of corporate actions and to provide more comprehensive information to investors (Gupta et al., 2009; Swain et al., 2008). In 2007, Canadian regulatory authorities introduced reporting rules regarding executive compensation and board of directors which applied starting from the financial year ending on December 31, 2008 (Torys, 2007). The amendments change, among other things, the manner in which executive pay is to be reported, and require disclosure of the board of directors‟ compensation, expertise, responsibility and relatedness to the firm‟s management. In addition, the amendments require an explanation of the philosophy underlying the determination of the level and structure of executive compensation. With these new reporting standards in place, the performance of members of the top management team in attaining corporate goals can more easily be matched against the compensation that they are being paid by the corporation.

Prior to 2007, Canadian legislators did not formulate any specific requirements regarding the disclosure of directors‟ pay and the ideology on which the compensation of the highest-paid executives was based. Recently, an increasing need has emerged for regulators, analysts, and researchers to be able to uncover the specific governance practices of firms in order to critically assess their performance. These disclosure amendments put a far greater responsibility on corporate leadership to report governance practices in the most comprehensive and accurate manner (Medland and Wright, 2008). Despite the substantial similarity to regulations introduced by the SEC, the actual style and specificities of disclosure are simplified to maintain the Canadian „principles-based‟ regime. Nonetheless, a flexible reporting approach allows a potential for deceptive corporate behavior, creating the need to examine the degree of companies‟ compliance with disclosure requirements as well as the specific actions companies have undertaken to ensure that their governance practices are of high ethical standard and easily accessible by investors. This article contributes to the growing body of literature analyzing information transparency and disclosure regulation in order to strengthen corporate governance regime in countries around the globe. We seek to review the recent amendments to the Canadian governance reporting legislation with particular emphasis on information related to executive compensation and boards of directors. Considering the non-mandatory nature and other specificities of the „comply-or-explain‟ approach in Canada, it is our goal to uncover the extent of public organizations‟ compliance with these newly amended standards of governance reporting. A research team was involved in the analysis of the relevant information disclosed in corporate proxy circulars of 263 Canadian companies over an average of five years surrounding the pre- and post- amendment period. Based on a comparison of 403 corporate proxy circulars in the post-amendment period, we identified important cross-firm variations in the type and format of disclosed information on executive compensation and boards of directors. We provide several recommendations on how Canadian publicly-traded organizations can improve their reporting practices in order to remedy the problems that cross-firm disclosure discrepancies generate for governance researchers and analysts. The remainder of this article is structured around the following key sections. We start by discussing the peculiarities of the Canadian „principles-based‟ governance regime as opposed to the American „rulebased‟ system. We then briefly analyze the findings of prior empirical studies on governance disclosure in Canada. We continue by providing a detailed description of the amendments introduced in 2007 to executive compensation and board of directors‟ disclosure regulation. Following the methods section, which discusses our study sample, we trace cross-firm variations in reporting behavior and provide

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recommendations for enhancing the disclosure practices of Canadian corporations. In the concluding section, we suggest several areas of inquiry which could guide future research efforts in the field of corporate governance reporting. 2. Literature review 2.1 Canadian regime

corporate

governance

The 2007 amendments to executive compensation and board of directors‟ disclosure requirements in Canada follow closely the logic of the corporate governance system operating in the United States (Broshko and Li, 2006). The increasing convergence of Canadian regulations with those of its neighbor can be explained by the following two trends. First, in light of the repeated occurrence of governance failures and the continuous efforts of American legislators to tighten the governance rules, it became apparent that Canadian corporations ought to be better equipped to prevent similar instances of corporate misconduct. Mounting stakeholder pressure convinced Canadian authorities to design tougher governance legislation that would at least partially replicate the strict and comprehensive nature of the US corporate governance regime (Thompson, 2006). Second, due to the relatively small size of the Canadian capital market, many Canadian corporations are cross-listed on American stock exchanges, which allows them to raise additional capital. Inconsistencies in reporting standards between the Canadian and American systems make such cross-listing problematic, and call for the development of more coherent disclosure regulations that would be aligned with the requirements of both markets (Barnes et al., 2004). This alignment could facilitate the disclosure procedures in companies cross-listed on US and Canadian stock exchanges while simultaneously enhancing the quality of Canadian governance reporting. Despite this trend towards convergence, the Canadian and American corporate governance regimes remain fundamentally different. While the „rules-based‟ approach prevails in the USA, Canadian authorities prefer a more flexible „principles-based‟ system (Broshko and Li, 2006). This governance flexibility stems from multiple peculiarities of corporate Canada, where the ownership structures are more concentrated, the levels of income taxation are higher, the number of members sitting on the board is lower, and the executive pay is less closely tied to firm performance than in the US (Bodolica and Spraggon, 2009). Due to the mandatory nature of US corporate governance legislation, all publicly-listed companies are required to fully comply with the rules of the SEC and the requirements of the national stock exchanges. Thus, US legislators favor regulatory enforcement over discretionary compliance as a

means to foster a solid governance culture within a tightly standardized legal framework. Conversely, the „principles-based‟ approach in Canada stipulates primarily a voluntary alignment with the corporate governance recommendations, allowing flexibility to accommodate specific circumstances and characteristics of organizations (MacAulay et al., 2009). Although the designated „best practices‟ are not compulsory in nature, Canadian corporations are encouraged to consider and address them in the development of their corporate governance policies. It is worth noting, however, that the disclosure of certain governance information has been mandatory in Canada since 1993, when all public corporations were required to report in their annual proxy statements the compensation figures for the five highest-paid executives (Park et al., 2001; Spraggon and Bodolica, 2011). The regime in Canada is consistent with the „comply-or-explain‟ logic, whereby companies are given the choice to either abide by the norms of „best practice‟ developed by local investment and stock market authorities, or to explain their practices in case of deviation from the proposed guidelines (Swain et al., 2008). In particular, organizations ought to provide a detailed explanation of the exact steps that were undertaken to achieve the same objective through alternative means than those stipulated in corporate governance regulations (Steeno, 2006). Within this system, a fundamental set of principles is developed to form a common ground for firms to organize their reporting strategies around a similar set of rules rather than to devise their disclosure practices on their own (Burke, 2002). Putting the main emphasis on disclosure of relevant governance information, the Canadian „principles-based‟ approach permits flexibility in the extent of reported data depending on the internal cost-benefit analysis of disclosure, while maintaining some level of uniformity in governance reporting across firms. This less rigid „comply-or-explain‟ ideology is considered to be more suitable for the Canadian market because it ensures that the costs of compliance do not outweigh the benefits for investors and other stakeholders, given that Canadian publicly-listed companies are typically smaller than their American counterparts. 2.2 Prior disclosure studies Many empirical studies have been conducted to date (Healy and Palepu, 2001) linking corporate disclosure behavior with a variety of antecedents (e.g., capital markets‟ transactions, corporate control contest, managerial stock compensation, litigation costs, and proprietary costs) and consequences (e.g., stock liquidity, cost of capital, and information intermediation). Yet, extant empirical evidence was built primarily on the US-based samples rather than Canadian ones. In a comparative study of „principlesbased‟ and „rules-based‟ regimes, Broshko and Li

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(2006) analyzed 176 Canadian and 1,436 American publicly-listed companies and noted the prevalence of fundamentally different governance practices across these countries, particularly with regard to corporate boards of directors. In comparison to US boards, Canadian boards are smaller in size, meet more frequently, are less independent from management, encounter fewer CEO-chair duality situations, have less female representation, and are staffed by younger directors with shorter tenures. Moreover, boards in Canada are less likely to have compensation, nominating and corporate governance committees; when they do have these committees, the committees tend to have fewer and less independent members. These cross-country differences prompted several researchers to inquire into the factors that influence the quality of governance-related information reporting in Canadian organizations. Observing a high variability of implementation and disclosure of corporate governance guidelines across firms, Bujaki and McConomy (2002) examined the motives associated with the voluntary reporting of governance practices in 300 TSX-traded companies. The authors showed that the comprehensiveness of adoption and disclosure of governance guidelines is higher in firms that have the following characteristics: they are larger in size, they have higher leverage ratios, they display a lower revenue growth potential, and they have boards with higher proportion of unrelated directors. The later finding is consistent with Ben-Amar and Zeghal (2011), who drew upon a sample of 181 Canadian publicly-listed corporations to show that a board of directors that is independent from management positively influences the transparency of disclosed data on executive compensation. An even more important inquiry has been whether disclosure is associated with positive corporate outcomes. In a review of prior empirical studies, Healy and Palepu (2001) concluded that a more transparent financial reporting behavior of corporations has the potential to generate beneficial consequences for both outside investors and reporting companies. While the former enhance their capacity to make accurate investment decisions, the later obtain benefits in the form of lower cost of capital due to diminished asymmetries of information. In an investigation of 263 Canadian companies, Klein et al. (2005) found that the existence of open governance disclosure mechanisms not only reduced information asymmetries between investors and managers but also enhanced corporate performance of firms with a variety of ownership structures. These results are aligned with Adjaoud et al. (2007) who analyzed the relationship between the quality of boards of directors and firm performance in 219 Canadian corporations. Employing disclosure as one of the key characteristics of board quality, the authors reported that disclosure of governance practices and directors‟ relatedness, biographies, and meeting attendance records

positively affected corporate performance, captured by indicators of economic value added and market value added. However, reporting practices in these firms did not exhibit a significant relationship with traditional measures of firm performance, such as return on investment, return on equity, earnings per share, and market-to-book ratio. In their study of the 300 largest companies on the TSX Index, Panasian et al. (2008) analyzed how Canadian firms responded to a TSX voluntary listing requirement that was intended to encourage greater independence of boards of directors from top management teams. Although many companies decided not to comply with these recommendations, those that did increase the proportion of outside directors sitting on the board were motivated primarily by poor firm performance, which improved significantly relative to companies that did not modify their boards. MacAulay et al. (2009) used data over the 2003-2007 period to examine how the 2005 introduction of new corporate governance requirements affected publicly-listed firms in Canada. While these requirements were found to improve governance practices in affected companies, the association between corporate governance and organizational performance has significantly weakened in the post-adoption period. However, despite the weaker association noted above, it can be concluded that financial reporting and governance disclosure are typically associated with beneficial corporate outcomes in the specific context of Canadian publicly-traded firms (Niu, 2006). 3. Discussion of amendments

the

2007

disclosure

3.1 Executive compensation 3.1.1 Summary compensation table Important changes have been made to the summary compensation table for the key executives (see Table 1). The old reporting format required a break-down of the total executive pay into the three broad components of annual compensation, long-term pay, and all other payments made in cash (Lando et al., 2005). All compensation components were stated in dollar values, with the exception of securities under options granted, which were reported as a numerical count. Since this style of reporting did not convey the exact dollar value of total executive pay, the new format requires disclosure of the monetary values of all the compensation components, including the shareand option-based awards. Considering that different valuation methods can be used to estimate the dollar value of securities granted, the amended format facilitates higher levels of reporting consistency across firms with regards to those pay elements which are not disbursed in cash. In addition, the summary table now includes a new category indicating pension

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value as well as a total compensation column. This indication of the specific monetary value of total rewards received by executives allows companies to identify and disclose the names of their five highest-

paid executives on the basis of their total compensation figures rather than on the dollar values of their salary and bonus exclusively.

Table 1. The old and new reporting formats of the summary compensation table for executives Old Format (< 2008) Annual compensation:  Salary ($)  Bonus ($)  Other annual compensation ($) Long term compensation:  Securities under options granted (#)  Restricted share awards ($)  LTIP payouts ($) All other compensation ($) 3.1.2 Equity-based and incentive plan awards Prior to the 2007 amendments, corporate proxy statements provided specific information about the stock option plans offered to executives, such as option grants and exercises during the fiscal year (Torys, 2004). Under the modified reporting standards, disclosure of incentives-related data is organized around two broad categories of equitybased awards and incentive plan awards (see Table 2). While the former category reports on both option- and share-based awards, the latter indicates the value of these awards vested during the year and the dollar

New format (≥ 2008) Salary ($) Share-based awards ($) Option-based awards ($) Non-equity incentive plan compensation:  Annual incentive plans ($)  LTIPs ($) Pension value ($) All other compensation ($) Total compensation ($) value of non-equity compensation that the executive has earned during the year (Medland and Wright, 2008). A tabular format is used to disclose details related to equity- and non-equity-based awards, followed by a narrative to explain the basis on which they were determined. This particular information offers researchers and investors the possibility of estimating the fair value that executives extract from their share- and option-based awards in a given year and indicates how much value might still be extracted in the future from vested and unexercised equitybased awards.

Table 2. The old and new reporting formats of the equity-based and incentive plan awards Old Format (< 2008) Stock options:  Grants during the year:  Shares under options (#)  Percent of total options granted (%)  Exercise price ($)  Value of securities on the grant date ($)  Expiration date  Option exercises during the year:  Securities acquired on exercise (#)  Aggregated value realized ($)  Unexercised option exercisable/unexercisable (#)  Unexercised in-the-money options exercisable/unexercisable ($)

3.1.3 Compensation discussion and analysis Another important amendment introduces a „compensation discussion and analysis‟ section in the proxy statements, which is to explain in detail the philosophy guiding the determination of executive

New format (≥ 2008) Share- and option-based awards:  Option-based awards:  Securities underlying unexercised options (#)  Option exercise price ($)  Option expiration date  Unexercised in-the-money options ($)  Share-based awards:  Shares not vested (#)  Share-based awards not vested ($)  Vested share-based awards not distributed ($) Incentive plan awards:  Option-based awards – vested in the year ($)  Share-based awards – vested in the year ($)  Non-equity incentive plan compensation – earned in the year ($) compensation levels and structure. The former reporting standards allowed corporate boards of directors to decide whether or not to provide interested parties with more specific information regarding the rationale and process of establishing the compensation packages of the members of top

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management team. Under the new disclosure rules, the compensation committee and the board of directors are required to create a carefully designed strategy for structuring executive pay in a way that is both easily justifiable in the eyes of firm stakeholders and highly motivational for executives in attaining optimal levels of performance. The new section incorporates a discussion of the key principles and objectives that underlie the executive compensation program, along with the steps that were undertaken as part of the compensation review process. It also describes the various elements included in the executive compensation program, together with the rationale behind each of them, and discusses how these elements are aligned with the strategic objectives that the corporation is aiming to achieve. For instance, if the company intends to offer a discretionary cash bonus or a retention bonus to its executives, a clear justification should be provided as to why this particular bonus is being used and on what performance criteria it is based. 3.1.4 Termination and change of control benefits Prior to the 2007 amendments, the information regarding benefits to be received by executives upon termination of employment or change of control was stated under the employment agreement section. It included a brief narrative indicating whether the company had entered in an employment agreement with any of its named executives and whether specific compensation protection provisions existed, without necessarily quantifying the payouts to be made to executives upon change of control or termination. The amended regulation requires a more detailed disclosure of the compensation-related clauses from the employment contract that determine the monetary benefits the executives will be entitled to in case of termination for just cause or change of corporate control. The duty to report severance pay is not limited to payments of cash but also requires disclosure of the treatment of existing equity-based awards offered to executives. This entails the provision of an adequate amount of detail describing various payout scenarios in relation to share- or option-based awards, such as whether an acceleration of vesting of options would occur or not in connection with a potential change of control or termination of employment.

3.2 Corporate board of directors 3.2.1 Compensation of non-management directors Historically, the information related to board of directors‟ compensation has been inadequately disclosed in corporate proxy statements. Prior to the 2007 amendments, companies reported either the total amount of cash payments that were disbursed to all directors for their services or the fixed dollar value of the annual retainer and meeting attendance fees to which each director was entitled in a given financial year. This type of disclosure necessitated a manual calculation of total fees paid to each unrelated board member individually by multiplying the meeting attendance fees by the number of attended meetings. A short narrative was also provided to explain whether the non-management directors were eligible to participate in stock option or other incentive plans established by the corporation, but no additional data was required concerning the monetary value of the total compensation earned by each member of the board. The amended standards now require that the compensation of directors be disclosed in a similar tabular format to that of the named executive officers for the purpose of securing uniformity and consistency of reported information for both executives and directors (Swain et al., 2008; Torys, 2007). However, the disclosure period for directors covers only the last financial year rather than the total of three most recent years required for executives. The introduction of the summary compensation table for directors, which breaks down the total compensation column into its various constituent elements, allows firm stakeholders to analyze fairly how the directors are being paid and estimate accurately the monetary value of all payments made to directors during the year. Apart from the specific details included in directors‟ compensation table, additional tables must be produced to explain the current state of option- and share-based awards and non-equity incentive plans to which unrelated directors are entitled (see Table 3). With this disclosure in place, it becomes possible to obtain a variety of pay-related information about directors, such as the number of unexercised options, the value of in-the-money options, the number and value of unvested shares, and the value of non-equity incentives earned during the year. Companies are also required to provide more details concerning the fees that are paid to directors, including the initial and annual board retainer, the retainer for committee chairs and lead director, and the fees for attending each board and committee meeting.

