Does governance matter for companies involved in real estate investment activities

Chapter One INTRODUCTION In this chapter we will give an executive summary the following subjects: ▪ Background of the study ▪ Motivation of the study ▪ Scope of the study ▪ Testable hypothesis ▪ Sample selection and sources of the data ▪ Methodology ▪ Organization of the study CHAPTER ONE-INTRODUCTION 2 Chapter One INTRODUCTION 1.1 Background Separation of ownership and management is one of the characteristics of many modern corporations 1 . Jensen and Meckling (1976) and Fama and Jensen (1983 a, b) argued that the separation of ownership and control leaves managers with ample leeway to pursue their own interests at the shareholders’ expense. Agency costs, therefore, arise when equity investors are not involved in the management of corporations. “Corporate governance’ as mechanisms devised to regulate the conduct of directors and management is thus important in corporations to mitigate agency problem. Markets will reward companies with good governance system. What does corporate governance exactly mean? Corporate governance comprises a system of mechanisms through which owners of a corporation can monitor and reward the corporation’s insiders and management, so to ensure that their capital funds are protected. In the seminal article by Sheifer and Vishny (1997), the theory of corporate governance centers on three main questions: (i) 1 How do the suppliers of finance get managers to return some of the profits to them? Coase’s (1937) theory of the firm which explains the underlying contractual view of firms is the foundation of making most of the studies of corporate governance and firm performance. A corporation is made up of a nexus of contracts, it difficult to fully specify ex-ante any ex-post contingencies in those contracts. Corporate governance, therefore, becomes an important and critical issue in the modern theory of firm. CHAPTER ONE-INTRODUCTION (ii) 3 How do they make sure that managers do not steal the capital they supply or invest it in bad projects? (iii) How do suppliers of finance control managers? The corporate governance literature identifies seven major mechanisms, which can be divided into two broad categories: internal monitoring and external control. The external control mechanisms rely on parties outside the firm to monitor the performance of top management, which include the debt policy, the managerial labor market, and the market for corporate control. The remaining four corporate control mechanisms are instituted inside the firm, which include shareholdings of managerial and institutions, large block-holders and the structure of board of directors. These interdependent mechanisms aim to alleviate the agency problems between managers and shareholders. Agrawal and Knoeber (1996) observed an optimal level of corporate governance across a section of firms. Quasi-rents 2 are common in real estate because of its unique characteristics such as asset specificity, fixity by location, and complex valuation method. These are possible roots for the lack of strict governance in real estate investments compared to investments in other asset types (Sirmans, 1999). Ghosh and Sirmans (2002) empirically examine the governance in real estate investment trust (REIT) in US. There are, however, limited studies that investigate corporate governance in public property companies listed outside the US market. Despite the Anglo-American influence of the practice and philosophy of corporate governance in Singapore (Li, 1994), there are still apparent weaknesses in the structure and activities of 2 The payment that is received by a resource of production activity over the opportunity cost in the short run. According to Zingales (1997), “The difference between the value of the product and the cost of the contracted manufacturer presents a quasi-rent, and it needs to be divided ex-post.” CHAPTER ONE-INTRODUCTION 4 Singapore’s corporations, which are not commonly observed in corporations in more developed economies in the UK and the US. The high concentration of ownership and the weak take-over market activities favor the owner-manager 3 structure in many public listed companies in Singapore (Mak and Li, 2001). This structure provides weak corporate governance on managers. The unique institutional characteristics and market environment in Singapore may offer a different case for empirical tests of the theory of governance. Land is scarce in Singapore. Many Singapore corporations own and invest in real estate as part of their portfolio strategy. Although there are only 29 companies listed in property sector of the Singapore Exchange (SGX). However, evidence shows that over 100 listed non-property companies on SGX are highly property intensive with more than 20 per cent of property assets in their total assets. 4 It is thus important to analyze how inherent characteristics in real estate investment will affect the constitution of the corporate structure, and the potential governance problems in a corporation. This study also investigates the relationship between corporate governance system and performance of firms in Singapore. 1.2 Motivations of the Study Governance plays an increasingly important monitoring role in today’s corporate activities. Theoretical and empirical studies examining the agent-principal conflicts have been well published in corporate finance literature. However, few of them have examined explicitly on the corporate governance problems associated with real estate investment, and this study thus attempts to fill-in the gap by using empirical data of listed companies in Singapore. There are four main motivations for undertaking this study. 3 4 An individual who makes all major decisions directly and monitors all activities. The data are based on the annual report of the financial year 2001 for each corporation. CHAPTER ONE-INTRODUCTION 5 Firstly, cross-country differences in laws and their enforcement create different ownership structure and government regulations, which may in turn affect in different ways how companies are controlled and the processes by which the corporate controls are implemented. 5 Motivated by the following comments by Sheifer and Vishny (1997, page 740), “Most of the available empirical evidence (on corporate governance) comes from the United States… More recently, there has been a great surge of work on Japan, and to a lesser extent on Germany, Italy, and Sweden. Unfortunately, except for the countries just mentioned, there has been extremely little research done on corporate governance around the world.” The question: “Do differences in institutional environment across countries affect the choice of corporate governance practices?” will be examined in this study. Secondly, based on the idea of Sirmans (1999) and Ghosh and Sirmans (2002), we believe that quasi-rents caused by unique characteristics of real estate may create difficult governance problems for firms with high concentration in real estate assets vis-à-vis other asset classes. Alternative corporate mechanisms may be required to protect the equity holders’ interest in firms with exposure to real estate markets. Studies of governance problems in Real Estate Investment Trust (REIT) are well explored. However, the study of effects of real estate investment activities on corporate governance in firms outside the US market is limited. Property companies listed on SGX are not subjected to the same legal instructions of REIT, such as no free cash flow, lower level of the ownership concentration, and no self-management of property assets. 6 In the absence of these regulations, should more corporate mechanisms be installed to monitor the property companies’ management in Singapore? 5 For example, Roe (1990), Li (1994), Sheifer and Vishny (1999 a, b) and others. This self-management requirement is not applicable to REITs in the US and Australia, where internally-advised structure is common for some REITs. 6 CHAPTER ONE-INTRODUCTION 6 Thirdly, owning and investing real estate is an important portfolio strategy of many Singapore companies, and real estate constitutes a large proportion of corporations’ tangible assets in the financial statements. There are only limited studies that test the governance problems in Singapore (Phan and Mak, 1999; Mak and Li, 2001), and none of them look at how real estate investment activities affect the effectiveness of the corporate governance of publicly listed firms. It is, therefore, useful to empirically examine how inherent characteristics of real estate will influence corporate structure, ownership structure, and also performance of publicly listed firms with intensity property holdings. Finally, cross-industry studies of the effectiveness of corporate governance are still lacking. Sirmans (1999) argues that governance issues may be more problematic in real estate than in other asset markets. However, there is still dearth of empirical evidence to support the hypothesis that corporate governance is relatively less effective with firms involved actively in real estate investment activities. This study compares the effectiveness of corporate governance for property and non-property firms with high concentration of real estate investment assets. The findings will have significant implications on whether non-real estate companies should divest their non-core real estate assets, and outsource their real estate needs to professional real estate firms with specialized industrial knowledge. 1.3 Scope of the Study This study focus mainly on the governance issues associated with real estate investment activities. Due to the small size of firms listed on the real estate sector of the SGX, which comprise only 29 firms at the time of the study, firms with high concentration of real estate assets, which is knows as “property intensive companies” are also included in the empirical tests. The “property asset CHAPTER ONE-INTRODUCTION 7 intensity” is measured by the proportion of property to total fixed assets held by a non real-estate company. A 20 per cent cut-off point is used to define of “property intensive” non-real estate firms in our sample. Based on this definition, non-real estate firms listed on the SGX can be divided into two categories: property intensive firms and non-property intensive (other) firms. Since property assets of non real estate firms are generally grouped into three subtypes: fixed properties, investment properties and development properties, “property intensive” non-real estate firms are further divided into two groups: firms that account real estate assets as a cost center, and firms that take limited property market risk in holding investment and/or development properties. 1.4 Testable Hypothesis The following testable hypotheses are formulated in this study: 1) The substitution hypothesis, which states that since alternative mechanisms exists, the relatively lower reliance on one mechanisms will not adversely affect the effectiveness of total governance mechanisms, is firstly investigated; 2) Since real estate investment has its specific characteristics, such as asset specificity, fixity by location, and complex valuation method, the governance may be more problematic in real estate than in other type industries. Therefore, real estate investment must be a significant determinant for some particular governance practices to eliminate the conflicts between owners and management; 3) CEO organizational control can be increased by adding more executive directors on the board, owning more equity, and serving in the position for a longer period. Therefore, the CHAPTER ONE-INTRODUCTION 8 discretionary power of the CEO is entrenched. This study also investigates that entrenchment hypothesis of the CEO control power; 4) Shareholder voting hypothesis, which states that directors’ decision control power in the nomination process as the directors’ voting rights increases by owning more common stocks of the firm, is also tested in following studies. 5) There are two perspectives in the literature for studying the relationship between governance mechanisms and firm performance. One perspective explores the relationship based on the assumption that certain governance system is optimal for all firms, that firms that conduct it will have higher performance or value; an alternative view is that although governance mechanisms are endogenously determined, there is unlikely to establish significant relationship between those monitoring mechanisms and firm value. This study tries to provide further evidence as to whether an endogenously determinants in the governance mechanisms will have possible effects on firm performance in Singapore market; 6) The hypothesis of the institutional impact on the corporate governance—institutional characteristics would influence the level of the performance of various corporate governance mechanisms 1.5 Sample Selection and Sources of the Data Firms listed on the Singapore Exchange (formerly known as the Stock Exchange of Singapore) (SGX) are used as the sample of this study. There are 386 firms listed on the main board and 106 firms listed on the SGX-SESDAQ as at end of 2001. Based on these 492 firms, we sieve out firms that meet the following criteria for our empirical analysis purposes: CHAPTER ONE-INTRODUCTION 9 1) The firms must have been listed on the SGX for at least two years by end of 2001; 2) There are annual reports for the firms; 3) Only Singapore dollar denominated stocks are selected; and 4) Annual report of the firms must contain information of chairman and CEO or its equivalence, such as the managing director or president. Based on the above criteria, 228 sample listed firms are selected in this study, which includes 20 firms listed on the property sector of the SGX. Cross sectional financial statements and firm-specific data for the 228 sample firms for the financial year ended in 2001 were collected. The financial data on net income, fixed asset, total assets, total debt, market capitalization, and total number of common stocks were collected from the computer database, Datastream®, at the department of real estate of the National University of Singapore. Corporate governance data such as the number of independent directors, characteristics of CEO, shareholdings of large blockholders and management were extracted mainly from annual reports of the sample companies. 1.6 Methodology Three quantitative methodologies that include the simultaneous equations system, binary response regression model, and classical linear regression model are used in this study to empirically test the corporate governance hypotheses. These models empirically test the significance of various corporate governance mechanisms. They also evaluate the effectiveness of governance CHAPTER ONE-INTRODUCTION 10 mechanisms between listed property companies, listed property intensive non-real estate companies and other companies. 1.6.1 Simultaneous Equations System The issue of endogenity among governance mechanisms has been extensively discussed in the corporate governance literature. As those mechanisms are jointly determined, there is a two-way causal relationship between the governance variables. To deal with the endogeneity of the mechanisms, this study tests the internal and external corporate governance mechanisms proposed by Agarwal and Knoeber (1996) using a simultaneous equations system technique. Two-stage least squares (2SLS) approach is used to estimate the significance of various governance mechanisms, and at the same time, test the feed-back effects and bi-directional causality of the governance mechanisms. 1.6.2 Binary Response Regression Model The leadership structure of the board is considered by corporate governance literature as an important governance mechanism. 7 It can be defined using a binary dummy variable that has a value of either one, if the same person in the board serves as both CEO and chairman; or zero, if there is a dual leadership structure. A binary response regression model is employed to find the determinants for the dual leadership structure in the board. This study uses the logit model to explain the likelihood of firms adopting a binary leadership structure in the management. 7 Agrawal and Knoeber (1996), Mak and Li (2001) treated the leadership structure of the board as one of governance mechanisms and introduced this variable into their simultaneous equations system. CHAPTER ONE-INTRODUCTION 11 1.6.3 Classical Linear Regression The classical linear ordinary least squares (OLS) regression is also used to test the relationship between corporate governance and firms’ performance, which is represented by the Tobin q measure. Different corporate governance variables are included in three independent OLS models to separate the effects of different corporate governance variables. The White’s test is used to test the heteroscedasticity in the model, when governance mechanisms are jointly included to explain the variations in firm performance. Finally, by comparing the results from both OLS and 2SLS estimations, we can isolate the problem of endogeneity between governance mechanisms and firm performance, and evaluate how these determinants affect the explanatory relationship between the corporate governance and firm performance. 1.7 Organization of the Study The remainder of this study is organized as follows. Chapter One describes the background, motivations and scope of the study. The testable hypotheses, the data sources and the empirical methodologies are also included in this chapter. In Chapter Two, relevant corporate governance literature is reviewed, which is followed by discussions of the knowledge and findings of current research in the subject. Chapter Three provides an overview of the institutional environment and the corporate governance system in Singapore. The regulatory framework relating to corporate control, accounting standards, and various corporate governance initiatives are described in this chapter. CHAPTER ONE-INTRODUCTION 12 The process of data collection and the sources of data are described in Chapter Four. This chapter sets up the definitions of various variables. The summary statistics of these variables, which include the Spearman correlations between the variables are also presented. Chapter Five discusses the steps and the techniques in the model building. Firstly, the simultaneous equations system is applied to test the endogenous relationships among the governance mechanisms; Secondly, a dummy dependent variable model is used to test the determinants of the board’s leadership structure. Next, the linear relationships between the corporate governance and firm performance are estimated. Two regression techniques: the OLS regression and the 2SLS regression, are employed to empirically test the relationships between the governance mechanisms and firm performance and to examine the effects of endogeneity of the determinants. The empirical results are analyzed in Chapter Six, which includes the evaluation of the model fitness, and the significance of the testable hypotheses. Differences in the results of the OLS and the 2SLS regressions on firm performance and various corporate governance mechanisms are also discussed. Chapter Seven concludes the study. Contributions of this research are discussed. Recommendations for further studies are presented, and limitations of this study are also highlighted. Chapter Two LITERATURE REVIEW In this chapter we will cover the following subjects: ▪ The theory of firm ▪ What is corporate governance? ▪ What constitutes corporate governance? ▪ The endogeneity issue ▪ Governance literature on real estate investment ▪ Corporate governance literature on Singapore Market This literature review chapter sets up the framework for the theory of the corporate governance. It covers the following questions: What causes the governance issue? What is the definition of the theory of corporate governance? What constitutes the corporate governance? The empirical analyses of the corporate governance are also presented. As well as the importance of the study of the governance issue in real estate investment and the pervious studies on the corporate governance in Singapore market are described. CHAPTER TWO-LITERATURE REVIEW 14 Chapter Two LITERATURE REVIEW 2.1 The Theory of Firm The research into the causality of corporate governance is invariably dependent on the emergence and the form of business organization of a corporation of firms. An understanding