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 Table 3. The required information to be disclosed in relation to directors‟ compensation Directors’ compensation table Fees earned ($) Share-based awards ($) Option-based awards ($) Non-equity incentive plan compensation ($) Pension value ($) All other compensation ($) Total compensation ($) 3.2.2 Election of directors Significant changes have been made to the contents and manner in which corporations disclose information regarding nominees to directorship under the „election of directors‟ section of proxy statements. Initially, companies reported in a tabular format the names of people nominated for election, their principal occupation, their country of residence, their date of appointment as director (if relevant), their membership on various board committees, and the number of common shares over which they exercise control. To comply with the NP 58-201 recommendations (OSC, 2005b), some companies chose to describe, either below the above mentioned table or in a separate appendix, whether the nominees are independent, their directorship with other issuers, and the attendance records of board and committee meetings. Only a few companies opted to provide additional biographical information about their current and potential directors, such as age, highest diplomas held, prior work experience, and major achievements in their field of expertise. The current disclosure practices on corporate directors tend to be more comprehensive, with widespread inclusion of key biographical data of each nominee to directorship. The table is now significantly extended to incorporate information about directors‟ age, place of residence, occupation, years of service, education, areas of expertise, level of relatedness, meetings attendance, membership and position occupied on other public company boards in the past five years, number of common shares and deferred share units controlled, and total value of securities held. Many organizations even include a picture of each board member and, more importantly, clarify the situation with regards to interlocking directorates involving any of the firm nominees. The latter information is particularly useful in assessing the overextension of corporate boards and whether such overextension is likely to generate detrimental effects for directors‟ performance of their duties on the board. 3.2.3 Board of directors’ committees The amended governance regulation also requires more detailed disclosure regarding the main committees of the board of directors, beyond a mere

Other data in tabular format Share- and option-based awards:  Same data as for executives (see Table 2) Non-equity incentive plan awards:  Same data as for executives (see Table 2)

description of their key activities and responsibilities. Of particular interest to legislators, analysts, and researchers are the compensation and audit committees of the board, which are expected to elaborate more specifically the philosophy or principles that guide their work and to provide an outlook of their activities for the most recently completed financial year. The compensation committee is now supposed to develop an informative report on the structure of executive pay to explain the alignment of executive pay with the long-term objectives of the firm, to ensure the competitive nature of compensation packages by comparing the Chief Executive Officer‟s (CEO) pay to that of the comparator group, and to justify the amounts being paid to executives in relation to the current level of corporate performance. Regarding the audit committee, data ought to be provided on any action plans drafted by the committee, the name and date of appointment of the external auditing firm, any change in the lead outside auditor in the past five years, and the audit fees, audit related fees and tax fees that were incurred by the company for auditing services. 4. Research method A team of six researchers and research assistants took part in a larger scale project, which involved a manual collection process of executive compensation and board of directors‟ data from proxy statements issued by Canadian corporations over a period between 2000 and 2011. The specific amendments to disclosure regulation that came into effect in 2008 brought about significant changes in firms‟ practices of reporting corporate governance information. Having had the opportunity to observe the extent of these changes in an empirical setting, our sample of analyzed proxy statements was partitioned into the pre- and postamendment periods. This partitioning was a necessary step in developing a revised model of recording executive compensation and board of directors‟ data that would better reflect the modification in the amount of reported data and more accurately compare the disclosure behavior of companies in the postamendment period. Initially, our sample comprised 263 public organizations, with an average of five years window of analysis. This research process generated 1,315 proxy statements, which were screened for corporate

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governance data gathering purposes. A total of 912 of the corporate proxies were issued prior to the year 2008, and the remaining 403 were released after the year 2008. Further, during the process of recording relevant governance variables, important crosscompany variations in data disclosure, both between the two amendment-related periods and within the post-amendment period, were observed by different members of the research team. While the variations in reporting format and content between the pre- and post- periods could be easily attributed to the enforcement of the new governance legislation, discrepancies in data reporting across firms in the post-amendment period were particularly unexpected. Therefore, in the final step we analyzed the 403 proxy statements from the post-disclosure period to determine the impact of the legislative change on disclosure behavior of corporations. In the next section we discuss the identified differences in compliance levels across firms as well as the potential problems researchers and analysts could face with variations in compliance with reporting standards. 5. Cross-firm disclosure variation in the post-amendment period 5.1 Executive compensation In the period following the coming into force of the amended regulation, significant cross-firm discrepancies were found in the disclosure of executive compensation information. Because the amended legislation builds on prior versions of reporting standards, many companies chose to employ a mix of old and new tabular formats for reporting specific details about various compensation elements, including the equity-based and incentive plan awards. While other firms have fully incorporated the updated compensation tables into their annual proxy statements, in some cases the new tables have columns or spaces for data that are not applicable for some companies. For instance, if a well-developed pension plan is not in place or the value of executives‟ pension is zero, the company may occasionally delete the pension-related column entirely from the summary compensation table instead of preserving this column and marking its values as nil. This deletion is undesirable, because any alteration in the formatting style and contents of tables, which are meant to be standardized, creates a lot of difficulty for researchers in gathering consistent information and generating reliable large-scale data analyses. The generally followed practice is to disclose executive pay data for the last three financial years, which typically appear in the summary compensation table in a reverse chronological order. However, some companies decline to follow this practice, and display the executive compensation data in chronological order. As a result, caution must be exercised by analysts when handling information from corporate

proxy statements. Although corporations are required to report compensation figures for their five highestpaid executives, some of them limit their disclosure to only two executives (CEO and Chief Financial Officer) while others go on to provide data for as many as nine top executives. While the voluntary provision of additional information is always welcomed by members of the outside community, firms‟ withdrawal from standard procedures regarding the number of reported executives undermines the ability of researchers to conduct comprehensive studies on compensation designs of top management teams. A few companies were found to reconstruct the required compensation tables or rename the tabular headings to better suit the specificities of their current compensation plans. For example, when organizations ought to report the value of share- and option-based awards made to their executives, some opt for the disclosure of both the numerical counts and dollar values of equity-based awards, while others modify the label of the column heading into „stock appreciation rights granted‟ to provide quantitative data within the table and more specific accounts in lengthy footnotes. Despite obvious cross-firm differences in the type of executive incentive plans implemented, the observed corporate practice of altering the parameters of a standard reporting format makes the data collection process cumbersome and potentially inaccurate. Furthermore, contrary to regulators‟ expectations, many public organizations still fail to provide an adequate level of detail concerning the total wealth implications for executives in the event of a change in control or termination of employment. Instead, a brief summary is offered to indicate the lump-sum payment to be made in case of adverse events without specifying the conditions that would allow entitled executives to benefit from unvested and unexercised share and option grants. In many instances, the analysis and discussion section in corporate proxies does not sufficiently elaborate the main principles that guide the determination of the magnitude and design of executive compensation packages. This variation in reporting prevents analysts from conducing reliable comparative studies on the effectiveness of compensation-allocation decisions in Canadian corporations. Another important discrepancy that has been observed, particularly for the firms cross-listed on the American stock markets, is the currency used in disclosure of compensation-related information. Some companies pay their executives in Canadian dollars but report the monetary figures in American dollars, while other companies do exactly the opposite. A few firms state the compensation values in the currency in which these were originally disbursed, so that both Canadian and American dollars might appear interchangeably within the same summary compensation table. Although the rates for converting

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one currency into another are typically provided in the table footnotes, some firms use the annual average exchange rate whereas others rely on the official exchange rate at the financial year end. Moreover, the actual value of option grants and shares owned by the executive may vary significantly due to cross-listing situations and currency fluctuations during the year. Compensation data collected over multiple years ought to be adjusted for inflation, taking into account the inflation rates in the firm‟s country of operation (i.e., Canada) and using the most recent financial year as a base year for conversion into standard Canadian or American dollars. Hence, currency conversion and inflation adjustment manipulations have to be treated with caution particularly when conducting comparative studies or performing time series analyses. 5.2 Corporate board of directors Given that prior corporate governance legislation did not require comprehensive reporting of directors‟ compensation, a significant amount of cross-firm variation was encountered in disclosure of this information. Despite the suggested tabular format (see Table 3), alterations in the structure and contents of directors‟ compensation table were commonplace. While some companies report data according to the seven proposed headings, others include only four headings, indicating the value of fees earned, amounts paid in cash, payments made in deferred share units, and percentage of total fees earned taken in deferred share units. If a given element, such as non-equity incentive plans, is not currently used to reward corporate directors, many organizations omit commenting on this element entirely by deleting the related heading from the compensation table. In addition, firms rarely follow the required tabular standards for providing additional details on directors‟ equity and non-equity based awards. This inconsistency in reporting not only affects the efficiency of the data collection process but also undermines researchers‟ ability to effectuate interorganizational comparisons. Not all companies offer a complete analysis of the fees paid to directors; some companies state only the total amount of fees earned, without breaking them down explicitly into board and chairmanship retainers and fees for attending board and committee meetings. Many firms choose to combine all the required information into a single table by providing meeting attendance details in the footnotes of the directors‟ compensation table, instead of disclosing these sets of data separately and for each director individually. Moreover, the placement of attendance records, which are employed in the calculation of directors‟ fees, differs greatly across organizations, with many of them still using a separate appendix to proxy statements for communicating compliance with the requirements of NI 58-101 (OSC, 2005a). As in

the situation with executive compensation disclosure, variations in the choice of currency and method of calculating the exchange rates when stating the fixed and variable elements of directors‟ compensation are likely to affect the conversion accuracy and data consistency. A reporting practice that was found to be particularly problematic for the purposes of data collection relates to the arbitrary order of appearance of the same board members across different tables. This situation is more understandable between the „election of directors‟ table and compensation-related tables, because the former reports information for all executive and non-executive nominees for directorship, while the latter indicates payments that are made to non-management directors exclusively. However, the discrepancy in the order of appearance of the same non-executive director across different compensation tables is less justifiable. Whereas in some cases companies list the independent directors in alphabetical order by their last name, in other cases the same directors are arranged based on the scale of cash payments, equity awards or non-equity incentives received. All of this inconsistency creates extra work for analysts and researchers attempting to accurately attribute different compensation elements to the same non-executive board member. Many differences were also observed in the formatting and contents of the „election of directors‟ table. For example, some issuers fail to indicate board members‟ age or municipality of residence, whereas others choose to comment on the educational background and industrial experience of directors in a longer narrative, rather than in a concise tabular format. For many companies, specific information about various members sitting on the board tends to be distributed over multiple sections and appendices of the corporate proxy statement. It is worth noting that data concerning directors‟ designation, date of appointment, committee membership, and number of shares and options held can typically be found at the beginning of the proxy, where the proxy is announcing matters to be acted upon at the special shareholders‟ meeting. However, details regarding directors‟ membership on other public company boards, interlocking directorates, and meeting attendance might be either reported in a separate appendix at the end of the proxy or merged along with the disclosure of directors‟ compensation somewhere in the middle of the document. In several instances, specifics regarding board members such as directorship positions in other issuers, committee chairing responsibilities and lead director roles assumed on external boards, and interlocking directorates might not be fully provided or might even be completely omitted from the proxy statement. These multiple inconsistencies in the placement, formatting, and type of reported information create additional difficulties for researchers and analysts in collecting accurate data on

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 directors‟ service on the board, exposing the process to the possibility of inaccurate inference and error. 6. Recommendations regarding disclosure practices 6.1 Executive compensation In light of the above discussion, the key recommendation that can be made to Canadian publicly-traded organizations is to work further towards strengthening the alignment of their reporting practices with the new corporate governance guidelines. With regard to executive compensation in particular, future organizational efforts could be directed towards improving consistency with the proposed tabular formats and contents to facilitate quantitative analysis of various elements included in the compensation package. Public issuers might take the initiative to invest additional time in making their proxy statements more streamlined in format yet more comprehensive in detail, especially due to the large number of stakeholders who are interested in their activities and with whom they regularly interact. Cross-firm comparisons would become more reliable if the reported information could be synchronized with the amended legislation. This consistency may be effectively achieved if the general look of compensation-related tables could stay intact, if the simultaneous alternations between the American and Canadian currencies could be avoided, if a consistent method for calculating the exchange rates could be employed, and if compensation figures could be disclosed for no fewer than the five highest-paid executives. Furthermore, Canadian business entities should not compromise on their discussion of the guiding principles and strategic objectives that underlie the determination of the level and design of the top management team‟s compensation, nor should they fail to comment on the specific financial implications for executives of adverse events such as change in control or termination of employment. It is our belief that compliance with these recommendations would allow every user of corporate proxy statements to extract detailed executive compensation information more easily and perform the relevant analyses more accurately. Researchers and analysts would be better able to forecast future trends in executive compensation and examine the sensitivity of executive compensation to variations in different measures of corporate performance; shareholders would be able to understand if the amounts paid to executives as compensation are aligned with the stated philosophy; and other companies operating in the same industry would find it easier to identify industry trends and set relevant benchmarks against market leaders.

6.2 Corporate board of directors Given that detailed disclosure requirements regarding directors‟ compensation have been only recently included in corporate governance regulations, much work remains to be done in this area of reporting. Companies could be advised to put greater emphasis on ensuring adequate disclosure of the various means by which directors are rewarded for their services on the board, such as annual retainers, meeting attendance fees, share- and option-based awards, and non-equity incentive plans. Taking into account the significant amount of expertise that Canadian issuers have already achieved in the field of executive compensation reporting, the key lessons learned from past experiences could be effectively extrapolated to improve the current practices of conveying required information on directors‟ compensation. In the near future, organizations could consider working on the relevant categorization of different elements of board compensation with a particular emphasis on nonmanagement directors. To secure a higher level of data consistency, the incorporation and usage of standard tabular formats in corporate proxy statements would be welcomed by researchers and analysts interested in reviewing the board compensation practices of public organizations. It is worth noting that since the amendments of 2007, there have been considerable improvements in structuring the „election of directors‟ section and reporting more explicitly about board of directors‟ demographic characteristics, educational background, and industry experience. Nonetheless, room for improvement remains in the content, design, and placement of other tables related to directors‟ attendance records, board interlocks, and service involvement with other business entities, which remain highly specific to the situation of each firm. For instance, if a board member is presently not in a situation of interlocking directorates, it would be strongly advisable to mark this data as non-applicable rather than to exclude it entirely from the proxy statement. Considering the critical importance of the audit and compensation committees of the board of directors, more details could be provided on the key activities of these committees, along with their strategic implications for firm performance. Because management directors are typically not compensated for their service on the board, a viable recommendation from the standpoint of governance researchers that may reduce confusions and avoid misinterpretations could be to separate board-related disclosure into two groups composed of executive and non-executive directors. In the spirit of full transparency and accountability to multiple corporate stakeholders, legislators could work further to devise standardized frameworks for reporting relevant board of directors‟ information.

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and

future

research

In this article we have discussed the specificities of the „principles-based‟ corporate governance regime in Canada and inquired into the level of public entities‟ compliance with the recently updated governance legislation in the country. Similar to the early evidence on disclosure practices of Canadian corporations, which was provided by Bujaki and McConomy (2002), we found many cross-firm variations in the extent and format of reporting the required information on executive compensation and board of directors. It seems that Canadian regulatory authorities were not particularly satisfied with the compliance levels of organizations and have been working on a new set of proposals to be enforced for the 2012 proxy season. These amendments are meant to emphasize performance and risk management techniques that would require companies to tie executive compensation levels more closely to the achievement of both short- and long-term performance targets and disclose risk-adjusted compensation for members of the top management team (Frazer et al., 2011). The world economy, which was heavily affected by the recent financial crisis, saw huge amounts of taxpayers‟ money being used to bail out poorly governed corporations (Spraggon and Bodolica, 2011). The repeated instances of managerial misconduct and resource misallocations induced legislators all over the globe to develop tougher governance policies and reporting standards, which would make organizations more accountable for their actions and decisions. While the consequences of this stricter disclosure regulation might be easier to estimate for organizations operating in the „rulebased‟ countries, its effects in more flexible „complyor-explain‟ regimes are more difficult to assess. Whether continuous amendments of extant governance guidelines will contribute to the attainment of higher levels of reporting compliance and standardization among Canadian companies is an important question that is worth addressing in future studies in the field. The major challenge for national policy makers and stock market authorities resides in the definition of reasonable boundaries of disclosure so that the uniqueness of the Canadian business context is fully taken into consideration. This task should be approached with caution and precision so that not only stakeholders but also corporations can significantly benefit from better information transparency, and leave behind the continuous struggle to cover the increasing costs of compliance with governance regulations. The recommendations outlined in this article could assist legislators in understanding and tackling the specific needs of analysts and researchers interested in assessing the effectiveness of corporate governance practices in today‟s organizations. When

designing the next generation of governance-related initiatives, greater emphasis could be put on the development of preventative measures that could contribute to the improvement of moral standards and ethical principles of business conduct. Future studies on governance disclosure could focus on examining the strength of the relationship between the reporting practices of Canadian publicly-traded organizations and different measures of both financial and social firm performance. More empirical investigations ought to be conducted on large Canadian samples to uncover the benefits and costs of greater disclosure in a flexible „principles-based‟ system. Comparative analyses of reporting guidelines developed by legislators in other countries with similar governance regimes could be beneficial for understanding the key lessons learned and give regulators insight into problematic areas that might be in need of further development (Collett and Hrasky, 2005; Lim et al., 2007). Acknowledgement: The authors would like to thank Anam Shahid for her valuable assistance during the early stages of this project. We are also grateful to Nabeela Ali, Samar Essam El Dien Amer, and Arsalan Afridi who were involved in the data collection process from corporate proxy statements. References 1.

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Adjaoud, F., Zeghal, D., and Andaleeb, S. (2007), “The effect of board‟s quality on performance: A study of Canadian firms”, Corporate Governance: An International Review, Vol. 15 No. 4, pp. 623–635. Barnes, J.A., Johnson, L.A., and Yarmus, J.S. (2004), “Corporate governance reform in Canada”, International Journal of Disclosure and Governance, Vol. 1 No. 3, pp. 260–268. Ben-Amar, W. and Zeghal, D. (2011), “Board of directors‟ independence and executive compensation disclosure transparency: Canadian evidence”, Journal of Applied Accounting Research, Vol. 12 No. 1, pp. 43–60. Bodolica, V. and Spraggon, M. (2009), “The implementation of special attributes of CEO compensation contracts around M&A transactions”, Strategic Management Journal, Vol. 30 No. 9, pp. 985–1011. Broshko, E.B. and Li, K. (2006), “Playing by the rules: Comparing principles-based and rules-based corporate governance in Canada and the U.S.”, Canadian Investment Review, Vol. 19 No. 1, pp. 18–25. Bujaki, M. and McConomy, B.J. (2002), “Corporate governance: Factors influencing voluntary disclosure by publicly traded Canadian firms”, Canadian Accounting Perspectives, Vol. 1 No. 2, pp. 105–139. Burke, K.S. (2002), “Regulating corporate governance through the market: Comparing the approaches of the United States, Canada and the United Kingdom”, Journal of Corporation Law, Vol. 27 No. 3, pp. 341– 380. Collett, P. and Hrasky, S. (2005), “Voluntary disclosure of corporate governance practices by listed

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Australian companies”, Corporate Governance: An International Review, Vol. 13 No. 2, pp. 188–196. Frazer, M., Johnson, G., Wright, C., and McCallum, L. (2011), Amendments to Executive Compensation Disclosure Rules Finalized for Fall 2011, August 12, retrieved from www.torys.com Gupta, P.P., Kennedy, D.B. and Weaver, S.C. (2009), “Corporate governance and firm value: Evidence from Canadian capital markets”, Corporate Ownership and Control, Vol. 6 No. 3, pp. 293–307. Healy, P. and Palepu, K. (2001), “Information asymmetry, corporate disclosure, and the capital markets: A review of the empirical disclosure literature”, Journal of Accounting and Economics, Vol. 31, pp. 405–440. Klein, P., Shapiro, D. and Young, J. (2005), “Corporate governance, family ownership and firm value: The Canadian evidence”, Corporate Governance: An International Review, Vol. 13 No. 6, pp. 769–784. Lando, R., MacDougall, A., Magidson, S., Price, D., Salter, J., Walsh, J., and Yalden, R. (2005), New Canadian Corporate Governance Rules to Come into Effect June 30, 2005, Osler update, retrieved from http://www.osler.com/resources.aspx?id=10211 Lim, S., Matolcsy, Z. and Chow, D. (2007), “The association between board composition and different types of voluntary disclosure”, European Accounting Review, Vol. 16 No. 3, pp. 555–583. MacAulay, K., Dutta, S., Oxner, M., & Hynes, T. (2009), “The impact of a change in corporate governance regulations on firms in Canada”, Quarterly Journal of Finance and Accounting, Vol. 48 No. 4, pp. 29–52. Medland, C. and Wright, C. (2008), New Rules for Executive Compensation Disclosure, September 30, retrieved from www.torys.com Niu, F.F. (2006), “Corporate governance and the quality of accounting earnings: A Canadian perspective”, International Journal of Managerial Finance, Vol. 2 No. 4, pp. 302–327.

18. Ontario Securities Commission (2005a), National Instrument 58-101: Disclosure of Corporate Governance Practices, June 17, retrieved from http://www.osc.gov.on.ca/en/SecuritiesLaw_rule_2005 0617_58-101_disc-corp-gov-pract.jsp 19. Ontario Securities Commission (2005b), National Policy 58-201: Corporate Governance Guidelines, June 17, retrieved from http://www.osc.gov.on.ca/en/SecuritiesLaw_rule_2005 0617_58-201_corp-gov-guidelines.jsp 20. Panasian, C., Prevost, A.K. and Bhabra, H.S. (2008), “Voluntary listing requirements and corporate performance: The case of the Dey Report and Canadian firms”, Financial Review, Vol. 43, pp. 129– 157. 21. Park, Y.W., Nelson, T. and Huson, M.R. (2001), “Executive pay and the disclosure environment: Canadian evidence”, Journal of Financial Research, Vol. 24 No. 3, pp. 347–365. 22. Spraggon, M. and Bodolica, V. (2011), “Postacquisition structuring of CEO pay packages: Incentives and punishments”, Strategic Organization, Vol. 9 No. 3, pp. 187–221. 23. Steeno, A., (2006), “Corporate governance: Economic analysis of a „comply or explain‟ approach”, Stanford Journal of Law, Business & Finance, Vol. 11 No. 2, pp. 387–408. 24. Swain, H., Carruthers, J., Minden, K. and Urban, C. (2008), Corporate Governance and Accountability in Canada, September 16, retrieved from http://www.aucc.ca/_pdf/english/programs/cepra/Final %20report_swain.pdf. 25. Thompson, M.A. (2006), “Investors call for better disclosure of executive compensation in Canada”, Workspan Focus, February, pp. 4–6. 26. Torys LLP (2004), Canada’s New Corporate Governance Disclosure Rules, November 5, retrieved from www.torys.com. 27. Torys LLP (2007), Canadian Securities Regulators Propose New Rules for Executive Compensation Disclosure, April 10, retrieved from www.torys.com

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THE CAPITALISM OF TURBULENCES AND THE OVERLIMITED LIABILITY OF THE TOO BIG TO FAIL CORPORATIONS: A PROPERTY ECONOMICS NOTE ON THE WORKING OF MORAL HAZARD Octavian-Dragomir Jora*, Radu Cristian Mușetescu**, Mihaela Iacob*** Abstract In the corporative realm of the organization of firms, endemic to modern capitalist economy, a common allegation is that “limited liability”, State historically allowed for political or fiscal reasons, would (though asymmetrically) incite stockholders and managers to overconfidence in their characteristic profit-driven endeavours. It is asserted that the corporative judicial-legal shield absorbs risks and unleashes moral hazard, eroding the genuine market capitalism (gambling, greed, monopolism, wickedness). In this article, we will re-examine the moral hazard around modern corporation, starting from an “institutionally neutral” analysis of the interpersonal asymmetry of knowledge, and shifting over to the domain of “comparative inter-institutional” judgements, opposing two counterfactual mutually exclusive frameworks: the one respecting naturally defined private property rights and the other one hampering them through State-made regulatory interventions. We will add more precision to an old classical debate upon the “illiberalism of corporations”, arguing that, along with the factors fuelling the modern boom-bust business cycles by means of easy money and credit, guilty as well for instability in the global markets is some sort of “over-limited responsibility” of corporations (for instance, in finance and banking industry), granted with those “too big to fail” privileges, invoking their “systemic importance” in terms of resource allocation or employment dynamic. Keywords: Business Corporation, Limited Liability, Private Property, State Interventionism, Moral Hazard 

Assistant Professor, Ph.D., Department of International Business and Economics, Faculty of International Business and Economics, The Bucharest Academy of Economic Studies, Romania E-mail: [email protected] ** Associate Professor, Ph.D., Department of International Business and Economics, Faculty of International Business and Economics, The Bucharest Academy of Economic Studies, Romania E-mail: [email protected] *** Assistant, Ph.D., Department of Finance, Faculty of Finance, Insurance, Banking and Stock Exchange, The Bucharest Academy of Economic Studies, Romania E-mail: [email protected]

Argument The literature devoted to business corporation, this “highly controversial entity” in modern international markets (epithet derived from scrutinizing its internal as well as its external functioning), basically defines it as a legal entity organized usually as a joint stock company, involving a large number of shareholders owning (differently sized) amounts of shares (that is fungible and abstract portions of the property of the corporation‟s equity, owned undivided by the shareholders, but only during the lifetime of the corporation). The main stake behind this otherwise trivial definition is to understand whether this entity is a historical product of free markets or it spurred out of State privilege granting, a matter in which the

recourse to sound law and economics core principles is of utmost importance. One caveat, for starters. From the precept of methodological individualism (so breaking this idea of a formal entity, some “legal fiction”), we observe that the corporation is composed of several individual characters (epistemologically irreducible entities), that manifest themselves within this framework through a rational set of behaviours, by means of legal contracts (or speculating on the boundaries of contracts); relevant for our analysis are the shareholders and their endowed directors / managers (either cooperating in the “division of corporate labour” or caught in conflicts of interests), filling in this legal entity1. 1

Even though common logic allows us to distinguish between such legally personalized entity and a person in the natural

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We will not recollect neither the classic debate on the “concession theory” of incorporation for private business purposes (that is by grant of a State privilege) versus the “inherence” counterpart (that is by means of free private contracting), nor the derivation of limited liability and property features from some overrated “entity status”2. Our task is to defend the idea that private property (in the definition given by the natural law tradition) is the basis for consistent contract and both represent the very foundations of free markets (as the sole institutional arrangement to epitomise justice and maximize efficiency), that limited liability is consistent with private property and free contract, and that hampering them fuels severe social discoordination and unrest (by sponsoring adverse incentives for individuals, i.e. involved in corporations). Our focus is on the relation between the systematic “over-limitation” of liability and modern boom-bust cycles. By pointing to “over-limitation” of liability / responsibility, we are targeting the moral hazard effect of various public privileges in inciting corporate actors (be they owners, creditors or employed agents, directors or managers) to use much more recklessly resources than in the case these privileges were absent. This article is built as follows: first, we give a brief account on the problem of moral hazard, emphasizing its property rights dimension, instead of a simple informational issue; then, we argue that limited liable corporations are not moral hazard culprits by their design, the propensity for misbehaviour getting exhibited only when discretionary political privileges are set in; afterwards, we link over limitation of corporate liability to business cycles; finally, we take on two cases, banking sector and automotive industry. The relevance of this paper resides in shedding some light on few biased allegations that set the trend in both the academic and pop economics of crises: that “boom-bust cycles are free market failures” and that “the (simple) limited liability of business corporations is a State-driven institutional failure”.

and physical sense, corporations have for long been treated, without any hesitation, as holders of rights and obligations in selling and purchasing of properties or in other forms of contract (credits, suing or being sued, hiring and firing of employees etc.). Nevertheless, the “legal personhood” can be taken either in the strong, but unrealistic, sense – distinct from any other person involved within it by ownership or by contract –, or in the weak, but realistic, sense – as mere conceptual and verbal expedient, created in order to avoid and economize referring to each and all of the members of the “associative aggregate”. 2 For a praxeological and jusnaturalist contractualist perspective on “corporate entity” and on the emergence of its alleged extensions (limited liability and perpetuity), see the Austrian-libertarian response by Block and Huebert (2009) to left-libertarian and socialist critiques as espoused, among others, by Eeghen (2005a; b), and defending, among others, Hessen (1979).

We state from the beginning that, methodologically, we place this analysis under the reign of the Austrian School of economics and political science. There is a fructuous compatibility between “Austrian” value subjectivism and “libertarian” jus naturalism, this being one of the more interesting pairings in modern social science, despite its eccentricity from mainstream academic and policy discourse, following hasty accusation of radicalism in both its analytical methodology (“the arrogance of a priori praxeology”) and in its policy recommendations (“evangelising that obsolete free market fundamentalism”). This “paradigm choice” was made due to the analytical comfort of praxeological approach: verbal reasoning in terms of teleological causality, logical inferences of strong theory from basic axioms of human action, needing neither empirical validation nor econometric modelling, but fundamental in decrypting historical events. Moral hazard: “asymmetric information” or “ill-defined ownership” failure? Incentives represent the external conditions that once internalized in purposeful human action make people – not “deterministic”, but altering the balance of subjective opportunity costs – undertake (or not) certain actions. Given that actions involve, naturaliter, allocation / transformation of owned resources, we can distinguish, depending on how efficiency (or, on the contrary, waste) in their allocation / transformation is favoured, between two basic types of incentives: natural (sound) and, respectively, adverse (perverse). The natural, good incentives leave the costs and benefits of an (consumption or production) action to reflect the game of unrestrained perceptions regarding the scarcity of resources and their value in an inter-subjective framework. Conversely, the adverse, bad ones “artificially” diminish the cost-benefit ratio of an action for some, there being speculated the ignorance or inability of third parties from where resources are transferred (or it is anticipated they will be transferred), reducing costs / increasing the benefits of the action in question. An example of a natural incentive is the widespread, institutional, respect for private property; adverse is to hamper this kind of respect. The current economic crisis brought into the light a standard adverse incentive: moral hazard. We call this a person‟s stimulus to use more resources than would normally use, because he knows (or he thinks he knows) that another person will provide, short of consent, some (or all) of these resources. Many economists have expeditiously inferred that moral hazard involves a market failure, a distorted allocation of resources. Mainstream economics explains moral hazard as a consequence of the fact that market participants are not uniformly informed about the economic reality and, also due to

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their diverging interests, they are prone to exploit the counter-parties‟ ignorance in contractual interactions. In other words, moral hazard results from “information asymmetry” and thus it is believed that the theory of moral hazard is part of the economic theory of imperfect information. Next, we will overview, restating Hülsmann (2006), the conventional moral hazard theory critique, also sketching the alternative which we consider to be superior regarding realism in the following line of thought:  on the one hand, information asymmetries in markets are just one of the causes for moral hazard; they involve allocative disturbances, expropriation, only accidental and ephemeral, because the “expropriated-to-be” can largely avoid them by improving the anticipatory judgments;  on the other hand, moral hazard comes likewise, and also “with great deal”, from government intervention, by expropriation in a way that cannot be avoided even within contexts imaginable as dealing with “perfect information”; on the contrary, it is all the more knowledgeably boosted. We begin by briefly taking notice of the conventional definition. Thereby, it cannot be disputed that people act according to different sets of knowledge about the surrounding world. The economist knows other things than the engineer, and the football player, other things than the philosopher. There is no doubt, even having the same specialized training, that people are not uniformly informed about the real world. Some economists have more knowledge about the economic theory and history, about the debates around them, about their application in various circumstances (e.g.: the causes and consequences of the “economic crises”) than others. Information asymmetry is a universal aspect of human life; it is both a cause and a result of the division of labour. There is no reason to assume that it is a priori harmful or sign of imperfection. Thus, the conventional theory is pressed to focus on an additional condition in explaining the occurrence of moral hazard: the separation of ownership from control Hülsmann (2006, 37)3. Hülsmann further notes the two main situations of moral hazard germination: agency contracts and co-ownership4. 3

Despite the term consecration in the corporation literature beginning with Berle and Means as consequence of modern corporate governance, in our case we refer to a common condition, manifesting when the ownership over a good / resource can be disconnected from the actual operation and control of that good / resource. 4 In the case of the agency contract, moral hazard can occur when an economic asset is not effectively controlled by its owner (the “principal”), but by another person called the “agent”, for example, by an employee. Once again, the “information asymmetry” phenomenon provides moral hazard in combination with this separation of ownership from control. The agent, who is fully informed about his own activities, has the motivation to act in his own material interests, against the

To support the argument that moral hazard is decisively explained by separating ownership from control and not only by information asymmetry – moreover, systematically appearing in environments where this separation becomes more acute than it would be through voluntary delegation / sharing, being forced without the consent of the resources‟ owner who is subject to this risk, all of this usually in statist / interventionist climates –, we firstly point to the way to manage it on a free market. On the free market, the combination of information asymmetry with separation of ownership from control is not sufficient to infer the systematic expropriation of the “less informed” entity who does not have control of his property – expropriation to which moral hazard is finally reducible (and incriminated). In other words, moral hazard on an unhampered market does not necessarily lead to expropriation because there are mechanisms the owner can make use of in order to protect himself from this risk, the expropriation being rather “accidental and ephemeral”. The argument is based on the understanding of the managing role that rational expectations / predictions play in such situations. A mention is to be made: we speak in this case of “expropriations” in a “broader” sense – “the employee does not do his best”, but respects the written contract regarding what to do, not do, and give to the employer. The idea is that, as far as the expectations related to the risk of expropriation are correct, the employer (the principal) withholds, ex ante, the ex post “expropriated-to-be” part of the employee (agent) as a discount to the marginal value of the labour services he entrepreneurially imputes to him, succeeding not to lose from expropriation; eventually, he could lose, due to entrepreneurially erring the imputation of this employee‟s contribution value to production; but, if correctly anticipating the “expropriation”, he can, basically, get rid of it5. material interests of his less informed principal. Consequently, whenever the principal cannot fully monitor the agent’s activities, the latter is stimulated to increase his (monetary and physical) income on the principal’s account. In the case of co-ownership, each owner has control over a portion of property, without having exclusive control. Information asymmetry can thus produce moral hazard combined with this separation of ownership from control. For instance, when a co-owner of an estate cannot fully monitor the activities of the other co-owners, the latter are tempted to use the property without (properly) clean, repair, increasing their money / material and / or psychical / subjective revenues on their partner’s expense. 5 For the principals operating on a free market there are more tools available. They can, by contractual design, protect themselves to a large extent, ex ante, from the risk of moral hazard, and from its effects, ex post, once installed. Ex ante, the insurance industry has fair examples: health insurance, exclusions, deductibles, co-payments. In traffic, there are radars or auto black boxes, etc. Ex post, there is the possibility to break the contract when suspecting the agent of conducting violations; the agent’s “fear” of being fired is an incentive that watches over the principal’s “garden of cucumbers”. Both reputation and “black list” have disciplinarian role.