of the nature of the firm is essential in studying the question of why corporate governance matter. There are many definitions of a firm in the economic and legal literature. These definitions have been used in neoclassical economic theories that explain the transaction cost and principle-agent relationships. The classical theory of firm is introduced by Coase (1937). In his seminar paper, he suggested that the introduction of the firm was mainly because of the existence of marketing costs. There are costs incurred when operating in a market. Forming an organization and allowing entrepreneur to directly allocate the resources can reduce some marketing costs. He also emphasized that an entrepreneur must exert efforts to reduce cost in operations. He must attempt to obtain factors of production at a price lower than that attained in the open market transaction; otherwise it will not make economic sense for the firm to exist. He also pointed out that writing a contract is itself costly. The contract should only state the limits to the powers of an entrepreneur. Within these limits, he can therefore have the flexibility to deploy the factors of production. Many researchers build their studies based on the work of Coase’s. Jensen and Mechkling’s work (1976) is one of the examples. They looked at a firm as a nexus of a set of contracting relationships among individuals. They gave the definition of the agency relationship as a contract CHAPTER TWO-LITERATURE REVIEW 15 in which a principal can engage an agent to perform some services on his behalf. The ex-ante made contract is usually treated as a necessary instrument to ensure agents to align their interests with principals’. However such contract can never make a complete forecast of the ex-post divergence. In order to eliminate the aberrant activities of the agent, principal must establish appropriate incentives and monitoring mechanisms. Both of those activities are also costly. The authors summarized the costs of the agency relationship as 1) the monitoring expenditures, 2) the bonding expenditures, and 3) the residual loss. Such concept of agency costs just makes a room for governance in a firm. In 1980, Fama further extended the work on the theory of the firm. He claimed that the classical agency theory fail to explain the functions of a large modern corporation, where the control of the firm is in the hands of managers who are separated from the firm’s security holders. The author believed that this separation of security ownership and control can be an efficient form of economic organization within the “set of contracts” perspective. According to Jensen and Meckling’s theory, the entrepreneur is not only a manager, but also a residual risk bearer. However, in the modern corporation, the separation of management and risk bearers exists. So, Fama pointed out that when looking at the risk bearing from the viewpoint of the portfolio theory, the risk bearers are likely to spread their wealth across many firms, and not interested in directly controlling the management of any individual firms. This efficient distribution of risk causes a large degree of separation of security ownership from control of a firm. As a consequence, big agency problems rise in a modern corporation. Grossman and Hart (1986) come up with an alternative definition of firm, which states that a firm is a collection of the assets that it owns. Base on this theory, they classified the contractual rights into two categories, which are specific rights and residual rights. Moreover, they define the ownership as the purchase of the residual rights. Since it is impossible to prepare a comprehensive CHAPTER TWO-LITERATURE REVIEW 16 contract ex-ante, the purchase of the residual rights is both meaningful and valuable. The authors claimed that it is meaningful because the ownership based on this purchase confers the right to make decisions in all contingencies unspecified by the initial contract; it is valuable because these residual rights can be important in bargaining the size of the ex post surplus as well as its distribution. Their incomplete contracting model creates a room for ex-post governance and because of the separation of contractual rights there may be incentives to optimally allocate the ownership among the firm. Rajan and Zingales (1998) put the theory of firm forward based on the concepts created by Grossman and Hart. They define the firm both in terms of the unique assets and in terms of the people who have an access to these assets. This definition expands the theory of firm by incorporating the theory of power in organizations. It explicitly recognizes that a firm is a complex structure that cannot be instantaneously replicated. In their paper, Rajan and Zingales interpreted the power within a firm, the role it plays and the origination of the firm. They suggest that access can be a better mechanism than ownership because the power from having access may be more contingent on a specific investment than the power of ownership. The ownership of physical assets is no longer the only source of power within a firm. This view of the firm well explains a variety of institutional arrangements as well as highlights the role played by an internal organization in enhancing the value of the firm. Although there are different views about the concept of a corporation, there is a common element among the corporate structure. That is when people enjoy the benefits of this business organization; they must pay for their loss of control. Investors lose control over the use of their capital; managers lose control over their sources of funding. The loss of control gives rise to conflicts between equity holders and managers. Therefore, mechanisms that eliminate the conflicts become more valuable to the corporations. Those mechanisms constitute the major part of the CHAPTER TWO-LITERATURE REVIEW 17 governance, which is more and more considered by individual investors, funds, banks, and other financial institutions. 2.2 What is Corporate Governance? The firm’s security holders are diversified across many of firms and they may not take a direct interest in the management of a particular firm. The ex post deviations from the contract set-up may also incentive a manager to consume more on the job than what has been agreed in his contract. These central questions arise: (i) How do the suppliers of finance get managers to return some of the profits to them? (ii) How do they make sure that managers do not steal the capital they supply or invest in bad project? (iii) How do suppliers of finance control managers? 8 Principal-agent problems arise from the separation of ownership and control between corporate outsiders and insiders. Considering this inherent conflict, there may be checks and balances on managerial behavior. Although economists and legal experts have raised concerns on the corporate governance, and its use as a defense of shareholders’ interests, there is no universally accepted definition of what the term corporate governance is defined. 8 Sheifer and Vishny (1997) CHAPTER TWO-LITERATURE REVIEW 18 Traditionally, corporate governance has been concerned with the issues of the exercise of choice and the creation of opportunities, and how choices and opportunities impact on institutions’ decision-making and accountability (Bird and Waters, 1987). Shleifer and Vishny (1997), however, consider corporate governance as an instrument that assures the suppliers of finance to corporations of getting a return on their investment. Robert and Nell (2001), present the definition of corporate governance as a relationship among various participants in determining the direction and performance of corporations. In Organization for Economic Co-operation and Development’s (OECD) definition, corporate governance structures are seen as mechanisms for making decisions that have not been specified by contract between principals and agents. Since it is costly to set up a comprehensive contract on exact tasks for the latter, Zingales (1998) defined the corporate governance as a complex set of constraints that shapes the ex-post bargaining over the quasi-rents generated by a firm. Within his definition, the corporate governance is considered as corporate authorities’ allocation which affects the process through quasi-rents distribution. Those authorities are include ownership, capital structure, managerial incentive schemes, takeovers, boards of directors, pressure from institutional investors, product market competition, labor market competition, organizational structure, etc. In summary, two conditions have made corporate governance critical to a firm. Firstly, agency problems exist in any form of business organization, as long as the interests between principals and agents differ. Secondly, because complete contracts are technologically infeasible, future contingencies are hard to describe and foresee. CHAPTER TWO-LITERATURE REVIEW 19 2.3 What Constitutes Corporate Governance? Broadly speaking, the principles of corporate governance can be explained from two perspectives. From a corporation’s perspective, corporate governance is about maximizing value subject to meeting the corporation’s financial, other legal and contractual obligations. From a public policy’s perspective, corporate governance is about ensuring accountability in the exercise of power and patronage by firms. Both perspectives provide a framework for corporate governance that reflects an interplay between internal incentives (which define the relationships among the key players in the corporation) and external forces (notably policy, legal, regulatory, and market)), which together govern the managerial behavior. The roots of investigating the characteristics of the internal and external features can be traced back to at least Berle and Means (1932), who argued that management ownership in large firms is insufficient to create managerial incentives for value maximization. Agrawal and Knoeber (1996) summarized the total internal and external factors into seven control mechanisms. The external mechanisms that discipline the firm’s performance include the production market competition, the market for corporate control, and the debt covenants. The internal contents consist of the shareholdings of managers, institutions, and large block-holders, and the use of outside directors. 