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However important the moral hazard emerging from a faulty definition of property rights and bounded rationality in contracting within free markets would be, it cannot be compared with the moral hazard resulting from the “forced separation of ownership from control”, Hülsmann (2006, 40) notes. As “forced” separation of ownership from control we understand the separation made against the owner‟s wish. Although owners can be forced both by the State and by the private entities, government intervention is obviously more important in practice, and not only because of the greater quantitative impact, but also because intervention is, by definition, acknowledged by the law and can therefore be anticipated. Hülsmann (2006) starts from the fact that an interventionist government dictates to other owners to use their resources in a different way than their owners would do. In doing so, the government transforms some persons or group X (i.e., itself) into uninvited co-owners of property of another agent Y. The essence of interventionism is precisely this: institutionalized uninvited co-ownership. The state becomes an uninvited and unwelcomed co-owner each time it levies a tax, inflates currency or imposes regulations and prohibitions. Once this behaviour is institutionalized, moral hazard gets to an “epic scale”. So long as forced separations can be anticipated, they have a systematic impact on behaviour. Individuals tend to join the beneficiaries of the institutionalized forced appropriation and to leave victims‟ class. This trend manifests itself, i.e., in inflation making and benefiting, in bureaucracy and in “official” (subsidized) unemployment (from the part of those involved in expropriators camp) or, conversely, in avoiding fiat money during hyperinflation, in tax evasion inside black markets, emigration, capital export (for those expropriated). Corporate actors are not immune to the perverted incentives provided by public institutions and policies. Moreover, the corporate format itself is accused of being a “license to misbehaviours” because of the “limited liability” legal shield. Corporations, limited liability, moral hazard: a disambiguation of critiques Praxeologically speaking, the large number of shareholders involved in a corporation, combined with the natural problem of the tension that arises Hülsmann (2006, 39) provides illustrations of the moral hazard analogy resolution mechanisms in the co-ownership sphere: the co-owners, aware of the challenges posed by the management of “communes”, can avoid the “tragedy” by designing mutual rules for governing the co-owned resources. Similarly to the principal-agent type situations, there is also room for entrepreneurial initiative to develop institutions and organizations to support the stakeholders to minimize the exposure to the moral hazard risk: connoisseurs’ organizations, traders’ communities, urban design rules, etc. (see Elinor Ostrom, on the “private government of the common goods”).

from the principal-agent relationship between the shareholders and the managers (because of the incongruity of personal interests and the informational asymmetry between the owner shareholders and the operator managers, which leads to the impossibility of the former to monitor the actions of the latter) lead to the need of limiting the risks and the possible losses by the owner shareholders, who are separated from the day-to-day functioning of the company. This is where their generalized option for limited liability (liability strictly limited to the amount of capital invested) comes from. But there are still many economists, political philosophers, jurists and sociologists claiming that the feature of limited liability is far from being both logical and legitimate freedom to choose the suitable format for contracting in markets; it is, allegedly, nothing but a political privilege granted historically by governments for deriving some fiscal and political rents and something provoking moral hazard. The limited liability principle causes a stir, being often identified with the institutional privileges surrounding corporatist phenomenon. The doctrine of “limited liability” within the corporate realm is erroneously perceived as insulating a contractbreacher or a tortfeasor from liability (even if he was negligent), so long as he is a “simple” shareholder, or that it exempts managers and officers of the corporation from liability for debts or torts6 of others. As Kinsella (2011) notes, “the doctrine merely says that shareholders are not jointly and severally liable for all the debts of the company that they have a share in. If a company that A owns shares in is sued and driven to bankruptcy, A loses the value of his shares but is not personally liable for the lawsuit against the company”. According to this principle, shareholders are only liable in a court of law for the capital invested in the corporation (private assets other than the capital invested in the corporation not being here “eligible”). Overall, if a corporation is in debt, limited liability means that debt can only be recovered from the corporation‟s existing capital (much as it still is). This is true in the limits of “business as usual”-type practices; if it is proven that a particular person from the company‟s entourage has committed a fraud, limited liability does not in the least protect that person against being lawfully prosecuted for the committed fraud. The logic of the limited liability principle is utterly clear. If we consider that in a corporation the number of shareholders (partners) and employees (agents) can get very high, the limited liability eliminates / reduces the risk of paying for the negligence or fraud of others, negligence or fraud 6

For a discussion on the modern “medievalization” of law by asking and sometimes receiving “vicarious liability” of “stakeholders” (i.e. owners or directors / managers of the corporation) for torts not involving them directly in a utilitarian hunt for “deeper compensation pockets” and in clear violation of “personal and proportional punishment” principle, see Kinsella (2011).

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 which can get – due to the number of partners and amount of resources – significantly far beyond the possibilities of a single person. From an “ethics and economics” perspective, limited liability does not raise insurmountable problems. The main problem is of agreement (ethically) and of anticipation (economically). We have to assess whether its operation involves or not “aggression” (unjustifiable initiation of violence) and “waste” (resources misplaced in markets):  As long as all concerned parties understand what all is about and accept the arrangement in terms of limited liability, the corporation of this type remains a benign phenomenon of the free market, subject like all the other to the rigors of competitive selection of the organization forms. Moreover, it can be said – just like the separation of ownership from control – that limitation of liability is a phenomenon present in many more instances / cases / examples than mere corporations. Any interpersonal exchange involves in a particular manner the limited liability. For who can, by selling something, stipulate what is to be done in any circumstance related to the operation of the sold object in order to “protect” the buyer? Or, given the fact that contracts are all, to a greater or lesser extent, incomplete, to consider them valid involves considering the limited liability as a natural principle for conducting contractual relations (and, hence, commercial relations) in general (Topan 2009, 171). Indeed, sometimes limited liability can be relevant enough to be explicitly “qualified” and “quantified”; but this thing does not make the principle less general. So, coercively prohibiting un-coercing actions (involving limited liability) is, ethically, unarguable (Hoppe) as presupposes societal wealth losses by hampering freedom of contracting, spoiling cooperation (Mises).  Partners of a corporation with limited liability – and who voluntarily engaged in contracts with it being aware of this thing – (such as suppliers, creditors, clients, etc.) just have to correctly anticipate in what degree, in the future, the partner corporation will be able, within the limits of the undertaken liability (mainly corporatist capital), to honour its debts: payment fees, interest, etc. It might even be said that this is actually always the case, and that the idea of “unlimited liability” is an entirely unrealistic concept (Topan 2009, 171). Even if the principle of unlimited liability is stipulated, from an economic point of view things would not change very much: in the sphere of capital from which debts could be recovered is also included the private property of entrepreneurs (i.e. including tangible resources), an amount that is necessarily limited. A creditor will have to anticipate, in conditions of reasonable transparency, the extent

to which he can recover his involved money from this “new whole”, the difference from the limited liability principle being only one of degree, and to ask for more protective buffer. Strictly speaking, unlimited liability is not compatible with the world we are living in, because it may in the end appear just like another form of limited liability (but with other “limits”) or it may signify the absence of scarcity of resources, something that is, obviously, absurd. The boom-bust business cycle: sponsored errors and moral hazard cynicism After scrutinizing the microeconomic design of incentives within the modern limited liable corporations, we pass to the other half of our topic: the relation of the (eventually ill incentivized) corporate world with the widespread phenomenon of economic turbulences, epitomized by what is both scholarly and trivially known as the “boom-bust business cycles”. The explanation of both the causes and the consequences of the emergence of “turbulences” (prevalent coincidentally or consequentially inside our modern corporatecapitalistic world) is one of the core and (still) intriguing issues in economics. The superficial explanations of boom-bust cycles – periods of production expansion and periods of contraction – usually make appeal in the mainstream economic literature to psychological or exogenous non-human factors, such as weather caprices or technological waves (Rothbard 2000, 80 and ff.). As opposed to other arguments advanced by different – and sometimes conflicting – theoretical accounts, we attempt to interpret it from the angle of natural property rights regime. We argue that the denial of a full private property rights design in monetary and banking fields determines a socialized financial system with fundamentally wrong incentives of operation. Moral hazard is a permanent feature of modern banking system even if it can take different forms of manifestation and obviously it manifests itself in a recurrent manner. Without addressing the fundamental question of how property rights should be defined and enforced in these fields, any solution is just temporary and moves the problem to another level. Classical and some modern economists argue that money is an economic good which performs the function of medium of exchange. Because of the difficulty to find a double coincidence of wants among the participants in a barter system, some economic goods with particular characteristics will be used by market participants in order to overpass the fundamental limit of a non-monetary economy. Money will always exist in societies where there is private property and freedom of exchange even if there is no central political authority. This natural

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perspective on money as a market phenomenon (Hoppe et others 1998, 19 and ff.) considers that the present monetary system is a result of a centuries-long process through which political authority denied the function of medium of exchange to market goods and awarded it to fiat money substitutes issued under a monopolistic license by centralized banking systems (under the reign of central banks). The main function of fiat money is redistribution of purchasing power in society through targeted increases in the money supply7. The politically chosen money substitutes cannot survive as media of exchange on a market without the political limitations in the freedom of choice for market participants such as the politically awarded function of legal tender, the monopoly in the production of the fiat money substitutes and the denial in the possibility of emergence of various other media of exchange in contracts between market participants. Moreover, increases in the money supply could be useless unless they are paired with an artificial reduction in the rate of interest fixed by the central banks. Or, at this point, the monetary manipulation causes huge, society-wide, misallocation of resources. The natural rate of interest is the representation of the social time preference as it is formed on a free credit market by the auctions of participants (Mises 1980, 377 and ff.). The natural rate of interest informs all entrepreneurs about the social ratios they have to pay attention to between present consumption against future consumption as well as the relative length of different production cycles consumers are ready to reward. The rate of interest determines an economywide coordination between all production and consumption activities and it could be called the best embodiment of the notorious Adam Smith‟s metaphor “the invisible hand”. The manipulation of the rate of interest under the contemporary conditions in the monetary system induces shocks in this coordination function. As the fixing by central bankers of the official rate of interest sets it under its natural level, the dis-coordination induced in the economy will work in the direction of discouragement of saving (and investment) in favour of present consumption as well as the encouragement of longer cycles of production, even farther from the consumers that will not meet their demand. As the business cycles theory argues, such a short-term 7

While the main beneficiary of any increase in the money supply has been historically the State – each time the central bank and the banking sector, the suppliers of “new” money, buy government debt –, there have been also other institutions that benefited from such a process: first among them, the banking institutions – whose businesses are artificially expanded – and second of all, all economic agents that get immediate access to credit from the newly increased money supply – until the moment when the entire society will discount the purchasing power of the monetary unit after the increase in the supply, they will benefit from an initially overvalued currency as compared to reality – or benefit from a later devalued currency – like exporters or debtors. All these constituencies will always pressure monetary administrators for further increases in the money supply.

expansion of economic activities is fuelled by the misrepresentation from the part of entrepreneurs of the stock of capital in society and cannot last until the consumers return to their natural time preference. Not lastly, the manipulation of the monetary system through the artificial reduction in the rate of interest leads to a higher preference of market participants for external finance. Paradoxically, this aspect aggravates recession as debt, as opposed to equity, limits the producers‟ freedom of restructuring, as they have to confront periodic fixed payments. Rounding the relation between economic turbulences and moral hazard spurring from limitation of liability (of corporations), we will recollect some of the previous ideas. On the market there are no black holes that could melt private responsibility, in the same manner as “enough liability” can‟t be created ex nihilo. On the other hand, there are situations in which, outside market logic, some economic agents enter the moral hazard spiral, thus becoming institutional beneficiaries of socialised losses. We incriminate the “over-limitation” of responsibility, as degenerating political privilege (through subsidies, State aids, “systemic risk” justified bailout imminence – such as “too big to fail” – or strategic privileges, or by “sponsoring” various product, employment or environment standards, favourable to some, but increasing the cost for the competitors, equivocal antitrust laws, etc.); this is what diminishes responsibility and fuels moral hazard8. Alone, limited liability cannot provide a causal explanation for “economic crisis”, ubiquitous in human actions. Economic crises arise from allocation mistakes of some pure “error-makers”, monetarily bribed by easy credits and combined with the system(at)ic moral hazard of the “wrongdoers” who anticipate to “fall on their feet”. Some of them, of course, may err, as it was the case with the iconic Lehman Brothers‟ crush. The excessive speculation is motivated by political over-limitation of liability, and not by the limited liability itself: the modern fiat money speed of movement (dependent on the speed of banking emission / multiplication) increases the tendency towards “purely speculative”, “nonproductive” activities, exacerbated by the political guarantees. As simple market actors, corporations do not carry the virus of capitalism‟s turbulences: consequently, the banking system incite to malinvestments and redistributive speculations, not because it is corporatist, but “due” to the system(at)ic protection it benefits from the lender of last resort and the public guarantor of deposits. The business corporations are not blameable for their misdeeds (being beneficiaries of inflated credit and capitalization through over-trading on stock 8

And, again, moral hazard is worse with… transparent information: when some know that profits are enhanced (or losses socialized) by the expropriation of others, they’ll dismally waste basically others’ resources.

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exchange) and the societal consequences of their actions (such as the boom-bust economic turbulences), simply for they are corporations, but for they have been accustomed (encouraged by the governmental setup) to self-consider and accordingly act as “too big to fail”, superior societal characters. Corporations and “too big to fail” dogma: banking and automotive sectors The manipulation of a monetary system based on fiat money has been traditionally paired with a particular form of the organization of the banking activities. This is the “fractional reserve banking”9. For economists with no opinion on the legitimacy of the regime of property rights, fractional reserve banking cannot be qualified as aggressive. It is just a form of financial intermediation through which private banks increase the money supply at their turn through the use of capital which is deposited by surplus saving units in on demand accounts. For economists more alert to the nature of the private property rights and obligations, such a banking activity violates the property rights of depositors as they are promised a full availability of capital from the on demand accounts while, in reality, a ratio of this capital is loaned to the debtors of the bank. Such a financial intermediation generates by its nature a so-called “maturity mismatch” between the assets of the banks (long term, illiquid) and the liabilities of the same banks (short term, allegedly liquid). Fractional reserve banking is institutionally illiquid and all institutional mechanisms designed to hedge this liquidity gap – like the one which is emergence of the function of central banks as lenders of last resort and the secondary ones such as deposit insurance, caps in cash withdrawals, the formation of industry wide pools of liquidity accessible to all the depository institutions – are weak. Moral hazard is always an outcome of a legal system which protects the aggressors against the private property rights while preventing the natural owners from controlling their resources (Hülsmann 2006, 36). The contemporary monetary and banking system generates different forms of apparently irrational behaviour that could be best explained by the faulty premises of the property rights system. It is a fact usually forgotten that any type of State intervention does not only reallocate existing property rights and wealth in society. Any public intervention 9

The essence of this arrangement is that only a fraction of a bank’s demand deposits are retained in reserve and available for immediate withdrawal (in the form of cash and other highly liquid assets), the remaining portion being lent out to borrowers (consequently never being actually available for immediate withdrawal to the rightful deposit-holders). The controversial issue stems from the fact that the bank lends out great part of the funds it receives in demand deposits, simultaneously guaranteeing all deposits are available for immediate withdrawal on demand. The fractional reserve arrangement is nowadays both legal and a common practice in current banking.

reveals to all market participants the rules under which their future behaviour will be regulated. An act of public intervention that prevents the failure of an economic agent will provide to all other economic agents the insurance that, in case they qualify for such public support, they will also receive it. Public interventionism, despite its complexity and inner inconsistencies, cannot be purely random so the market participants can “read” and understand the logic of reallocation of resources in society. They will always bet on the type of future State interventions and they will alter their behaviour accordingly. The usual explanation of “herd behaviour” which is considered a type of irrational behaviour from the part of market participants – and a “market failure” – is, in fact, usually associated with such modifications of the behaviour of market participants in anticipation of institutional changes in the regime of property rights. Market failures, if we adopt a coherent perspective based on a regime of natural property rights, are nothing but outcomes of institutionalized aggression against private property rights. Hülsmann (1998, 1) calls them “clusters of entrepreneurial errors”; and they are, in some sense, “institutionally sponsored” clusters. The existence of a “lender of last resort” which is permanently ready to supply fiat money substitutes against almost any collateral works like an insurance policy for bankers10. Their ability to rationally assess and price risk is futile as long as such risk is transferred to the monetary administrators. Moreover, under the pressure to dispose of the new sums of money available after the monetary expansion induced by the central banks, such qualified lenders will be ready to credit any type of potential debtor, irrespective of his financial situation. Such a moral hazard generated by the precarious institutional setting has been misinterpreted by mainstream economists as the “greed”11 of the bankers in their quest for profit. It must be stressed again and again that the profit rationale is always legitimate in the correct property rights setting and impossible to block in the ethics of argumentation and the science of praxeology. Not only that profit is rational and natural but it is also the right incentive in the economic activity. It becomes condemnable only in a socialized system of property where the majority formulates (and violently enforces) a particular model of behaviour for all the members of society.

10

The guarantee deposit system, supported by the State, intensifies the effects induced by the lender of last resort, the consequence being the banks’ tendency to reduce the capital – the major objective is now to maximize the value for the shareholders. 11 The otherwise hard to define although rather ubiquitous greed (present in different degrees in almost everyone’s behaviour) is fundamentally risky only when associated with fraud defined in the natural, property based sense, although sanctioned as legal by modern legislations (such as the possibility to create debt / credit without properly defined savings, by current fractional reserve banking).

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A particular form of the function of central banks as “lenders of last resort” is taken when applied to the case of large financial institutions of “systemic scale importance”. It is the argument of “too big to fail”. According to the logic that the failure of large, allegedly critical, operators in a particular sector with whom all the industry participants are connected through contracts and transactions will determine systemic failures, monetary administrators are ready to perform their function of lenders of last resort particularly in the case of such operators. Besides the wrong incentives induced by the artificial availability of liquidity, financial institutions are induced to consolidate by the extra-premium and less risk they obtain in the case they are qualified as “big”. Large institutions with difficulties to assess risk and engage in economic calculation will meet the exact same problems experienced by the Soviet-type planned economies12. While the financial industry is the most “special” industry in the economy according to the logic of interventionism, we should also remember that it is not the only one. Different other industries have historically enjoyed a “particular” role in the claim of the State that it can actively promote economic growth and social welfare. They are “strategic” industries, real “engines of growth”. Among them, the automotive industry always had a distinct place. While nobody could deny the quality of the automotive industry as an “assembly industry” that integrates a complex supply chain of producers and suppliers, the right incentives for producers in this industry have been distorted by State interventionism and redistribution. Even if we ignore such dramatic interventions like the nationalization of certain auto producers by their nation States (see France and Renault), the industry experienced atypical State redistributionism. But what is significant is that such government interventionism not only consumed massive financial resources, but distorted the incentives of the producers to be competitive. One significant case in this respect is the American automotive producer Chrysler. While emerging as an innovative technology intensive producer in the 20s, Chrysler expanded soon in the aftermath. However, it was overwhelmed by State interventionism. During World War Two, nearly all of its production facilities were producing military vehicles. While Chrysler grew afterwards due to some innovative and technology-intensive models of automobiles, it failed to pay attention to the development of the market conditions and consumer 12

The special nature of State intervention in the monetary and banking system is supported by a particular discourse on the allegedly special role played by money and banks in an economic activity. Such a particularism explains why rules and interventions that seem unacceptable in the case of other economic goods and activities of production – like, for example, a central authority that fixes prices and decides volumes of production – do not apply to the monetary and banking system.

tastes. Such a factor could be explained by the dependence of State protectionism in trade affairs as well as costly regulatory requirements. As the smallest of the “Big Three” American auto producers, strict regulations in what regards auto safety put Chrysler in difficulty. Moreover, the American automotive industry experienced another form of moral hazard which was trade unionism. In other words, because of the huge political leverage of the powerful United Automotive Workers, the entire American auto industry experienced huge labour costs and, in consequence, bigger difficulties in restructuring and adapting to new market conditions. In consequence, the energy crises of the 80s put the final blow to the financial situation of this American producer. Its survival was compromised and the only way of continuing its operations was government funding. The theory of Hülsmann is fully confirmed by historical facts. In consequence, the United States Congress voted the grant of 1,5 billion USD as a co-financing package through Chrysler Corporation Loan Guarantee Act of 1979. The Chief Executive Officer of General Motors at that time, Thomas A. Murphy, considered that the bailout of Chrysler was “a basic challenge to the philosophy of America”. Obviously, the direction of government funds to a competitor among three was not only a waste of resources, but also a blow to the welfare of the other two producers. The public support for one competitor ignores – besides the resources allocated against the market process – the possibility that the other competitors could expand their activities. Government interventions are always favouring some producers at the expense of others (besides taxpayers and consumers). The 1979 bailout of Chrysler was indeed a valuable lesson for the American automotive industry. One of them was that philosophy does not have too much value in modern times. Second of them, you could maximize, as a businessman, your financial results even by obtaining funds from government redistribution. It is a real challenge for the entire discipline of business ethics that pressures for ethical decisions of businessmen but ignores whether a businessman should accept government funding. What is sure is that Chrysler didn‟t learn anything from the 1979 bailout except the power of Public Relations and government lobbying. Even if it was argued that Chrysler paid back fully its debt towards the American government (even a 350 million US dollars interest), the alteration of the correct incentives of the other producers was manifest. The latter learned a lot as, for example, General Motors who did not have any philosophical prejudice in pressing for the 2008 wide auto bailout. Almost three decades later, the bailout of the two of the three American automobile producers (General Motors plus Chrysler) costs more than 20 billion US dollars. Despite the debate whether there was a legal government act or not (the funds were taken from

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TARP funds, formally destined to the financial industry), the bailout proved that, essentially, this creates only addicts and not independent marketoriented producers. The survival of big business is too frequently a result of the success of government lobbying and not of the satisfaction of consumers. Principles such as that government should “save” firms from bankruptcy only for an increase in unemployment could be avoided are not only defaulting on logic, but obviously manipulate. Conclusions Conventionally, it has been agreed that the “modern global capitalist world” is (also) the institutional result of corporate business productivity in spatial and range expansion. With its / their prons and cons. Corporations are, beyond the idea of “separate entity” that would define them (i.e., legally animated… person), merely, special associative inter-personal structures. The irony is that the detail which explains both the virtues and vices of corporations is the same: the limited liability “privilege”. Somehow due to this situation, the obtainable capital base of a corporation becomes superior to that of any other legal associative form: the corporation attracts, through stock exchange, capitalists tempted by unlimited profits, under conditions of limited losses. And the risks, packed in a limited buffer, incite to technological innovations and thus alert the overall economic dynamics. But, somehow, capitalism‟s and free market‟s genuine vocation has been distorted by “unchaining” free corporate enterprise and chaos tends to reign in: speculative instability increases, because ownership of assets is separated from their management, and responsibility is melted into an “impersonal vacuum”; concentration of power increases in markets (through scale effects and inter-firms m&a mechanism), “a few” controlling the scarce resources in economy; the managers obsession to dedicate profit to shareholders paroxysmally increases (in order not to be sanctioned / dismisses after “hostile takeovers”), and the capitalist ethos gets much too materialist and much less CSR oriented; the temptation to lose the personal moral spirit in corporatist entourages rises – where responsibility is limited, morality tends to follow suit. The corporation is the temple of moral hazard. We emphasized that limited liability as such is not the source of corporative misbehaviour, but the over-limitation of responsibility by means of privileges granted. We spoke about those received in the name of systemic financial stability or systemic employment stability, pointing out that banking sector has by default some features that incite to recklessness, as do some other major employing corporations, such as those operating in “star industries” as car-making one. In financial industry, the iconic corporate sector stuffed with institutional privileges, the way money is issued and put into

circulation by the central bank in tandem with the banking system incites to extensive malinvestment behaviours, systemically harmful – economic crises – thanks to the privilege of the latter to be bailed-out on high grounds (such as “too big to fail”); and this kind of excuses is contagious. Various other corporations are treated as “jobs and votes” suppliers. But their real mission is to supply goods for consumers in order to get profit for their owners. If consumers do not seem to reward a particular business for its products, this does not mean but that business should abandon its operation and leave the room for another business that should fill in the gap. Entrepreneurial failure is a normal event in a free market and should be treated accordingly. The blocking of the “creative destruction process” is a receipt for a path to a planned economy and reveals an inner distrust in capitalism. If the producers do not act under the spectre of possible failure (loss or bankruptcy), incentives to increase efficiency, to innovate, to pay attention to customers‟ needs are vanished. State “hand” creates the most corrupt, mean and pervasive moral hazard in the economy. Acknowledgement: this work was co-financed from the European Social Fund through Sectoral Operational Program Human Resources Development 2007-2013, project number POSDRU / 1,5 / S / 59184 “Performance and Excellence in postdoctoral research in Romanian economics science domain”. References 1.

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Dun, Frank van. 2009. The modern business corporation versus the free market, http://users.ugent.be/~frvandun/Texts/Articles/Corpora tion%20versus%20Market.pdf. Eeghen, Piet-Hein van. 1997. The capitalist case against the corporation. Review of Social Economy 55: 85–113. Eeghen, Piet-Hein van. 2005a. The corporation at issue, part I: The clash of classical liberal values and the negative consequences for capitalist practices. Journal of Libertarian Studies, Summer: 49-70. Eeghen, Piet-Hein van. 2005b. The corporation at issue, part II: A critique of Robert Hessen‟s In Defense of the Corporation and proposed conditions for private incorporation. Journal of Libertarian Studies, Fall: 3757. Hessen, Robert. 1979. In defense of the corporation. Stanford, California: Hoover Institution Press, Stanford University. Hoppe, Hans-Hermann; Jörg Guido Hülsmann şi Walter Block. 1998. Against fiduciary media. The Quarterly Journal of Austrian Economics, vol. 1, no. 1: 19-50. Hoppe, Hans-Hermann. [1993] 2006. The economics and ethics of private property. Studies in political economy and philosophy. Auburn, Ala.: Ludwig von Mises Institute. Hülsmann, Jörg Guido. 1998. Towards a general theory of error cycles. The Quarterly Journal of Austrian Economics, vol. 1, no. 4: 1-23.

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16. Ostrom, Elinor. 1996. Governing the commons. New York: Cambridge University Press. 17. Rothbard, Murray Newton. [1962, 1977] 2004. Man, economy and state (with Power and market). Auburn, Ala.: Ludwig von Mises Institute. 18. Rothbard, Murray Newton. [1982] 1998. Ethics of liberty. New York: New York University Press. 19. Rothbard, Murray. [1963] 2000. America’s Great Depression, Fifth Edition. Alabama: Ludwig von Mises Institute. 20. Topan, Vlad. 2009. Întreprinderea în afacerile internaţionale. O abordare din perspectiva Şcolii Austriece. Ph.D. thesis. The Bucharest University of Economic Studies.

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THE IMPACT OF COMPANY-SPECIFIC AND EXTERNAL FACTORS ON CORPORATE RISK TAKING: THE CASE OF EGYPTIAN INSURANCE COMPANIES Mohamed Sherif*, Mahmoud Elsayed** Abstract Using a two-way panel regression analysis with fixed and random effects and the generalized method of moment(GMM), we investigate the impact of both firm-specific and external factors on the risk taking of Egyptian insurance companies. We use hand-collected data of Egyptian insurance companies over the period from 2006 to 2011 to estimate the relationship between total and systematic risks as risk measures and the independent variables. Following Eling and Mark (2011) the extent of risk taking is quantified through variations in stock prices and these are explained by firm-specific and external factors. We find that differences in company size, interest rate level and economic development affect variations in stock prices. The analysis also highlights differences between the life and non-life insurers, with the non-life insurers exhibiting a higher level of risk (market and premium) and board independence. The pattern of results are qualitatively the same for non-life insurers but different for life insurers when we use GMM method. Keywords: Risk Management, Corporate Risk Taking, Corporate Governance, Insurance Industry, Egypt JEL Classification: G34, D21, D23 * Cairo University, Faculty of Commerce, Giza, Egypt E-mail: Mohamed.Sherif @ foc.cu.edu.eg School of Management and Languages, Heriot-Watt University, Edinburgh, EH14 4AS Tel: 44 (0) 131 451 3681 Fax: 44 (0) 131 451 3079 E-mail: [email protected] ** Cairo University, Faculty of Commerce, Giza, Egypt E-mail:mah.elsayednjk. [email protected] We thank Ahmed Saad for providing the data. All remaining errors are ours.

Introduction Corporate governance and measuring corporate risk taking are an important effort to ensure accountability and responsibility of every part of the organization and has been identified to mean different things to different people. It can be broadly classified into internal and external mechanisms (Denis and McConnell, 2003; Sarkar et al., 2008). Internal mechanisms or firm-specific factors are those related to board structure, management and executive compensation and ownership structure. These mechanisms are the core of corporate governance, in particular the efficiency of board, which has played a significant role in this regard due to its characteristics. External mechanisms relate to the market for corporate control and disclosure requirements, are chosen to proxy the environment in which insurers operate, i.e. the takeover market and the shareholder

protection offered by the legal system in which the business operates. The importance of the factors associated with corporate risk taking in general and insurance companies in particular has attracted considerable attention in both the economic and financial literature and is widely believed to play an important role in corporate governance, particularly in monitoring top management. This influence of risk management and board of directors on corporate risk taking and firm performance has been discussed for a number of years, but mainly in the United States and European business context. There are different ways to measure the insurance company risk taking, such as determination of risk-based capital via cash flow simulations (Cummins et al., 1999) or an analysis of factors explaining insurance company financial health (Chen and Wong, 2004). A number of methodologies have been adopted in this context, including multiple discriminant analysis (Carson

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 and Hoyt, 1995), neural networks (Brockett et al., 1994), and cascaded logistic regressions (Baranoff et al., 1999). Regulatory authorities assess insurer risk taking by performing stress tests or deriving solvency ratios. It is worth noting that a significant body of research involves identifying the parameters relevant for company failure (see, BarNiv and McDonald, 1992; Ohlson, 1980; Trieschmann and Pinches, 1973). As most of the empirical evidence concerns developed markets such as the UK and US stock markets, it is necessary to investigate this issue for other markets to check the robustness of the US and UK results. Also, academics and policy makers in both developed and emerging markets are increasingly grappling with this issue as they seek to avoid or reduce the relevant level of risk which in turn will reform their governance mechanisms. Despite the importance of corporate risk taking in emerging countries, a very few studies (see Adenikinju and Ayorinde (2001) and Sanda et al. (2005)) have been made on the emerging insurance business environment. This is because, firstly, developing countries have mainly chosen a state-sponsored route of development with a

relatively insignificant role of the private corporate sector which made corporate finance not an interesting area of research for many decades. Secondly, developing countries suffer from the lack of data, since data on relevant variables are often not available. Thirdly, the analysis of the Egyptian market is of particular interest for three main reasons:(i) this market has been the focus of little research despite its importance (one of the largest markets in Africa); (ii) the Egyptian economy is a small open economy and it is likely that international factors play an important role in explaining risk taking decisions and variations in stock prices; and (iii) given the great Egyptian revolution, it is now the appropriate time for Egyptian companies seeking to reduce the level of risk and reform their governance mechanisms. The Egyptian insurance industry undoubtedly faced the most difficult period during the Egyptian revolution of 2011, as reflected in the number of individual policies seen in Table 1. These developments raise many questions concerning the nature of risk taking and the way of quantifying this type of risk in Egyptian insurance companies.

Table 1. Number of policies and sums assured (in thousands) in Egyptian Insurance Companies 2006 Number of policies: Individual 147032 Group 515 Sums Assured: Individual 5883542 Group 23619430

2007

2008

2009

2010

2011

176165 536

157464 528

158146 431

180363 482

158883 485

10139158 27740740

9744821 44594760

11106490 49741142

13598856 45969718

11131402 62443244

Source: (Egyptian Financial Supervisory Authority EFSA, 2011)

This controversy, besides the lack of research in developing countries in general and Egypt in particular, motivates this study on the financing practices of the Egyptian insurance companies, where answers for many questions are still not clearly developed. Hence, the study intends to reduce the knowledge gap by investigating the corporate risk taking in large Egyptian insurance firms and analyse whether firm-specific and external factors have an impact on the level of risk, as measured by total and systematic risks. Equipped with the previous analysis, this paper aims to examine the Egyptian evidence on the relationship between the firm-specific and external factors and corporate risk taking using data of Egyptian insurance companies between 2006 and 2011. Company-specific characteristics are credit risk, market risk, liquidity risk, premium risk, reserve risk, leverage and firm size, while external factors are growth rate of the gross domestic product (GDP growth) and an average short-term (three month) interest rate. Further, we extend our

analysis to examine the relationship between the board characteristics and firm risk taking of Egyptian insurance companies. In essence, we are asking whether board characteristics, namely board independence and board meetings, are better able to explain the data of corporate risk taking. The idea is to identify the amount of risk taking through variations in stock prices. The analysis in this paper is innovative in several ways. It is, to our knowledge, the first attempt to analyze a set of different internal and external risk drivers and their relationship to corporate risk taking in emerging markets. Furthermore, this is one of the first papers that use a dataset of Egyptian insurers to evaluate firm and environmental factors at an international level. The remainder of the paper is set out as follows. Section 2 is a brief literature review on corporate risk drivers. Section 3 provides details of the methodology and models. Section 4 presents the data and empirical results and section 5 concludes.

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 Literature Review The extent of risk taking is quantified through variations in stock prices and these are explained by firm-specific and external factors that proxy the environment in which the insurers are active. Indeed, there is a great deal of research that documents the correlation between risk drivers and corporate risk taking. One strand of research on risk taking and variations in asset pricing (see, inter alia Hermalin and Weisbach (1991); Goodstein et al. (1994); Weir and Laing (1999); Adenikinju and Ayorinde (2001); Ferris et al. (2003); Sanda et al. (2005)) has investigated the internal factors discussed in academia and practice as potential drivers of risk associated with insurance companies. Internal factors include the company's management, organization, and business policy. Here, Ashby et al. (2003) emphasize that insurance company failures result from a combination of different causes and effects. Yet, the root of most failures is poor management. It is not clear whether skillful managers engage in more or less risk taking and do have a sense of responsibility with a long-term orientation toward business success (in contrast to a short-term bonus orientation). Skills would then be a combination of entrepreneurial competence and managerial responsibility, which is difficult to quantify. In this line Baranoff and Sager (2002) investigate the relation between capital and risk in the Life insurance industry in the period after the adoption of life risk-based capital (RBC) regulation over the period from 1993 to 1997 using Autoregressive two-stage least squares. They find that for life insurers the relation between capital and asset risk is positive and significant, while the relation between capital and product risk is negative. The contrast between the positive relation of capital to asset risk and the negative relation of capital to product risk underscore the importance of distinguishing these two components of risk. Using the longitudinal factor analysis, Baranoff et al. (2007) examine the capital structure in the life insurance industry over the period from 1994 through 2000 and compare the effects of two different perspectives of asset risk represented by two different proxies and two size segments of the industry in two separate periods. They find that regulatory asset risk (RAR) and opportunity asset risk (OAR) are not equivalent proxies for asset risks and the large life insurers and small life insurers differ substantially in the importance of the two asset risks exert strongly positive and approximately equal effects on the capital ratio. But for the smaller life insurers, the RAR faddist is insignificant, whereas the OAR remains strong and positive as important in the prebull market period as for large insurers.

Low (2009) investigates the impact of equitybased compensation on managerial risk-taking behavior using both the abnormal returns and univariate analyses over the period from 1990 to 2000. He finds strong empirical evidence on the impact of equity-based compensation on managerial risk-taking, which are listed as (i) equity-based compensation affects managers' risktaking behavior, this risk reduction is concentrated among firms with low managerial equity-based incentives, in particular firms with low chief executive officer portfolio sensitivity to stock return volatility. Further, the risk reduction is valuedestroying; (ii) firms respond to the increased protection accorded by the regime shift by providing managers with greater incentives for risktaking. In the same vein, Lee et al. (1997) examine the change in property-liability insurers' risk taking around enactments of state guaranty fund laws using t-test and Wilcoxon signed-ranks test in addition to the two-sample t-test and the mannwhitney test. They find an evidence supportive that the risk of insurer' asset portfolios increases following enactment, but this increase in risk is significant only for stock insurers. Their evidence of increased risk-taking following guaranty-fund adoptions suggests that the way these funds are organized creates counter productive investment incentives, while the evidence on changes in risktaking helps resolve statistical problems that have been troublesome for studies of bank deposit insurance. In the same line, Cummins and Sommer (1996) investigate the capital and portfolio risk decisions of property-liability insurance firms using OLS over the period from 1979 to 1990. They find supportive evidence that managerial incentives play a role in determining capital and risk in insurance markets, implying significant implications for insurance solvency regulation. Another factor thought to have an influence on risk taking in insurance companies is financial distress and insolvency. Here, Sharpe and Stadnik (2007) test a statistical model to identify Australian general insurers experiencing financial distress using multiple discriminant analysis and logit and probit analysis over the period from 1998 to 2001. They find that insurers are more likely to be distressed. They are generally small and have low return on assets and cession ratios. Relative to holdings of liquid assets, they have high levels of property and reinsurance assets, they also write more overseas business, and less motor insurance and long-tailed insurance lines, relative to fire and household insurance. Following Bar and McDonald (1992) and Trieschmann and Pinches (1973), Carson and Hoyt (1995) investigate the Life insurer financial distress. For insurance companies adopting three empirical models; namely recursive partitioning,