2.3.1 External Forces Hart (1983) proposed the idea that the competition in the product market reduces managerial slack. The managerial slack is the outcome of the separation of ownership and control in a firm, and this separation gives the managers an opportunity to pursue their own objectives. The manager’s goals CHAPTER TWO-LITERATURE REVIEW 20 on growth maximization or effort minimization may be in conflict with the profit or market value maximization goals of the firm. However, the author pointed out that when a firm operates in a market, it will face the competition from other firms in the same industrial, and the competition makes the performance of different firms interdependent. Given this interdependency, when the cost of the firm is falls, other firm’s cost are also likely to be low. The managers are only allowed a partial reduction in the slack. Thus, the competition in the product markets is a necessary but not enough form of discipline on managers. Competition in capital markets also plays an important role in eliminating the managerial slack. Corporate control of firms is always considered as an important component of the capital market. Economic evidence indicates that corporate control in the capital market benefit shareholders and society, and it has strong influence of the corporate organization form. The market for corporate control is often referred to as the takeover market, which is defined as a market in which alternative managerial teams compete for the rights to manage the corporate resources (Jensen and Ruback, 1983). Manne (1965) is one of the researchers who recognize the critical role of the market for corporate control. The causality of this control mechanism is the existence of a high positive correlation between corporate managerial efficiency and the market price of the company shares. The author interpreted that if the market price of the corporation’s common stock is low, and if a group of individuals or another corporation believes it could manage the corporation more efficiently, it has the incentive to purchase the corporation and increase its value from an improved management. If the purchase were to occur, it is likely that the new owners would fire the management, because they believe that it is the poor management that causes the corporation’s suboptimal performance. Consequently, the threat of a takeover installs a scheme for the market for corporate control, which CHAPTER TWO-LITERATURE REVIEW 21 enforces competitive efficiency among corporate managers, and thereby protects the interests of the small and non-controlling shareholders. The findings of Grossman and Hart (1980), Jarrel, et al (1988), Jensen and Ruback (1983), Jensen (1988), and Instefjord (1999) also indicate that the market for corporate control induces wealth creation in various ways. Which include a reduction in wasteful bankruptcy proceedings, a more efficient management of corporations, protections for non-controlling corporate investors, an increased mobility of capital, and a more efficient allocation of resources. Jensen’s (1986) free cash flow theory indicates that takeover is an imperfect mechanism for companies, where management has access to significant discretionary cash flows. The management will be reluctant to use outside capitals, which will otherwise subject them to the monitoring of the capital market. Since the existence of free cash flow has negative implications for takeover activity, Jensen advocates debt creation, which comes with mandating interest payments, as a good alternative control to minimize the agency conflict. The threat of the failure to make debt service payments serves as an effective force that motivates the management of the firm to be more efficient. Shleifer and Vishny (1997) also discussed the debt contracts as a specific governance arrangement. They said the defining feature of debt that transfers the control rights to creditors reduces agency cost. These controls prevent a manager from investing in negative net present value projects, and on the other hand force him to sell assts that are worth more in alternative use. However, Jensen, Shleifer and Vishny also emphasize that while debt contracts may be beneficial in reducing the agency problem; increased leverage also has its associated costs. Firstly, debtors may prevent firms from undertaking new projects, because debt covenants restrict them from CHAPTER TWO-LITERATURE REVIEW 22 raising additional funds. Secondly, bankruptcy may also increase costs. Because of these costs, debt contracts may not always have positive control effects. Therefore, an optimal debt-equity ratio, as suggested by Jensen at a point where the marginal costs of debt just offset the marginal benefits, should be adopted by firms. While the external forces of corporate control are powerful instruments in disciplining managers and ensuring that they will behave corresponding closely to shareholders’ wishes. However these mechanisms alone cannot solve the whole problems of corporate governance. Whidbee (1997) finds that the effectiveness of external control mechanisms is weak in some industrial sectors. For example, the market for corporate control through hostile takeover is rare in the banking industry. The majority of bank acquisitions are friendly rather than hostile. In this situation, alternative monitoring mechanisms like internal incentives and monitoring mechanisms assumes an important role. 2.3.2 Internal Monitoring and Incentives In its narrowest sense, corporate governance can be viewed as a set of arrangements internal to the corporation that defines the relationship between managers and shareholders. At the center of this system is the board of directors, so the key internal governance mechanism is the rules for selecting the directors. Since the most important right adhered to the shareholders is the right to select the board of the directors, ownership structure should be the foundation of the internal arrangements. Since both ownership structure and board composition constitute a major part of internal mechanisms that reduces the agency problems in companies, an extensive theoretical and empirical research that investigates determinants of ownership structure and board composition has been conducted in recent years. CHAPTER TWO-LITERATURE REVIEW 23 2.3.2.1 Determinants of Managerial Ownership and the Link between Ownership and Performance The ownership structure is measured by the allocation of shares among insiders and outsiders (Jensen and Meckling, 1976). Agency problems arise when there is a potential conflict of interest between corporate managers and dispersed shareholders, and when managers do not have an ownership interest in the firm. Jensen and Meckling divide stockholders into two groups—an inside shareholder who manages the firm as well as has exclusive voting rights, and the outside shareholders, who have no voting rights. They also show how the allocation of shares among insiders and outsiders can influence the value of the firm. Following Jensen and Meckling paper, studies in the determinants of managerial ownership and the link between ownership and firm value have expanded rapidly in both the theoretical and the empirical fronts. Based on the theory of principal-agent, managerial ownership is well known as an important component of the ownership structure. There is an extensive theoretical literature explaining the empirical link between managerial ownership and firm performance. However, the interpretations in these studies remain ambiguous. The role of insider ownership is complex. While it aligns the interests of managers and shareholders and thus enhances performance, it also creates managerial entrenchment, which adversely affects performance. Morck et al. (1988) find evidence of a significant nonmonotonic relationship, when estimate a piecewise-linear relation between the fractions of shares owned by corporate insiders and Tobin's Q, using cross-section data of 371 fortune 500 firms in 1980. The Tobin’s Q fist increases as insider ownership increases up to 5%, then falls as ownership increases to 25% and increases CHAPTER TWO-LITERATURE REVIEW 24 again slightly at a higher ownership level. McConnell and Servaes (1990) examine a larger set of Fortune 500 firms than those examined by Morck et al. and they find a significant curvilinear relation between Tobin’s Q and managerial ownership, with an inflection point at between 40% and 50% ownership. Hermalin and Weisbach (1991) analyze 142 NYSE firms and find that Tobin’s Q rises with ownership up to a stake of 1%. The relationship is negative in the ownership range of 1-5%, and it becomes positive again in the ownership range of 5-20%. It turns into a negative region when ownership level exceeds 20%. Kole (1995) compares the results in the recent studies that use different management stock ownership data and he shows that differences in firm size can account for the differences in the results of those studies. Holderness et al. (1999) analysis the relationships using a comprehensive cross section of 1,500 publicly traded U.S. firms in 1935 and compare the results with those using a modern benchmark of more than 4,200 exchange-listed firms for 1995. The shape of the performance-ownership relation in 1935 is similar to the pattern identified by Morck et al. However, the pattern was weaker in the 1995 samples. These studies generally interpret the positive relation at low levels of managerial ownership as evidence of incentive alignment, whereas the negative relationship at high levels of managerial ownership as evidence that managers become ‘entrenched’ and can indulge in non-value-maximizing activities without being disciplined by diversified shareholders. In contrast, Demsetz (1983) argues that the ownership structure of the firm that ‘emerges is an endogenous outcome of competitive selection of an equilibrium organization of the firm that balances various cost advantages and disadvantages’. Therefore, Demsetz points out that there is no relationship between ownership structure and profitability. Demsetz and Lehn (1985) provide additional evidence to support Demsetz’s conclusion. They investigate the accounting profit rate of 511 U.S. companies in 1980 on different measure of ownership concentration, and find no CHAPTER TWO-LITERATURE REVIEW 25 significant correlationship. Himmelberg et al. (1999) extend the cross-sectional results of Demsetz and Lehn (1985) using panel data and show that managerial ownership is explained by key variables in the contracting environment. In other words, after controlling both for observed firm’s characteristics and firm’s fixed effects, they cannot find a relationship between changes in managerial ownership and firm performance. Lauterbach and Vaninsky (1999) empirically examine the effect of ownership structure on firm performance of 280 Israeli firms. They separate the sample firms into family firms, firms controlled by partnerships of individuals, concern controlled firms, and firms where blockholders have less than 50% of the vote. The results show that owner-manager firms are less efficient in generating net income than firms managed by a professional (non-owner) manager, and that family firms run by their owners perform (relatively) the worst. Associated with the ownership structure, the board of director is also an important internal device in the agency literature to provide monitoring functions to resolve, or at least mitigate, agency conflicts between management and shareholders. 