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 logistic regression, and multiple discriminant analysis, they find that surplus and leverage measures are strong indicators of insurer financial strength. However, no evidence is found for a strong relationship between state minimum capital requirements and insolvency. Baranoff et al. (1999) investigate whether segmentation of the life/health insurance industry by product specially or size can improve solvency models. They find that segmentation improves upon whole industry models specialized by product line and by size are better than unitary models. Similarly, Eling et al. (2007) outline the specifics of solvency, to provide a basic understanding of solvency and also encourage additional research on best practices for successful risk-based capital standards. They indicate that insurance supervision in the EU is undergoing significant change as the European commission works toward harmonization across member countries as well as implementation of standards that are appropriate for a rapidly changing market place. Eling and Schumacher (2007) analyze the situation in which the fund under consideration represents the entire risky investment using the Hotelling-Pabst statistic. They compare the Sharpe ratio with twelve other performance measures. They find that despite significant deviations of hedge fund returns from a normal distribution, the comparison of the Sharpe ratio to the other performance measures results in virtually identical rank ordering across hedge funds. Post et al. (2007) provide an overview and evaluation of the various international financial reporting standards (IFRS) arguments that concern the changes IFRS is likely to cause in the European insurance industry and indicate that the effects of IFRS are exaggerated and the main area of IFRS impact on the European insurance industry is likely to be on insurance product design. Also, Kim et al. (1995) employ dynamic statistical methodology, particularly event history analysis, to examine insurer insolvencies and factors associated with these insolvencies using multivariate discriminant analysis and binary response regression models. They indicate that examination of various factors associated with property-liability and life insurer insolvencies reveals several statistically significant relationships. For property-liability insurers, they find statistically significant factors with consistent signs in various versions of the exponential model including organizational age, premium growth, investment yields, underwriting results, expense ratios, loss reserve expousure, and realized and unrealized capital gains. For life insurers, statistically significant factors with consistent signs in various versions of the exponential model included organizational age, investment yields, expense ratios real estate holdings, income performance, and realized and unrealized capital gains. Klumpes (2004) investigates the performance

benchmarking in the U.K life insurance industry using regressions analysis. He finds that performance benchmarking is applied to measure the profit and cost efficiency of UK life insurance products that are required by 'polarization' regulations to be distributed through either independent financial advisers. Klumpes (2005) examines the economic and organizational factors affecting the level of risk taking and managerial propensity using three alternative measures: traditional accounting-based measures, economic value added(EVA) and multi period, actuarial cash flow based measures such as embedded value(EV) using univariate and multivariate tests and logistic regression. He indicates that life insurance CEOs are more likely to use EV for strategic management planning and control purposes, and that this preference is strongly conditioned by the firm's ownership structure. These results support the managerial incentive hypothesis, after controlling for the effects of other organizational structural and behavioral variables that potentially influence the level of risk and choice of financial performance measure. Harrington et al. (2008) analyze whether the 1994-1999 'soft' market in medical malpractice insurance led some firms to underprice, grow rapidly, and subsequently experience upward revisions in loss forecasts 'loss development' which could have aggravated subsequent market 'crises'. The results indicate a positive relation between loss development and premium growth among growing firms. Underpricing was likely more prevalent among non-specialist malpractice insurers. Elston and Goldberg (2003) examine the factors affecting the level of executive compensation in Germany, with particular emphasis on the agency problem created by the separation of management and ownership using OLS. They find that, similar to US firms, German firms also have agency problems caused by the separation of ownership from control, with ownership dispersion leading to higher compensation. Eling and Schmeiser (2010) investigate the impact of crisis on insurance companies and to derive consequences for risk management and insurance regulation. They indicate that the importance of outlining potential consequences seen from the crisis and the consequences derived believed to have sufficient evidence on the level of risk taking. Chen and Wong (2004) test the solvency status of individual insurers in the four Asian economies and to assess the effect of Asian financial crisis on the financial health of the insurance companies. They find that the factors that significantly affect general insurers, financial health in Asian economic are firm size, investment performance, liquidity ratio, surplus growth, combine ratio, and operating margin. While the

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 factors that significantly affect life insurers, financial health are firm size, change in product mix, but the last three factors are more applicable to Japan. Moreover, the financial health of insurance companies in Singapore seems to be significantly weakened by the Asian financial crisis. Chen et al. (2006) examine the impact of option-based compensation on several marketbased measures of bank risk: total, systematic, idiosyncratic and interest rate risks. They find a robust across alternative risk measures, statistical methodologies, and model specifications. Overall, the results support a management risk-taking hypothesis over a managerial risk aversion hypothesis . The results also have important implications for regulators in monitoring the risk levels of banks. In the same vein, Grace (2004) examines several hypotheses about the structure and level of compensation for property-liability chief executive officers (CEOs) using OLS. He finds that corporate governance structures, managers' stock ownership, and regulatory attention are not adequate to prevent CEOs from receiving compensation levels in excess of what economic factors predict. Contrary to findings in prior studies, there is little evidence that use of incentive compensation paid increases with insurer investment opportunities, as traditional measured. Another strand has investigated external factors of risk taking, which are those cannot be influenced by the company. These are divided into general economic conditions, institutional intervention, and other risk factors. Factors for economic conditions and institutional intervention can be taken from the underwriting cycle literature (see, Cummins and Outreville, 1987; LammTennant and Weiss, 1997). In this regards, variations in interest rates should play an important role in determining insurer business risk, as premiums are calculated as discounted future claims or benefits. This argument is especially relevant for life insurers and long-tail casualty business. Here, Grace and Hotchkiss (1995) and Chen et al. (1999) analyse underwriting cycles and find that prices and underwriting profits are related to changes in the economic environment as measured by changes in real prices (inflation) or real GDP. Catastrophes are accompanied by an unusual and massive impact on claims and these might affect the business risk of insurance companies. With regard to corporate governance, the degree of regulation and disclosure requirements are two important external risk drivers. The higher the degree of regulation (such as price, product, or capital regulation), the lower is the competition in an industry. A low degree of competition without differentiation in products and prices might lower risk, but it also has a dampening effect on innovation. It is worth noting that higher disclosure requirements reduce information

asymmetries between stockholders and managers, leading to more accurate estimates of future earnings and firm value. The switch from local generally accepted accounting principles (GAAP) to international financial reporting standards (IFRS) is an aspect in this context. The IFRS introduce more and standardized disclosure requirements, which should enhance the transparency and comparability of international insurers. Following on from the seminal work of Fama and Jensen (1983), it has been argued that boards can be effective mechanisms to monitor top management on behalf of dispersed shareholders. Boards effectuate management appointment, dismissal, suspension and reward. Board characteristics, therefore, are relevant to corporate performance. A natural variable of interest in this case is board composition. The empirical evidence on this count is, however, mixed. Weisbach (1988) was one of the earliest to report an association of board turnover, risk taking, firm performance and the presence of outside directors. Fama (1980) argued that the viability of the board as a marketinduced mechanism for low-cost internal transfer of control might be enhanced by the inclusion of outside directors. Echoing this view, Cadbury (1992) argued for more non-executive director representation on the boards of firms and the separation of the chairman and chief executive and their reflections on the level of risk taking. In the same vein, Weisbach (1988) found that risk taking and performance measures are more highly correlated with CEO turnover for firms in which outsiders dominate the boards of directors than for those in which insiders dominate. Bhagat and Black (1999) provide evidence for a positive impact of the number of outsiders, while Hermalin and Weisbach (1991) did not uncover any robust relationship. A second variable of focus is CEO remuneration. Two important considerations assume relevance in this context. The first is the participation constraint which suggests that compensation of the CEO must be higher than the income available from alternative sources. The second is the incentive constraint, which indicates that aligning the incentives of the CEO with those of the shareholders is the easiest way to circumvent moral hazard on the part of the CEO (Jensen and Meckling, 1976; Fama , 1980). In this line, Chen et al. (2001) examine the relation between risk and managerial ownership for a sample of life insurance companies in the United States. They find that the level of life insurance company risk is dependent on the level of managerial ownership, specifically, as the level of managerial ownership increases, the level of risk increases supporting a wealth transfer hypothesis over a risk aversion hypothesis. The findings suggest that when compensation packages encourage higher levels of managerial ownership,

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 manager and stockholder interest converge with regulators can control the risk-taking activities of life insurers by requiring a separation between ownership and management. Also, Cheng et al. (2011) investigate the relationship between risk taking of life-health insurers and stability of their institutional ownership. The main three findings are: (i) stable institutional ownership is associated with lower total risk of life-health insurers, supporting the prudent-man law hypothesis; (ii) when investors are sorted in terms of stringency of the prudent-man restrictions, their negative effect on risk holds for all, except insurance companies, as owners of life health insurers; and (iii) large institutional owners do not raise the riskiness of the investee-firms as proposed by the large shareholder hypothesis. Cole et al. (2011) test the alternative theories regarding the relation between separation of ownership and management and risk taking by examining the implications of ownership structure for firm's risk taking behavior in the U.S. propertyliability insurance industry, to impact firm risk. They find that each ownership structure is significantly different from every other ownership structure in terms of risk. Also, Core et al. (1999) examine the association between executive pay and a comprehensive set of board and ownership structure variables and find that measures of board and ownership structure explain a significant amount of cross-sectional variation in CEO (chief executive officers) compensation, after controlling for standard economic determinants of pay. Moreover, the signs of the coefficients on the board and ownership structure variables suggest that CEOs earn greater compensation when governance structures are less effective. They also find that the predicted component of compensation arising from these characteristics of board and ownership structure has significant impact on firm performance. Mayer et al. (1997) investigate the role of outside directors in the corporate-control process by exploiting variation in ownership structure within the insurance industry. They find that firms that switch between stock and mutual charters make corresponding changes in board composition and

mutuals' by laws more frequently stipulate participation by outside directors. For growth rate as an external factor, John et al.(2008) examine the relationship between investor protection and the risk choices in corporate investment and find that corporate risk-taking and firm growth rates are positively related to the quality of investor protection. He and Sommer (2010) investigate the implications of separation of ownership and control for board composition over a spectrum of ownership structures present in the U.S. propertyliability insurance industry. They find that agency costs associated with manager-owner conflicts increase with the degree of separation of ownership and control, as greater agency costs imply a greater need for monitoring by outside directors on the board. Therefore, use of outside directors is expected to increase as the separation of ownership and control gets larger. Further, they found evidence supportive of: (i)corporate board roles, which fulfil two roles: boards play an institutional role and providing a link between the organization and its environment; (ii) boards discharge a governance role, monitoring and disciplining of inefficient management; and (iii) the strategic role, chartering the future growth path of the firm in a competitive setup. In this line, Monks and Minow (1995) argue that board monitoring can lead to an improvement in the quality of managerial decision-making. Yet, the root of most failures is poor management. It is not clear whether skillful managers engage in more or less risk taking and do have a sense of responsibility with a long-term orientation toward business success (in contrast to a short-term bonus orientation). Skill would then be a combination of entrepreneurial competence and managerial responsibility, which are difficult to quantify. Methodology and Models In the following section, the research methodology is set up to estimate different specifications associated with risk drivers and firm risk taking. Based on the above analysis, the following model is employed:

BETA / VOL = [MR, CR, LR, PR, RR, LEV , SIZ , SB, BM , GDP, IR] where the BETA is measured by the covariance of stock return and market return (EGX30) divided by the variance of the market return; VOL is the logarithmic changes of the insurer's stock price; MR is market risk measured by ratio of equity and real estate investments to total assets; CR is credit risk measured by ratio of loans and fixed-income securities to total assets; LR is the liquidity risk measured by ratio of cash and

(1)

near-cash items and marketable securities to total assets; PR is the premium risk measured by the yearly net insurance premium growth RR is reserve risk measured by ratio of total insurance reserves to total net premiums earned;LEV is Leverage measured by ratio of total liabilities to shareholders equity;SIZ is the firm size, measured by LN(total assets); SB is the supervisory board compensation and measured by percentage of independent

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 members of the supervisory board;BM is board meetings measured by number of meetings held by the supervisory board; GDP is GDP Growth measured by the yearly growth rate of gross domestic;IR is the interest rate, measured by the Short term interest rate based on 3-month offered interbank rate.

To examine the relationship between risk drivers (internal and external) and corporate risk taking (systematic (Beta) and total (VOL) risks), let the risk measure be the dependent variable and the risk drivers be explanatory variables. The systematic (Beta) and total (VOL) risks and relationship model for life insurance companies is then presented as follows:

9

11

k =1

k =10

9

11

k =1

k =10

LBeta =    j LINTi   j LEXTi   i LVOL =    j LINTi   j LEXTi   i where L is the life insurance companies; is the intercept; and are the internal and external drivers respectively.

(3)

To investigate the relation between risk measures of nonlife insurance companies and the same independent variables, the following models are adopted:

9

11

k =1

k =10

9

11

k =1

k =10

NLBeta =    j NLINTi   j NLEXTi   i NLVOL =    j NLINTi   j NLEXTi   i where is the non-life insurance companies; is the intercept; and are the internal and external drivers respectively. To accomplish the above objectives, the study employs pooled and panel data analysis techniques where panel data analysis are usually estimated by fixed effects and random effects techniques. In pooled model, all observations are put together and the regression coefficients describe the overall influence with no specific time or individual aspects. It assumes that the error term captures the differences between the firms (across-sectional units) over the time. The pooled model is simply be estimated by Ordinary Least Square (OLS). However, OLS will be appropriate if no individual firm or time-specific effects exist. If they are, the unobserved effects of unobserved individual and time specific factors on dependent variable can be accommodated by using one of the panel data techniques (Gujarati, 2003). A panel data technique helps researchers to substantially minimize the problems that arise when there is an omitted variables problems such as time and individual-specific variables and provide robust parameter estimates than time series and/or crosssectional data. It is usually estimated by fixed effects model and random effects models. The fixed effect model allows control for unobserved heterogeneity which describes individual specific effects not capturing by observed variables. The term ``fixed effects" is attributed to the idea that

(2)

(4)

(5)

although the intercept may differ across individuals (firms), each individual's intercept does not vary over time; that is, it is time invariant. Unlike fixed effects model, the unobserved effects in random effects model is captured by the error term ( ) consisting of an individual specific one ( ) and an overall component ( ) which is the combined time series and cross-section error. The random effects model will be estimated by the Generalized Least Squares (GLS) technique. This is because the GLS technique takes into account the different correlation structure of the error term in the random effects model (Gujarati, 2003). Assume that and are random variables so that every equation in the linear model can be written in the form:

Yt = X t  u

(6)

According to equation (6), we can imply two sets of the relationships between the residual and the explanatory variables. Firstly, where there is no correlation between the explanatory variables and the residuals. In this case we say that the expectation of , given a set of information , can be given by ( | and the orthogonality | condition appears as ( . Calling at the second case, which is common in the practical world, there is a correlation between the residual and the explanatory variables. Therefore it is

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 important to find other variables that did not correlate with residuals but correlate with the original variables; these variables are called instrumental variables. Suppose that we have n observations on K variables, denoted as which are correlated with where ( is nonsingular but remains negatively correlated with the residual , that is, ( , so that . Hence we include , as instrumental variables instead of the problematic regressors. Again, these instrumental variables are correlated with (explanatory variable) but uncorrelated with the residual. Consider the following estimator:

 = (Z X )1 Z Y =   (Z X )1 Z u =   (Z x / n)1 Z u / n

1 T Z (Yt  Lt ) T t =1

(8)

Assume that the model is just-identified, then the sample version is set to be zero (orthogonality condition) and the GMM estimator (the standard instrumental variables estimator) can be evaluated as: ́

{∑

}∑

(9)

(7)

Then postulate that is nonsingular, 0, and ̃ , where ̃ is called the simple instrumental variable estimator (IV). If the model contains a group of [ ] ́

observations, then and ( ( ( which implies that the sample counterparts of the moment conditions can be given by:

[ ] {[[ ] ∑

However, if the matrix is non singular and the model is over identified, we estimate the model as presented in equation (9). To estimate the variance of the standard instrumental variables estimator ̀ for the sample version, we use:

] ̀ [[ ] ∑

]}

(10)

where ̀ is an estimate of

1 T  A = lim[ ]  E{ut ut  zt zt } T  T t =1  =  When the residuals are serially uncorrelated and homoscedastic with a variance of , ( can be obtained by: ̀

̀ ∑

where ̀

(12) ̀

[ ] ∑(

Substituting into equation (9), the Variance of GMM (the standard instrumental variables estimator) is given by:

̀

̀ {∑

}

{∑

} {∑

}

(13)

(11)

Data and Empirical Results Data The data adopted in this study are annual data on Egyptian insurance companies and span the period from 2006 to 2011. Panel data are used as it observes multiple companies over multiple time periods. Hence, in this study we adopt panel data to examine a number of explanatory variables using the regression models discussed above. Hsiao (1986) in his book `analysis of panel data' highlighted the significant advantages from using panel data over cross-sectional and time-series data sets. Firstly, panel data provide a large number of data points, increasing the degrees of freedom and reducing the collinearity among explanatory variables. Secondly, longitudinal data allows certain questions to be addressed that cannot be done through using cross-sectional or time-series data sets. Finally, panel data while capable of testing more complicated behavioral models, can also resolve or reduce the problem of the certain

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 effects that occur due to omitted or mismeasured variables, which are correlated with the explanatory variables. Thus panel data are able to control better these effects (Hsiao,1986). The data has been collected from various sources. Data on stock prices are obtained from DataStream and Egyptian disclosure book. To examine the effect of firm size on corporate risk taking, the variables of total assets and sales are gathered from the annual report of insurance companies issued by the Egyptian Financial Supervisory Authority, stock market index in the same periods, and price of shares of the insurance companies. Empirical Findings We begin our analysis with the descriptive analysis as in Table 2. The table presents the mean, standard deviation and correlations of two risk measures and Eleven risk drivers. As we can see from Panel A and B, there is a wide spread in average and standard deviation across the risk measures and risk drivers. Data are separated by life and non-life, which includes reinsurance companies. The discussion is focused on differences between life and non-life insurers. Comparing the different industries, the average beta is higher for non-life insurance (0.024) than for life insurers (0.008), a finding in agreement to that of Borde et al. (1994) who find that U.S. life insurers have a lower beta than non-life insurers. We believe that our finding is meaningful since non-life insurers in Egypt typically have significant savings processes, which result in large investment portfolios, and experience only a limited degree of uncertainty from the underwriting business. life insurers in Egypt have a smaller investment portfolio and are more prone to underwriting risk, especially in lines with catastrophes exposure. This situation should result in the returns of life insurers being more dominated by the investment result, whereas the returns of non-life insurers may be more dominated by underwriting results. One consequence of this difference between the two lines of business could be that non-life insurers are more correlated to stock market returns, as documented by a beta close to 1, while life insurers should have a lower beta. The risk drivers in Panel B of Table 2 reveal some interesting cross-industry differences. On average credit risk and liquidity risk are higher in life insurers than nonlife. In contrast, premium risk and reserve risk are higher in nonlife insurers than life insurance. We believe that our finding is meaningful since non-life insurers in Egypt typically characterized by short-term contracts

which reflect on the value of claims by insurers. On average we find differences for the control-related variables supervisory board independence and board meetings, which are both higher for the life insurers than non-life. This might reflect the fact that in life insurers industry the independence and control of executives can come under more public scrutiny (the publication of independent supervisory board members is mandatory in Egypt). In general, this highlights the distinct characteristics of the corporate governance environment in Egypt. Given the asset accumulation function of life insurers that leads to high reserves, it is reasonable to find a higher leverage and size compared to nonlife insurance companies. Also, the higher market risk of non-life insurance companies seems plausible given the nonlife insurer business model. Further, we find no significant differences between GDP and interest rate in both life and non-life insurers. Table 2 also presents Pearson‟s correlation coefficients between considered variables. As expected, the correlation between both risk measures for nonlife insurers is positive. Most of the correlations between internal risk and beta are positive and significant. The correlation between leverage and systematic risk is positive and significant with life insurers. The correlation between size and the risk measures (systematic risk and total risk) is significant and positive in life and nonlife insurers for systematic risk indicating that with increasing size, the insurers become more aligned with the market and thus more prone to systematic risk. Interestingly, the correlation between corporate governance related variables (supervisory board independence and board meetings) and the insurers‟ beta is significant and positive for life insurers, while for volatility, this is only the case for board meetings but with a negative correlation. With regard to external risk drivers, we find that GDP growth is positively correlated with total risk but uncorrelated with systematic risk. Also, GPD growth is negatively aligned with the shortterm interest rate. To detect multi-collinearity, an ordinary least-squares regression of both risk measures against all other variables is conducted. The results of the random and fixed effects regressions with beta and volatility as dependent variables are presented in Table 3 and Table 4. As specification tests we report the p-value of the Hausman statistic with the random effect models and the p-value of the f-test with the fixed effect models.