2.3.2.2 The Determinants of Board Composition and Board Effectiveness The agency theory describes a significant role of the board of directors in the organizational and governance structure of typical large corporation. Fama and Jensen (1983a) discuss the role of market and organizational mechanisms in eliminating the agency conflicts and better aligning management interests with equity holders or residual claimants, who are largely diffused. Among the most important organizational controls is the board of directors. The board is considered to have three main missions in a firm, which includes providing advice and counsel to management, serving as disciplinarian, and acting in crisis situations. CHAPTER TWO-LITERATURE REVIEW 26 The primary role of the board of directors is presumed to carry out the monitoring function on behalf of the shareholders. Since it is difficult for shareholders to monitor the day-to-day decision made by the management, the board effectiveness in such function has attracted an extensive attention of scholars. The board effectiveness is dependent on three characteristics of a board: board composition, board independence, and board size (Kose and Lemma, 1998). Hermalin and Weisbach (1988) conduct an empirical study on the determinants of board composition by using 142 firms’ data from 1971 to 1983. Two general hypotheses have been presented in the paper. Firstly, they find that the board composition is associated with the internal promotion and the CEO-tenure. Insiders may leave the company at the beginning of a new CEO’s tenure if they feel that they have little chance to become the next CEO. In addition, a new CEO may have less power than an established CEO in selecting his own board. Their findings also show a positive correlation between poor performance and the removal of insiders and the hiring of outsiders. Since poor performance is an indication of ineffectiveness management behavior, there is a need for greater monitoring of management. Therefore, poor performance will cause insiders to leave the board and outsiders to join the board. Although, the authors provide the agency explanations for the factors that lead to changes among corporate directors, they also point out the limitations of the explanations. On the other hand, Bathala and Rao (1995) present empirical results that are consistent with the prediction of the agency theory. The results support the relationship between board composition and a number of agency cost and financial variables. By employing a cross-sectional estimation, they claim that the decision of individual firms to use an optimal board composition is not only depended upon alternative mechanisms employed by the firms, but also systematically related to the institutional holdings, growth opportunities, and CEO tenure. CHAPTER TWO-LITERATURE REVIEW 27 The common view in the empirical finance and agency literature is that the degree of board independence is closely related to its composition. The degree of board independence is assumed to be positively related to the presence of outside directors in the boardroom. According to Mace (1971), “the titles and prestige of (outside directorship) candidates are of primary important.” Outside directors are valued not only for their ability to monitor, but also for their ability to advise, solidify business and personal relationships, and signal that the company is doing well. While the impact of board effectiveness and the contribution of outside directorship to shareholder wealth and the discipline of top management have been widely examined, the evidence, thus far, on board composition and effectiveness is mixed. Fama and Jensen (1983) acknowledge the role of outside directors as arbitrators in disagreements among internal managers. Since the value of the outside directors’ human capital depends primarily on how they are able to limit the decision discretion of individual top managers. The authors hypothesize that the outside directors have incentives to develop their reputation as experts in decision control. Weisbach’s (1988) study on director incentives and CEO turnover supports the suggestion of Fama and Jensen. After controlling for ownership, size, market, and industry effects, he finds that CEOs are more likely to be removed following poor performance, if outside directors have voting control. Thus, outside directors are assumed to be good at representing shareholder interests. The empirical work conducted by Brickley and James (1987) shows that there is a significantly negative relationship between the proportion of outside directors on boards of banks and the regulations of banking acquisitions. This result suggests that outside directors play a major role in evaluating takeover proposals. They also find that where corporate-control market is weak in disciplining poor management, boards dominated by outside directors improve managerial control in the firm. CHAPTER TWO-LITERATURE REVIEW 28 Rosenstein and Wyatt (1990) use the Center for Research in Security Prices (CRSP) financial data and announcements of outside director appointments from the Wall Street Journal to measure the wealth effects of these announcements for the period 1980-1985. They find significant positive excess returns around the days of the announcements by using the standard event study methodology. Thus, announcements of the appointment of an outside director are associated with an increase in shareholder wealth. Additional evidence on the importance of corporate board, and particularly outside directors in improving shareholder wealth is also found by Byrd and Hickman (1992). Examining 128 tender offer bids made from 1980 through 1987 to 111 firms, they find that the average announcement-date abnormal return is significantly less negative for bidding firms, where at least half of the board seats are held by independent outside directors. Using cross-sectional piecewise regressions, they find a curvilinear relationship between the proportion of independent directors on the board and the bidding firms’ announcement-date abnormal returns. The positive relationship turns into negative when the fraction of the independent director reaches at a 60% level. Similar results have been reported by Brickley et al (1994). In order to shed some new lights on the debate of the monitoring function provided by outsider directors, the authors take an event study methodology by looking at a sample of firm adopting poison pill. 9 The sample consists of 247 firms adopting poison pills over the period 1984-1986. The main finding of the paper is a statistically significant, positive relation between the stock-market reaction to the adoption of poison pills and the fraction of outside directors. This is consistent with the hypothesis that outside directors represent shareholder interests. 9 “A tactic used by a company that fears an unwanted takeover by ensuring that a successful takeover bid will trigger some event that substantially reduces the value of the company”—Dictionary of Business, Oxford University Press, 2002. CHAPTER TWO-LITERATURE REVIEW 29 The same hypothesis has also been tested by other studies. Borokhovich, et al (1996) documents a strong positive relationship between the percentage of outside directors and the frequency of outside CEOs’ succession. Evidence from stock returns around succession announcements indicates that, on average, shareholders’ wealth increase due to the outside appointment, but the wealth is reduced when an insider replaces a fired CEO. Maug (1997) focuses monitoring function of outside directors on a corporate restructuring problem. The model discussed in the paper shows how independent directors can be regarded as an institution that regulates the relationship between shareholders and managers, in a world where contracts are incomplete. Mayers, et al (1997) find that life insurance firms that change from stock to mutual ownership increase the percentage of outside directors, while property/casualty firms that switch from mutual to stock ownership reduce the percentage of outside directors. They suggest that monitoring by outside directors is compensated for the lack of a credible external monitoring mechanism in mutual firms. Although many scholars consider the board of directors as a potential mechanism to provide an effective monitoring of managers, several board and outside director characteristics suggest that outside directors will not necessarily act in shareholder interests. Firstly, in a general situation, insiders (CEO, managers) inherently dominate the board’s decision in choosing the outside directors and providing the information they analyze. If management incentives are not aligned with those of shareholders, they will nominate outside directors who are more inclined to support CHAPTER TWO-LITERATURE REVIEW 30 their decisions. 10 Secondly, interlocking 11 directorship may reduce the willingness of outside directors to challenge the CEO. Finally, outside directors who are appointed for their expertise in a narrow area may feel uncomfortable in challenging the management’s decisions that are beyond their area of expertise. Demsetz (1983) suggests that “the board of directors can do very little to improve on the powerful incentives that presently guide management to serve the interests of shareholders”. He further interprets that since executive compensation contracts, the pressures of the competition of product market and the market for corporate control will provide adequate monitoring of corporate managers. Additional monitoring function by the board of directors cannot improve and could possibly impose a harmful constraint on an optimal management. Fosberg (1989) employs a paired sample methodology to test the relationship between the proportion of outside directors and various measures of firm performance. The study assumes that if the management is poorly supervised by the board of directors, it will be easy for the management to act in ways benefiting itself personally and/or not engaging in value-maximizing investments. Therefore, the value of a firm can be affected by each of these actions. Firms with well-disciplined management will not experience these distortions in their cash flows. Consequently, if outside directors are useful in disciplining management, there should be differences among the cash flows of companies where outside directors’ monitoring is strong vis-à-vis those with weak monitoring. However, the empirical results do not confirm the hypothesis that the presence of outside directors enhances firm performance. Specifically, no relationship is found between the proportion of outside directors in the board and various variables used to gauge the firm performance. Two explanations are offered for the findings. Firstly, the 10 This issue of outside directors’ independence has been discussed by Flanagan (1982), Vance (1983), Mace (1986), and Losrch and MacIver (1989). 11 The board of directors has careers that are tied with each other. CHAPTER TWO-LITERATURE REVIEW 31 management may succeed in getting outside directors elected to the board who are either incapable or unwilling to properly discipline management. Secondly, other mechanisms for controlling the agency costs associated with the separation of ownership and control effectively work in disciplining management, thereby leaving little room for the role of outside directors. According to the research for strategic implementation and organization control, Baysinger and Hoskisson (1990) state that the outside directors do not have access to information that is normally privileged to inside directors. They serve on several boards, but may not be able to have full understanding and knowledge of each business to be truly effective. Hermalin and Weisbach (1991) argue that the residual agency problems are similar in the individual firm and the variation in the firm performance should therefore not be correlated with the actions taken to reduce such agency problems through board composition. They collect a panel data of 142 NYSE firms and test the differences in firm performance with regards to the board composition and ownership structure. The findings of the paper show that both inside and outside directors is equally ineffective in representing the shareholders’ interest. The results may be influenced by the top management’s control in the board-selection process. Jensen (1993) also claims that the board of directors, the center of the internal control system, cannot protect the corporation assets properly. By referring to the cases of GM, Kodak and IBM, the author points out two shortcomings of the internal control systems. Firstly, the reaction took by the internal control against the poor management is too late. Secondly, it will take a long time for the internal control system to make a change. Therefore, the author claims, “ineffective governance is a major part of the problem with internal control mechanisms”. Warther (1998) builds a model to reconcile the opposing opinions on the board effectiveness for CHAPTER TWO-LITERATURE REVIEW 32 the monitoring function. As the two opposing camps concentrate on different dimensions of the board, the conclusions are not as contradictory. The ineffectiveness-boards viewpoint focuses on the board’s behavior; however, the effective-boards viewpoint concentrates on the board’s disciplinary effect. In the model, author assumes that because the board members’ utility is a function of both the firm’s performance and their continued membership on the board, “the board of directors occupies a position somewhere between perfect alignment with control management or shareholders”. Finally, the prediction of the model shows that although individual board members are always reluctant to step forward to oppose the management, they can still be treated as an important source of discipline. In order to increase the efficiency of the board of directors, the Cadbury Committee 12 has put forward a number of suggestions for changing the structure of the board. Among other things, the committee has recommended that the chairman of the board should (usually) be independent. Since the premiere role of the board of directors is to monitor and discipline the performance of top management, allowing the CEO to fulfill the same role as chairperson of the board is thought to compromise the desired system of checks and balances. Thus, a dual leadership structure of a board is also considered as another important component that can affect the independency of the board of directors. The ‘dual’ board leadership structure is a case of having two different people in the chairman of the board and the chief executive officer (CEO) positions. 13 The proponents of dual leadership structure maintain that the combination of the role of CEO and chairperson would limit the monitoring function of the board of directors. Firstly, non-independent leadership may constrain the board independence and reduce the possibility that the board can properly execute its 12 The Cadbury Committee was appointed by the Conservative Government of the United Kingdom in May 1991 with a broad mandate to “…address the financial aspects of corporate governance”. 13 The definition of the dual leadership structure used here is similar to the terminology used by Fosberg and Nelson (1999). CHAPTER TWO-LITERATURE REVIEW 33 governance role (Lorsch and MacIver, 1989; Fizel and Louie, 1990). Secondly, this kind of leadership structure signals the absence of the separation of decision management and decision control (Fama and Jensen, 1983). Finally, insecure directors will not have the shareholders interests in mind when evaluating management performance, which in turn, erodes the long-term organizational wealth. Based on the earlier arguments, there is a hypothesis that the choice between the duality versus the non-independent board leadership will influence the organization performance. Empirical tests of this hypothesis have been conducted in several papers. Rechner and Dalton (1991) examine the financial implications for the choices of board leadership structure with a sample of 141 corporations over a 6-year time period. 14 The results indicate significant differences in the performance between the two groups of firms with different leadership structure in performance measures. It is especially notable that firms adopting dual leadership consistently outperformed those relying upon non-independent leadership. Pi and Timme (1993) further contend that the unitary leadership structure (the same person wearing two hats—CEO and chairman of the board) exacerbates the principle-agent conflicts because of the consolidation of the decision management and the decision control processes. The findings provide insights into the impact of concentration of decision making with decision control on performance in banking sector. It is evident that banks with a dual leadership structure are more profitable and are more cost efficient than those with a unitary leadership structure. Fosberg and Nelson’s (1999) study test two theories that explain why some firms adopt a dual 14 In this paper, authors use different terminology from Fosberg and Nelson. Dual means that a board leadership structure in which the CEO wears two hats—one as CEO of the firm, the other as chairperson of the board of directors. CHAPTER TWO-LITERATURE REVIEW 34 leadership structure: the agency problem theory and the normal succession theory. They employ time series data of leadership structure changes of 54 firms to investigate the relationship between leadership structure and firm performance. Although the results in this study support both theories, the evidence, however, shows that firms that use the dual leadership structure to control agency problems experience statistically significant improvements in performance over the three-year period following the leadership structure change. The previous studies have provided strong evidence on how various governance mechanisms can limit the agent’s self-serving behavior, they do not; however, explain the relationship among those mechanisms. Some recent studies on the issue of endogeneity governance mechanisms will give different perspectives of the theory of corporate governance with particularly respect to the interaction between governance mechanisms. 