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 Table 2. Descriptive statistics and correlation between risk measures and risk drivers

Beta Vol

MR

CR

LR

PR

Panel A:Life Insurance 0.0075 0.6820 0.3222 0.1480 0.2971 1.937 Mean Std .Dev. 0.0261 0.1070 0.3375 0.1334 0.2374 6.688

RR

LEV SIZ

SB

BM GDP IR

3.475 10.60 12.69 0.8726 6.354 0.0247 0.0944 3.119 11.73 1.871 0.0308 3.609 0.0331 0.0110

Panel A:Non-Life Insurance 0.0239 0.4744 0.4027 0.1354 0.2397 39.18 4.585 1.945 12.59 0.8522 6.167 0.0245 0.0946 Mean Std .Dev. 0.0125 0.2240 0.2712 0.0975 0.1648 6.1326 16.02 1.536 1.698 0.0396 3.515 0.0329 0.0113 Panel B: Pearson Correlation Matrix-Life Insurance 1.0000 Beta -0.08 1.0000 Vol -0.31 -0.14 1.0000 MR 0.32 0.23 -0.09 1.0000 CR 0.23 -0.08 -0.38 -0.13 1.0000 LR -0.17 0.13 0.48 -0.23 -0.26 1.0000 PR 0.21 0.14 -0.60 0.19 0.39 -0.22 1.0000 RR 0.21 0.18 -0.66 0.04 0.10 -0.27 0.46 1.0000 LEV 0.28 0.11 -0.76 0.24 0.28 -0.37 0.74 0.46 1.0000 SIZ 0.15 0.11 -0.30 0.21 0.15 -0.12 0.35 0.19 0.53 1.0000 SB 0.15 -0.02 -0.43 -0.13 0.15 -0.24 0.09 0.34 0.18 0.35 1.0000 BM 0.17 0.42 -0.03 0.28 -0.02 -0.17 -0.04 0.09 -0.14 -0.04 -0.07 1.0000 GDP 0.09 0.42 0.04 -0.25 0.17 -0.01 0.07 -0.14 0.16 -0.01 0.05 -0.63 1.0000 IR Panel B: Pearson Correlation Matrix-Non-Life Insurance 1.0000 Beta 0.46 1.0000 Vol 0.13 0.17 1.0000 MR -0.02 -0.13 -0.05 1.0000 CR -0.10 -0.08 -0.37 -0.16 1.0000 LR 0.30 0.26 0.30 -0.19 -0.32 1.0000 PR 0.08 0.09 -0.01 -0.08 -0.19 -0.05 1.0000 RR -0.01 -0.03 -0.40 0.12 0.37 -0.27 -0.01 1.0000 LEV 0.01 -0.12 -0.42 0.01 0.42 -0.38 0.01 0.43 1.0000 SIZ 0.08 -0.08 -0.27 -0.07 0.28 -0.36 -0.06 0.27 0.58 1.0000 SB

BM GDP IR

-0.01 -0.12 -0.27 0.17 0.11 -0.49 0.23 0.71 0.10 -0.03 -0.16 0.34

0.05 0.09

-0.04 -0.69 -0.04 0.07

-0.04 -0.05 0.17

0.02

-0.15

Starting from the random effects regressions, Table 3 shows results for two types of insurers (life and non-life). With beta, we focus on the comovement of the individual insurer's stock price with the overall market movement, i.e., systematic risk. With volatility, we analyze total risk, i.e., we consider both systematic and unsystematic (firmspecific) effects. The variables are grouped into

0.20 0.03

0.02 0.36 1.0000 -0.20 -0.10 -0.12 1.0000 0.12

0.10

-0.64 1.0000

three categories as seen in Table 2: (i) internal risk drivers; (ii) internal risk drivers related to corporate governance; and (iii) external risk drivers. For each explanatory variable we present coefficient and significance estimates. In terms of sign estimates, the results are generally robust as most variables have either an entirely positive or negative impact on beta or volatility.

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1

Table 3. Regression results for random effects models Random Effects Regression Beta

Volatility

Life

Nonlife

Life

Nonlife

-0.0081 (0.0142) 0.0250 (0.0194)

0.0073 (0.0045) 0.0066 (0.0115)

-0.1282 (0.0684)* 0.0690 (0.0937)**

0.1233 (0.0546)** -0.1523 (0.1391)

0.0025 (0.0117) -0.0018 (0.0005)*** 0.0011 (0.0013) -0.0001 (0.0002)

0.0011 (0.0078) 0.0000 (0.0000)*** 0.0001 (0.0001) 0.0001 (0.0008)

-0.0304 (0.0562) 0.0096 (0.0026)*** -0.0049 (0.0064) -0.0003 (0.0012)

0.0425 (0.0938) 0.0001 (0.0001) 0.0006 (0.0008) -0.0088 (0.0097)

SIZ

0.0004 (0.0025)

0.0014 (0.0009)

0.0147 (0.0121)

0.0198 (0.0114)*

SB

0.0036 (0.0018)***

0.0366 (0.0360)

-0.0044 (0.0085)

-0.1271 (0.4344)

BM

-0.0028 (0.0027) -0.0125 (3.918)

0.0007 (0.0004)* 0.0723 (0.0438)*

0.0059 (0.0130) 1.3162 (0.3766)*

0.0047 (0.0047) 2.963 (0.5289)***

-0.1688 (0.1321) 0.3347

0.0989 (0.1206) 0.2057

1.2118 (0.6343)* 0.4786

-8.446 (1.4556)*** 0.6398

37.58 (0.0001)

1.86 (0.9973)

-12.59 (0.0001)

1.04 (0.9998)

MR

CR LR PR RR

LEV

GDP IR R2 Hausman

Note: (*:10%,**:5%,***:1% significance)

Next is the internal risk drivers. The most relevant internal risk drivers for beta lifesupervisory board independence and premium risk are discussed, while for the most relevant internal risk drivers for beta non-life insurers are premium risk, and board meetings. For volatility, life-market risk, premium risk and interest rate are the most relevant internal risk drivers, while volatility nonlife-market risk and firm size are the most relevant drivers. We find strong evidence that larger firms are associated with a higher premium risk. That size affecting risk taking is also in line with the literature (Cheng et al., 2011). The positive

sign for beta implies that with increasing size the analyzed insurers tend to become more aligned with the market. Smaller insurers, which tend to be less diversified, might be able to decouple from overall market movements. But also the estimates for the volatility are positive, which is contrary to our expectation that larger firms exhibit lower total risk, e.g., due to diversification of risks. However, the implications may be different when risk is not considered as an aggregate measure, such as our total risk proxy.

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1

Table 4. Regression results for fixed effects models Fixed Effects Regression Beta

Volatility

Life

Nonlife

Life

Nonlife

-0.0127 (0.0151) 0.0405 (0.0208)*

0.0088 (0.0053)* 0.0055 (0.0137)

-0.1503 (0.0778)* 0.0002 (0.1068)

0.1496 (0.0651)** -0.1990 (0.1670)

-0.0025 (0.0125) -0.0016 (0.0006)*** 0.0016 (0.0013) 0.0000 (0.0003)

-0.0032 (0.0098) 0.0000 (0.0000)*** 0.0001 (0.0001) 0.0000 (0.0009)

-0.0079 (0.0644) 0.0113 (0.0032)*** -0.0103 (0.0069) -0.0014 (0.0014)

0.0757 (0.1193) 0.0001 (0.0001) 0.0007 (0.0009) -0.0095 (0.0114)

-0.0005 (0.0026) 0.0045 (0.0019)**

0.0017 (0.0011) 0.0456 (0.0426)

0.02344 (0.0135)* -0.0051 (0.0096)

0.0231 (0.0130)* -0.2882 (0.5185)

-0.0054 (0.0030)* -0.1017 (0.0785)

0.0008 (0.0004)* 0.0697 (0.0475)

0.0099 (0.0153) 1.7227 (0.4039)***

0.0058 (0.0054) 2.992 (0.5790)***

R2

-0.1508 (0.1389) 0.2791

0.0999 (0.1299) 0.1998

1.2584 (0.7142)* 0.4474

-8.477 (1.583)*** 0.6381

F-test

3.90 [00007]

2.61 [0.0057]

5.01 [0.0001]

16.61 [0.0000]

MR

CR LR PR RR

LEV SIZ SB BM

GDP IR

We find Leverage is insignificant for both systematic risk and total risk, which is in contrast to the case in the U.S. sample of Borde et al. (1994), who find a positive and significantly influence of leverage on total risk and a mixed (positive for life insurance companies and negative for non-life insurance companies) influence on systematic risk. However, Cummins and Sommer (1996) find a positive relation between capital and (total) risk for the property/casualty industry and Baranoff and Sager (2002) find a positive relation for the life insurance industry with asset risk. Our findings generally confirm this relationship as, in our case, a higher leverage ratio can be considered as a proxy for lower capital. As insurers usually have little equity compared to their liabilities, the estimates for the regression coefficients are rather small. Also, Liquidity risk is especially insignificant with volatility and exhibits a negative sign for life insurers. Holding more cash generally should reduce liquidity risk, but it also reduces asset returns, as cash does not earn interest, and therefore increases the risk for life insurers of not being able to fulfill guarantees. For the non-life insurers, the

coefficient is positive for systematic risk. Borde et al. (1994) find for their U.S. sample a negative relation of liquidity with systematic risk and a positive relation with total risk. This difference might be explained by the different reactions U.S. and Egyptian insurers have to a changing risk situation. For the corporate governance-related risk drivers, the significant estimate of supervisory board independence is positive. in this line, John and Senbet (1998) discuss the role of the supervisory board in solving problems related to agency theory (and thus corporate governance), Core et al. (1999) relate weak board structures to agency problems and lower firm performance (as well as higher executive compensation). Boone et al. (2007) find indication that board independence is negatively related to executive influence. These results from previous work imply that increased control, e.g., through board outsiders, should be accompanied by less managerial discretion, resulting in better shareholder protection. This manifests in our case as higher risk taking, as shareholders may consider their investment as an

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 option. There is a positive effect of the number of board meetings on total risk for life and non-life insurers. The positive relation of board meetings and risk might be explained by firms with a higher (systematic and total) risk responding to this situation by increasing control efforts. The relation of the number of board meetings to risk is equal to the relation of board independence to risk, namely, positive, providing support for the idea that the board is indeed reacting to some high-risk situation. Moving onto external risk drivers, GDP is the most relevant of the two external risk drivers and exhibits a negative relation with systematic risk and positive with total risk. The interest rate level is positively connected to total risk. This is in line with Chen and Wong (2004) who find for Asian property-liability insurers a positive relationship

between the absolute level of interest rates and an “unhealthy rate”. The authors interpret the interest rate not as a crediting, but as a financing cost rate. The short-term interest rate in our analysis may be interpreted similarly. Therefore, in our model, increasing the cost of short-term financing and liquidity is related to a higher probability of becoming insolvent and thus higher total risk. The fact that liquidity risk, i.e., the ratio of cash and near-cash items and other marketable securities to total assets, is negatively associated with total risk supports this hypothesis. When we turn our attention to Dynamic Panel Data Analyses (considering endogeneity issues) we employ the GMM methodology to estimate the models. The results are presented in Table 5. GMM estimations of models

Table 5. Generalized Method of Moment-GMM Generalized Method of Moment-GMM Beta

MR

CR LR PR RR

LEV SIZ SB BM

GDP IR R2 j-statistic

Volatility

Life

Nonlife

Life

Nonlife

-0.0173 (0.0230) 0.0377 (0.0388)

-0.0022 (0.0206) 0.0365 (0.0383)

0.0023 (0.1117) 0.0137 (1496)

0.0700 (2.82565) -0.0071 (0.2.4526)

-0.0079 (0.0137) -0.0036 (0.0014) 0.0010 (0.0011)* -0.0004 (0.0006) -0.0023 (00025)

-0.0066 (0.0151) 0.0000 (0.0000)*** -0.0005 (0.0005) -0.0023 (0.0032) 0.0036 (0.0026)

-0.0180 (0.0776) -0.0006 (0.0055) -0.0020 (0.0075) 0.0006 (0.0036) 0.0181 (0.0102)*

-0.16329 (1.8722) -0.0022 (0.0026) 0.0000 (0.0095) -0.0089 (0.2834) 0.1551 (0.1723)

0.0109 (0.0636) 0.0013 (0.0014) -0.0397 (0.1872)

-0.0312 (0.0509) 0.0009 (0.0012) 0.1365 (0.0800)*

0.4471 (0.2302)* 0.0009 (0.0055)*** 1.0506 (0.6147)*

0.9949 (4.3167) -0.4056 (0.1065)*** 24.197 (10.236)**

0.0030 (0.0033) 0.2791

-0.0087 (0.2687) 0.1998

0.0060 (0.30136) 0.4474

-7.5187 (24.518) 0.6381

11.5730 (0.1155)

6.6734 (0.4637)

5.15320 (0.6413)

6.8857 (0.3315)

It is worth noting that significant differences in estimation results may indicate potential effects of the Endogeneity on risk taking. We do find slightly changes in sign estimates for the significant variables, but do find some interesting variations in significance for the internal risk drivers, external risk drives and corporate governance variables with the total risk measure across the insurers industry.

The direction of the impact of risk drivers on the risk measures remains-on average- unchanged. We found strong positive significant influence to firm size, supervisory board independence and GDP growth on the total risk of the Egyptian insurance companies with life insurers, while the premium risk has a negative impact on the systematic risk. For the Egyptian non-life insurers, we find that the

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 premium risk and GDP have positive impact on the systematic risk, while board meeting and GDP have positive influence on the total risk. In light of this additional test, we conclude that our results are robust with regard to model modifications. We observe changes of significance for some of the variables when we use instrumental variables. This is especially true for corporate governance related variables as well as for size and premium risk.

the separate effects of risk- based ownership and risk based control, as well as the influence of other measures of risk taking, but some questions have not been answered yet. For instance, why is it that the empirical results about the influence of types of risk measures on company performance may vary for different institutional settings and countries? References 1.

Conclusion This article examines the effect of internal and external factors on firm risk taking. we adopt stock prices to clarify variations in risk across life and non-life insurance companies. Our analysis is based on a comprehensive sample of Egyptian life and non-life insurance firms over the period from 2006 to 2011. Our study reveals the need to be cautious when comparing the results of previous empirical work. As the review of the literature shows that many factors can alter the outcome of corporate risk taking analysis: alternative definitions of risk measures, different institutional environments, and methodologies. We confirmed some of these findings. First, we determined that alternative insurers may lead to varying results. In fact, our study shows that there is a difference between the level of risk associated with life and non-life insurers. Although, in general, we did not find a significant relationship between the most of internal factors associated with non-life insurers when we use the systematic risk as a measure of risk, we did find that the presence of the impact of the internal and external factors to hamper the results when we use the total level of risk as a measure of risk. Therefore, our article does not confer much importance on corporate risk taking per se but on the significance and effect of different measures of risk taking. It points to the necessity of further investigation into how life and non-life insurance firms should be controlled and managed to be successful by reducing the relative level of risk. Second, our study shows that different methodologies drive different results and that we should take into account a firm's unobservable heterogeneity and endogeneity issues when analyzing corporate risk taking. Third, interestingly, our research produced some contradictory results when compared with other insurance company multicountry studies. This suggests that the conclusions of multicountry studies that use mainly samples composed of large insurance firms may not apply to the whole universe of listed insurance firms. Overall, our study suggests that although a priori it could seem that corporate risk taking might be an overstudied topic, we should explore it further. Recent studies have started to disentangle

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DOES STATUTORY AUDITORS MATTER IN BANKDOMINATED CORPORATE GOVERNANCE? EVIDENCE FROM JAPAN Naoki Watanabel*, Hideaki Sakawa** Abstract This paper presents examination of the relation between the role of statutory auditors and corporate governance mechanisms in Japan in the early 1990s. Under Japanese commercial law before 2003, the establishment of an audit committee was required, but not appointment of outside auditors. Consequently, firms came to coexist with and without outside auditors. The empirical question arises of whether outside auditors in Japan are effective monitors or not. We find the following three points in this paper. First, managerial entrenchment effects exist for the appointment of outside auditors. Second, we can find a negative relation between Japanese bank ownership and firms with outside auditors. Finally, financial keiretsu memberships are not significantly effective for the appointment of outside auditors.*** Keywords: Auditors; Bank Ownership; Corporate Governance; Financial Keiretsu Memberships * Assistant Professor at Faculty of Business Administration, Ritsumeikan University. ** Associate Professor at Graduate School of Economics, Nagoya-City University. Contact Author: 1 Yamanohata, Mizuho-cho, Mizuho-ku, Nagoya, Aichi, 467-8501, Japan E-mail: [email protected] *** The authors are grateful for Yoshiro Tsutsui and Yasuharu Ukai for their helpful suggestions. Preliminary version of this paper is presented at the 21th Asian Pacific Conference on International Accounting Issues in 2009 and the annual meeting of Japan Finance Association in 2010. We also thank to all the participants of our session at the conference and meeting. This research is financially supported by RISS Research Project of Kansai University.