2.4 The Endogeneity Issue There is an interaction between internal and external corporate governance mechanisms. In particularly, there is a substitution effect between the external devices for managerial control and internal mechanisms for control. Hermalin and Weisbach (1991) recognize the endogeneity problem among firm performance, board composition and CEO share ownership. The results offer further evidence on the substitution hypothesis. Using the Tobin’s q variable as a performance measure, and the ownership of management and board composition as explanatory variables, the authors find an interrelationship between insider ownership and board composition. Similar results are found by Barnhart et al (1994). They also show that both managerial ownership and board composition may be endogenous to performance. In the paper, they investigate the effect of board composition, which is determined by the proportion of independent outside CHAPTER TWO-LITERATURE REVIEW 35 directors, on the overall corporate performance by controlling for the managerial ownership. They use both ordinary least squares (OLS) and instrumental variable (IV) methods in the empirical analysis employing a sample of 369 firms. Both of those estimates indicate significant curvilinear relationships between the board composition and the firm performance. Many of the previous studies that examine effects of the corporate governance mechanisms on the firm performance did not put sufficient on the importance of the endogenity of internal and external control mechanisms. By considering the interactions of these mechanisms, Jensen et al (1992) empirically test the simultaneous relationships of insider ownership, debt policy, and dividend policy. The insider ownership is not a firm-specific attribute, authors argue that insider ownership and the choice of financial policies are directly related the operating characteristics of firms. The results support the proposition that financial decisions and insider ownership are endogenously determined. The level of insider ownership has a negative influence on the firm’s debt and dividend levels. Shivdasani’s (1993) uses a choice-based sample to estimate the impact of board and ownership structure on likelihood of the hostile takeover. Two significant results are found. Firstly, outside directors in hostile takeover targets have lower level of ownership than those in the in the nontarget. This result shows that, “the outside directors of hostile targets have a lesser financial inventive in monitoring managers”. Secondly, the ownership by large unaffiliated shareholders has a significantly positive effect on the likelihood of a hostile attempt, which suggests that those two control mechanisms are substitutable. Hirshleifer and Thakor (1994) provide a rigorous theoretical analysis of relationship between the board of directors and the takeover market. The paper develops a model in which the internal mechanism for corporate control (as represented by actions by the board of directors) and the CHAPTER TWO-LITERATURE REVIEW 36 external market for corporate control (as represented by the actions of a takeover bidding) are considered simultaneously. A sequential equilibrium is obtained as an outcome of this interaction between the board and the bidder. The model implies that unsuccessful takeover attempts may be followed by a high frequency of management turnover. The authors interpret this implication as that even though a takeover attempt is rejected, the board can infer form the bid that bidder possesses adverse information about the managers. Another implication is that when the board acts to maximize shareholder wealth, an active takeover market tends to substitute for the internal dismissal by the board. All these results provide the theoretical support for the testable hypothesis that takeovers and boards are substitutions devices in corporate governance. Agrawal and Knoeber (1996) conduct another study on the endogeneity issue among corporate control mechanisms and firm performance by including a large and more complete set of control mechanisms. They employ a sample of nearly 400 large U.S. firms of which they measure insider shareholding, institutional shareholding, shareholding of large blockholders, the composition of the corporate board (represented by the representation of outside directors on the board), debt policy, and use of the external labor market for managers, and takeover activity. An increase use of each mechanism yields a benefit by improving managerial incentives, but it also entails additional cost. They assume that the choice of any of those sever control mechanisms may depend upon the choice of the other six. Optimal choice is attained when marginal benefit of the use of an additional mechanism just offsets the marginal cost. They analyze all the corporate mechanisms in a system framework, and find evidence of interdependence among the control mechanisms. However, when they add the firm performance into the same framework, the effects of insider shareholding, firm debt, and corporate control activity become statistically insignificant. Only the effect of the outsiders in the board of directors persisted. This finding suggests that when the endogeneity of corporate governance mechanisms is recognized in the empirical analysis, the monitoring mechanisms appear to be insignificant in affecting the firm value. CHAPTER TWO-LITERATURE REVIEW 37 2.5 Governance Literature on Real Estate Investment Bathala and Rao (1995) have offered that firms may rely more on one or the other mechanism because of firm-specific marginal benefits and costs. Thus, firm specific and industry characteristics might be a determinant of the varying degrees of the different control mechanisms chosen by the firm. According to the previous financial literature, three main factors influence the governance problem. The first factor is asset specificity. When the product is standardized, competition in the marketplace will reduce governance issues. The second factor is information asymmetry. When information about a product is more widely known, the governance is less problematic. The final factor is contracts issue. When it is possible to write complete contracts ex-ante, the governance mechanisms are less important. Based on those identifies, Sirmans (1999) claims that the effectiveness of those issues might greater in the real estate investment. First, real estate is certainly specific because it is a fixed-in-location asset, it may be fitted with a specific tenant, and it may be of specific architecture. Second, because the valuation of the real estate assets is quite complex to the outsiders and its value is highly consistent to the local nature of the market, so the information of the real estate asset may be costly to obtain. So there do exist problem of information asymmetry. Finally, although real estate market has developed a unique set of contracts, such as mortgages, leases, to resolve the contracting problem, do real estate markets create greater potential for quasi-rents that must be dealt with ex post, e.g., cyclical nature of real estate investing create unique governance problem. CHAPTER TWO-LITERATURE REVIEW 38 Similar as Sirmans, some other real estate scholars also recognize that since Quasi-rent is a common element in real estate investment, there may be an opportunity for the slack in strict governance in real estate investment (Sirmans, 1999). Most of the literatures on the governance issues in the real estate investment are based on the US market mainly focusing on REITs. There are no or limited studies that examine the corporate governance in public property companies listed outside the US market. However, those studies on REITs provide a new perspective of corporate governance research and constitute a useful academic framework to guide other studies on governance issues in real estate investment activities around world. McIntosh et al (1994) test the relationship between a REIT’s stock price performance and the subsequent changes in top management. As the top managers’ contributions to firm value cannot be directly observed, the authors employed stock returns as a potential source of information in their empirical analysis. Using a logit analysis, their findings indicate an inverse relationship between the probability of a REIT management change and the stock price performance, which imply that the termination of top managers’ career is more likely to be a response to poor management performance. Cannon and Vogt (1995) empirically test the agency conflicts in REITs and explore whether ownership structure reduces such conflicts. They compared two REIT forms that are self-administered REITs and advisor REITs, and found that various forms of ownership do influence both performance and compensation. In the self-administered REITs, the executive compensation is positively influenced by the REIT’s annual market return. This explains that the use of ownership structure as a monitoring device among self-administered REITs is decreasing. In contrast, the ownership structure has significant influences on the market performance of advisor REITs. CHAPTER TWO-LITERATURE REVIEW 39 Friday et al (1999) report further evidence on the relationship between ownership structure and firm value, which is measured by market-to-book ratios for REITs over the period 1980-1994. Empirical estimations reveal a nonlinear relationship between the REIT market-to-book ratios and the ownership structure. Low levels of inside ownership are associated with increased market-to-book ratios for equity REITs. However, as inside block ownership rises above 5%, equity REIT market-to-book ratios decline. This result provides evidence on the entrenchment hypothesis associated with increased inside ownership. The authors claim that as inside ownership increases, the insiders become more entrenched and are able to pursue personal benefits at the expense of outside shareholders’, and they are also less prone to be ousted from their inside positions via the market for corporate control. Friday and Sirmans (1998) examine the influence of board of directors composition and characteristics on the real estate investment trust (REIT) shareholders’ wealth. They assumed that if the market perceives that if certain board characteristics represented by the percentage of outsider directors can effectively monitor and discipline the errant management behavior, the shareholders wealth can be maximized. A positive relationship should exist between REIT shareholder wealth (measured by firm market-to-book ratios) and the levels of the alignment in the monitoring mechanisms. Their empirical results also show that when outsider director representation increases above 50%, the benefits of additional monitoring provided by increased numbers of outside directors declines. Therefore the authors conclude that the benefits associated with an increase in number of outsiders in the board may be outweighed by the corresponding costs caused by poorer communication. Ghosh