1. Introduction The importance of corporate governance mechanisms has been increasingly emphasized worldwide. An audit committee is an important monitoring mechanism of corporate governance. Klein (2002) points out that the audit committee is a subset of the board of directors and has the responsibility of monitoring the firm‟s financial-reporting process. The relations between corporate ownership and formations of audit committees or monitoring roles of statutory auditors are empirically investigated worldwide from the view of separation of ownership and control (Chau and Leung, 2006; Collier and Gregory, 1999; Deli et al., 2000; Menon and Williams, 1994; Pincus et al., 1989). Previous studies are based on the characteristics of corporate ownership in each country, different from Japanese corporate governance structures. Japanese corporate governance mechanisms are regarded as “relation-oriented” or bank-centered” systems and differ from western market-oriented systems (Aoki, 1990). In Japan, however, the introduction of audit committee has not been permitted until the amendment of Commercial Law in 2003 and statutory auditor has taken monitoring roles during 1990s. Few

analyses explore the relation between corporate governance mechanisms and monitoring roles of statutory auditors in Japanese 1990s. The purpose of this paper is to analyze the relation between statutory auditors and investigate whether or not they take an effective monitoring role like audit committees in US. In addition, we also examine how Japanese corporate governance features of such as managerial ownership, bank ownership, and financial keiretsu memberships affect the monitoring roles of auditors in Japan. We attempt to provide new evidence to analyze these relations in Japan. This paper presents examination of the relation between Japanese corporate ownership structure and the existence of outside auditors because they are independent from board of directors and expected for effective monitors. Therefore, we make three hypotheses about the relation between Japanese corporate governance mechanisms and the effectiveness of statutory auditors. To analyze the differences of monitoring activities between firms with and without outside auditors, we use the sample period before Japanese regulation was altered to include outside auditors in the audit committee.

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The salient conclusions of this paper can be summarized as the following three points. First, managerial entrenchment effects arise from the appointment of outside auditors, but this effect is diminishing. Second, a negative relation exists between Japanese bank ownership and firms with outside auditors. Finally, financial keiretsu memberships are not significantly supported. The remainder of this paper is summarized into the following five sections. Section 2 discusses the related studies of the literature and audit system in Japan. In section 3, we describe development of our hypotheses. Section 4 presents a description of data and empirical models. Section 5 presents empirical results. In section 6, we summarize the conclusions of this paper. 2. Related Literature Committees in Japan

and

Audit

Fama (1980) and Fama and Jensen (1983) discuss that the incentives of outside directors help to monitor managers effectively. Results of prior studies imply that independent auditors used in the US are helpful to monitor firms‟ financial accounting processes better. Nevertheless, few studies analyze whether Japanese statutory audit systems help to monitor their firms‟ processes effectively or not. In this section, we introduce the role of Japanese statutory auditors and compare them with audit committees of the US. In the US, the audit committee must include a majority of independent auditors, which are determined by the listing regulations of NYSE and NASDAQ based on their Reports and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Auditor Committee. They state that the audit committee is the “ultimate monitor” of the financial accounting system. Carcello and Neal (2000), for example, show that the dependent audit committee tends to send a going concern report when a firm experiences financial distress. In Japan, auditors are elected at shareholders‟ meetings and Japanese statutory auditor systems are different from those of the US. In Japan, auditors need not attend the board meeting. In large companies, Japanese commercial law gives them the right to attend the board meeting and express their opinions. Therefore, auditors participate in the process of decision without the right to vote. Before 1994, Japanese commercial law required establishment of statutory auditors for all firms but did not mandate the appointment of outside auditors. Especially, in the early 1990s, nearly 40% of Japanese companies listed at the First Section of the Tokyo Stock Exchange (TSE) had not appointed outside auditors in their statutory auditors1. Thereafter, Japanese law came to require “large” companies to maintain statutory audit systems with outside auditors for enhancing the 1

independence of auditors. Japanese commercial law classified a "large" company as a company of ¥500 million in paid-in capital or ¥20 billion in liabilities. These "large" companies must establish statutory auditor systems whose members include more than three auditors and include at least one outside auditor. Aoki (1990) points out that Japanese corporate governance mechanisms are “relation-oriented” or bank-centered systems whose features consist of two points. First, Japanese corporations were believed to adopt lifetime employment systems; directors were often elected from among the senior management of the company, which is regarded as “internal” promotion. Auditors were also elected from among senior managers who could not be promoted to be directors of their firms. Second, Japanese bankcentered systems represent commercial banks‟ ties and financial keiretsu memberships. Some scholars point out the lack of monitoring devices of statutory auditors in Japan. Miyamata (2006) argues the case of a lawsuit of Daiwa Bank (the jurisdiction of the Osaka District Court) and evaluates this as a lack of their monitoring mechanisms. He concludes that this lawsuit served as the foundation, the origin, of the commercial law‟s amendments in 2003 which permits for firms to establish audit committees. Comparison of the US and Japan raises an empirical question related to the effectiveness of Japanese statutory auditors‟ monitoring roles. Regulations about auditor committees in US strictly determine the auditor committee‟s composition. On the other hands, Japanese listed firms had an option whether or not they appointed outside auditors in their statutory auditors. To analyze the effectiveness of Japanese statutory auditors, we present three hypotheses in the next section. 3. Hypotheses Development This paper presents examination of the relation between Japanese corporate ownership structure and the existence of outside auditors. In Japan, the role of outside auditors is expected to be independent of managers and a monitor of them. Therefore, we can predict that outside auditors tend to be appointed in firms with effective monitors. Japanese corporate governance mechanisms are so-called bank-centered systems, and are featured as managerial and bank ownership and financial keiretsu memberships (Aoki, 1990; Morck and Nakamura, 1999; Morck et al., 2000). We construct three hypotheses and examine the relation between Japanese corporate governance mechanisms and the existence of auditors in the following sub-section.

See the descriptive statistics of Appendix.

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1 3.1 Relation between Japanese managerial ownership and outside auditors Jensen and Meckling (1976) show that managerial ownership serves to align the interests of managers with those of shareholders and therefore increases firm value. In contrast, Stulz (1988) points out that stronger managerial ownership contributes to the entrenchment of managers by reducing the threats of takeovers. Morck et al. (1988) and McConnell and Servaes (1990, 1995) empirically support the view of the managerial entrenchment hypothesis over certain ranges of managerial ownership in the US. In Japan, Morck et al. (2000) find that managerial ownership increases monotonically with firm value, which implies that the managerial entrenchment hypothesis proposed by Stulz (1998) is less important in Japan than that in US because crossshareholding and bank-ownership limit hostile takeovers. Basu et al. (2007) and Sakawa and Watanabel (2008) report that high degrees of managerial ownership increased levels of compensation. These results imply that the managerial entrenchment hypothesis applies also in Japan. The relation between outside auditors and managerial ownership in Japan is explainable according to two views, which are the convergenceof-interest hypothesis and managerial entrenchment hypothesis (Morck et al., 1988). We construct following two hypotheses H1a and H1b. H1a: Considering the „aligning interests of managers‟ hypothesis, we expect that a positive relation exists between the existence of outside auditors and managerial ownership. H1b: Considering the „managerial entrenchment‟ hypothesis, we expect that a nonpositive relation exists between the existence of outside auditors and managerial ownership. Moreover, the possibility remains that the effect of „managerial entrenchment‟ or „aligning interests of managers‟ effect is not monotonic for the level of managerial ownership. Therefore, we also analyze additional estimation, following Morck et al. (1988) and Morck et al. (2000). 3.2 Relation between Japanese bank ownership and outside auditors Numerous previous studies point out that Japanese banks take a monitoring role under the bank-centered corporate governance mechanism (Aoki, 1990). Kaplan and Minton (1994) find that bank-appointed directors increase with poor performance and that turnover of top executives is active when bankappointed directors are newly appointed to the board.

They conclude that commercial banks serve important disciplinary or monitoring roles in Japan. Some scholars raise questions about the monitoring roles of commercial banks in Japan (Morck and Nakamura, 1999; Morck et al,. 2000; Hiraki et al., 2003; Sakawa et al., 2012). Hiraki et al. (2003) find that both main bank borrowing and the cross shareholdings between the main bank and its client‟s business corporation are negatively related to Tobin‟s Q. Furthermore, Morck et al. (2000) find that Japanese bank ownership decreases with a firm‟s value from the lower to modest range of Tobin‟s Q because a bank‟s ownership is insufficient to align the interests of bank with other stakeholders. In addition, Sakawa et al. (2012) find that bank ownership and bank-appointed directors are not helpful to adopt adequate incentive for managers and imply that monitoring roles of banks are insufficient in recent Japan. In this case, banks are not expected to take a role of appointing outside auditors. Therefore, we construct the following hypotheses H2a and H2b. H2a: A positive relation exists between the existence of outside auditors and bank ownership. H2b: A non-positive or negative relation exists between the existence of outside auditors and bank ownership. We also analyze additional estimation to check whether a „positive‟ or „negative‟ relation is not monotonic for the level of managerial ownership. 3.3 Relation between Japanese business group and outside auditors Some scholars point out that one important characteristic of the Japanese corporate governance mechanism is their business group memberships: socalled financial keiretsu. Berglof and Perotti (1994) argue that the financial keiretsu system plays a role in monitoring and controlling managers effectively. Kato (1997) finds that top executives of firms with financial keiretsu ties earn less than those without keiretsu ties. In contrast, Gurati and Singh (1998) argue that coordination costs among keiretsu memberships reduce profits of firms with financial keiretsu ties. Moreover, Miwa and Ramseyer (2002) point out that financial keiretsus serve only a ceremonial role. In other words, we cannot predict the monitoring role of financial keiretsu. We can construct two predictions about the relation between financial keiretsu memberships and outside auditors. They tend to appoint outside auditors in the firms belonging to their memberships if the financial keiretsu takes a monitoring role. However, no significant relation exists when financial keiretsu memberships do not take a monitoring role, as suggested by Miwa and Ramseyer (2002). These two

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predictions are summarized as the following two hypotheses H3a and H3b. H3a: A positive relation exists between keiretsu memberships and outside directors. H3b: A non-positive relation exists between keiretsu memberships and outside directors. 4. Data, Descriptive Empirical Model

Statistics,

and

4.1 Data Source and Data Selection

manufacturing firms listed in the First Section of the Tokyo Stock Exchange. Financial data were obtained from the Nikkei NEEDS database. Data related to characteristics and the numbers of auditor members were collected manually from Yakuin Shiki Ho. The financial keiretsu ties data were collected from Kigyo Keiretsu Souran (1991). We constructed the financial keiretsu dummy, which denotes whether or not each firm belongs to an executive gathering known as Shachokai (presidents‟ club)4 following Hoshi and Kashyap (2001). 4.2. Descriptive Statistics

For this study, we choose the sample period 1991– 1993 when Japanese regulation did not require inclusion of more than one outside auditor in the statutory auditor system. Therefore, we can analyze the differences of monitoring activities between firms with and without outside auditors. The sample comprises 1566 observations acquired during 1991–1993 for 522 Japanese

We provide definitions of the variables (Outside Auditor, Managerial Ownership, Bank Ownership, Financial keiretsu memberships, logarithm of asset, market to book ratio, and debt to asset ratio) and their descriptive statistics in Table 1.

Table 1. Descriptive Statistics (n = 1566) Variable

Mean

P Outside Auditor Ratio (%) Number of Outside Auditors Managerial Ownership Bank Ownership Keiretsu Firm Size (Billion Yen) MTB D/A (%)

0.619 33.225 0.964 0.021 0.410 0.113 11.483 2.217 0.560

Standard Deviation 0.486 31.628 0.919 0.041 0.130 0.317 1.085 1.260 0.174

Note: The variables are defined in the Appendix.

Table 2. Mean Differences Test Variables Outside Auditor Ratio (%) Number of Outside Auditors Managerial Ownership Bank Ownership Keiretsu Ln(Firm Size) MTB D/ A Observations

P=0 0.000 0.000 0.027 0.444 0.124 241137 2.183 0.537 597

P=1 53.695 1.557 0.018 0.388 0.106 173903 2.237 0.574 969

Wilcoxon rank-sum Z-value p-value -34.757 0.000 -35.163 0.000 4.575 0.000 8.299 0.000 1.072 0.284 4.494 0.000 0.104 0.917 -4.463 0.000 -

Note: We divide sample firms whether p equals to 1 or 0. In column 2 and 3, the mean variables of each group are reported. We also test the mean differences of each variable by Wilcoxon rank-sum test. The Z value and p value of the test is reported in column 4 and 5.

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Table 1 shows that the average ratio of outside auditor is about 33.2%, indicating that a substantial share of firms do not appoint an outside auditor. The managerial ownership has a mean of 2.1%. It is apparently too low to exist with the convergence of interest hypothesis. The mean of bank ownership is about 40%, which is consistent with Morck et al. (2000). Sample firms include about 11.3% of firms with financial keiretsu ties. The average of firm size is about 11.4 billion yen. That of the firm‟s market to book ratio (MTB) is about 2.21. The debt to asset ratio (D/A) is about 0.56, signifying that long-term debt is vital for the capital structure of sample firms. Table 2 reports that the mean differences test results between firms with and without outside auditors. Managerial ownership is significantly lower––about 0.9%––in a firm with outside auditors, supporting hypothesis H1b. Regarding bank ownership, the degree of bank ownership is significantly lower in the firms with outside auditors, which is consistent with H2b. No significant

difference was found between firms with and without financial keiretsu ties. Firms without outside auditors are significantly larger, but the debt to asset ratio (D/A) is significantly larger for firms with outside auditors. Klein (2002) points out that creditors‟ demands for independent audit committees increase with a high debt to asset ratio. This result is consistent with Klein (2002) and suggests that firms which depend more on debt tend to hire outside auditors. 4.3. Empirical Models Because of the binomial nature of the dependent variable, we select a logit model to test three hypotheses. The dependent variable is 1 if outside auditors are included in the statutory auditor system; otherwise it is equal to 0. The logit model used for estimation is the following estimated equation:

Logit( p)   0  1ManagerialOwnership  2 BankOwnership   3 Keiretsu  4 ln(asset)   5 MTB   6 ( D / A)  ut

In equation (1), p is the probability that an outside auditor exists. We use ownership variables to examine the relation between ownership structure and the existence of outside auditors. To control for the firm size, we adopt the logarithm of firm assets (ln(Firm Size)). Klein (2002) shows that firms with high growth opportunities do not demand independent auditor committees. To control for firms‟ high growth opportunities, we also adopt the market-to-book ratio (MTB). Finally, the debt to asset ratio (D/A) is adopted to control for firms‟ risk-taking behavior.

We adopt three independent variables to examine three hypotheses: managerial ownership (Managerial Ownership), bank ownership (Bank Ownership), and financial keiretsu memberships (Keiretsu). We construct the following estimated equation (2) adding the squared terms of managerial ownership to identify which of hypotheses 1a and 1b is supported.

Logit( p)   0  1ManagerialOwnership   2 (ManagerialOwnership)^ 2

  3 BankOwners hip   4 Keiretsu   5 Ln(asset )   6 MTB   7 ( D / A)  ut

Furthermore, to analyze hypotheses 2a and 2b, we construct the following estimated equation (3),

4 ( BankOwnership)^2  5Keiretsu 6 Ln(asset)  7 MTB  8 ( D / A)  ut

Results of estimated equation (1), (2), and (3) are presented in Table 3. The predicted signs of logistic estimations are reported in the second columns of Table 3. Logistic regression results of equation (1) are also described in the second column of Table 3. The model‟s χ2 is 114.82; it is significant at the 1% level.

(2)

adding the squared terms of managerial ownership and bank ownership.

Logit( p)   0  1ManagerialOwnership  2 (ManagerialOwnership)^2   3 BankOwnership

5. Empirical Results

(1)

(3)

The pseudo-R2 is 0.055. In the third and fourth column, the estimated results of equation (2) and (3) are reported, respectively. These models‟ χ2 are 134.19 and 134.46, which are significant at the 1% level. Both the pseudo-R2 of equation (2) and that of equation (3) are about 0.065.

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Corporate Ownership & Control / Volume 10, Issue 3, 2013, Continued - 1

Table 3. Estimation Results Variables Managerial Ownership

Equation(1) -6.941 ** (-4.79)

-3.603 ** (-7.18)

Equation(2) -18.566 ** (-5.86) 56.582 ** (3.79) -3.575 ** (-7.06)

0.093 (0.49) -0.129 * (-2.10) -0.065 (-1.33) 0.928 * (2.56) 3.246 ** (4.73) 0.0552 114.82 **

0.021 (0.11) -0.157 * (-2.52) -0.072 (-1.48) 0.695 + (-1.88) 3.852 ** (5.44) 0.0645 134.19 **

Square of Managerial Ownership Bank Ownership Square of Bank Ownership Keiretsu Ln(Firm Size) MTB D/ A Constant Terms Pseudo R2 Chi Square test

Equation(3) -18.311 ** (-5.71) 55.537 ** (3.68) -4.876 + (-1.91) 1.588 (0.52) 0.016 (0.09) -0.157 * (-2.52) -0.074 (-1.52) 0.712 + (1.92) 4.089 ** (4.85) 0.0646 134.46 **

Note: We report the estimated results of each logit model (1), (2), and (3) in this table. + p

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