and Sirmans (2003) explicitly deal with the endogeneity problem of performance, board independence, ownership structure, and CEO characteristics and compensation in real estate investment in their models. They assume that the restrictions on the source of income, the asset, CHAPTER TWO-LITERATURE REVIEW 40 and ownership structure make REIT’s agency problems different from other industries. The effectiveness of alternative control and monitoring mechanisms is also varied with the REIT’s governance structure. The authors interpret that firstly, REITs are subject to the restrictive rule in the excess share provision, which makes the ownership structure quite dispersed in the REIT. This rule makes it more difficult for large outside blockholders to acquire stakes and pose any serious takeover threat. The rare occurrence of disciplinary takeover makes other monitoring mechanisms critical to the REIT performance. Secondly, REIT managers are insulated from hostile takeover threats, and this unique managerial arrangement in REITs reduces their incentive to exert themselves for greater performance. Therefore, internal monitoring mechanisms rather than externals are more important for REIT to reduce agency problems. In their empirical models they employ the managerial ownership structure (measured as CEO stock ownership), board composition (as represented by the proportion of the outside directors on the board), and firm performance (measured by ROI and ROE) in one simultaneous framework to address the endogeneity problems in the regression. The two-stage least squares results show that higher CEO stock ownership and control through tenure and chairmanship of the board reduces the representation by outside members on REIT boards, which in turn adversely affect the REIT performance. The greater representation by outside directors on REIT boards enhances performance, even though the relationship is weak. CHAPTER TWO-LITERATURE REVIEW 41 2.6 Corporate Governance Literature on Singapore Market After the Asian Financial Crisis in 1998, governments in some of the Asian countries have recognized that the sound governance practice can not only build up investors’ confidence, but also can enhance confidence in the market fundamentals. The issue of corporate governance has been brought up to a prominent situation. Because of the growing complexity of business activities and in the speed of globalization, Singapore has taken the lead in setting up the standards of corporate governance. However, theoretical and empirical studies that look at the impact of the unique characteristics of Singapore economy on the governance issue are still limited. Low (1999) does a case study of corporate governance in Singapore. She mentions that corporate governance in Singapore is based on the Anglo-American model. Several factors that have effects on corporate governance have been discussed in the paper. Firstly, the proportion of shares owned by blockholders is very high compared to many Western countries. The author explains that due to such high concentration and pervasive interlocking of ownership, the tight Singapore Exchange control and the large numbers of government linked companies the market for corporate control through a hostile takeover is rare in the local market. Secondly, the author points out that the continued government participation in many private sectors firms reduces their exposure to competitive markets and therefore, creates moral hazard problems through implied performance guarantees. Finally, the paper claim that the effectiveness of the board is affected by the difficulty of removing poor performing directors and appointing new ones due to the large stake held by directors, families and passive shareholders. Phan and Mak (1999) conduct an empirical study on the relationship between corporate governance and firm performance in different institutional environments compared to the Western economies. The following questions are examined in their paper: Is the structure of board CHAPTER TWO-LITERATURE REVIEW 42 independence related to firm performance? Are there differences in the firm performance between government-linked corporations and non-government-linked corporations? And are the ownership patterns related to firm performance? The results show that government linked companies (GLCs) have a negative relation with the firm performance, while those companies with a foreign ownership limits are strongly associated with higher returns on equity. Ownership structure characteristics are not related to firm performance. They also find that the Singapore corporate governance system could best be described as “a mix of regulation, judicial review, free market economics, and government intervention”. However, their study does not deal with the potential effects of the endogenous determinants among corporate control mechanisms. Mak and Li (2001) examined the determinants and interrelationships among corporate ownership and board structure characteristics by using a sample of Singapore listed firms. Their study replicates the approach used by Agrawal and Knoeber (1996) and assumes that corporate governance mechanisms of corporate ownership and board structure are endogenously determined. Their findings indicate that corporate ownership and board structures are interrelated, which suggest that: firstly, “firms with higher managerial ownership tend to have lower proportion of outside directors”. Secondly, “where a board has a high proportion of outside directors, it is more likely to be a small board”. Thirdly, “a dual leadership structure is more likely to be employed by firms with higher blockholder ownership and unregulated firms”. The results further support the argument that the corporate governance mechanisms are indeed endogenously determined and therefore do not affect firm value. The above studies have explored the effects of institutional factors on corporate governance in Singapore, but none of them looks at the governance issue in real estate investment. In a land scarce Singapore, real estate is an important corporate asset of many firms. Evidence has indicated that many non-property companies are highly asset intensive in Singapore (Liow, 2001). Owning CHAPTER TWO-LITERATURE REVIEW 43 and investing in real estate also constitute an important portfolio strategy of many investors. The direct real estate market activities will have significant long-term co integration relationship with the listed property firms’ performance (Ong, 1994, 1995). Therefore, it will be useful to empirically examine how the inherent characteristics of real estate investment will have influence on the choice of corporate governance mechanisms by property related companies compared to the non-property related companies. 2.7 Summary This chapter gives a comprehensive review of literature in the corporate governance. It covers a wide range of subjects ranging from the basic concepts of a corporation, the constitution of the governance, monitoring and incentive mechanisms, and the endogeneity problem exists among the governance mechanisms. The review is useful in helping to develop a cohesive theoretical and analytical framework for the estimation of corporate governance mechanisms in real estate investment. There three motivations why real estate investments, or more specifically, corporate governance in property and property intensive companies are selected for analysis in this thesis. Firstly, the separation of ownership and control is common in many securitized real estate firms; secondly, the inherent characteristics of real estate investment such as asset specificity, fixity by location, complex valuation method, are possible causes for the slack in strict governance in real estate investment. Finally, an understanding of the impact of institutions on the choice of governance mechanisms is necessary for evaluating whether more governance mechanisms should be installed to protect the equity holders’ interest in property and property intensive companies. Chapter Three INSTITUTIONAL ENVIRNOMENT AND CAPITAL MARKET IN SINGAPORE This chapter provides background information of the regulatory environment and corporate structure in Singapore. It will also review the market for corporate control and the financial disclosure requirement in Singapore. CHAPTER THREE-INSTITUTIONAL ENVIRONMENT AND CAPITAL MARKET IN SINGAPORE 45 Chapter Three INSTITUTIONAL ENVIRONMENT AND CAPITAL MARKET IN SINGAPORE 3.1 Institutional & Regulatory Environment Low (1999) pointed out that there are several shortcomings in the corporate governance system for Singapore listed companies. Firstly, the Asian’s culture influences the day-to-day decisions of firms, which means that people tend to avoid aggression and confrontation in their business dealings. Secondly, the regulations on takeovers in Singapore involve a mixture of self-regulation and legislative intervention. The market for corporate control is weak, which depends mainly on hostile takeover of poorly managed firms. As a result of the lack of legal backing and enforcement of these standards, “the quality of publicly-available corporate information is generally lower than in the Western developed countries” (Phan and Mak, 1999). The above weaknesses in the corporate governance system suggest that the principle of the decision management and decision control may be violated. Therefore, this institutional environment contributes to an owner-managers structure, which inclines to make decisions that may not align with the interests of minority shareholders. Furthermore, it is difficult for outsiders to monitor and control errant managers in this situation. 3.1.1 Market for Corporate Control More and more literature on Western market recognized the critical role of the market for corporate control (Manne, 1996). The threat of a takeover installs a scheme for corporate control CHAPTER THREE-INSTITUTIONAL ENVIRONMENT AND CAPITAL MARKET IN SINGAPORE 46 by the market, which enforces competitive efficiency and strict monitoring on corporate managers’ performance, and thus protects the interests of the majority of shareholders. However, the external mechanism for corporate control is weak in Singapore, where the occurrence of hostile takeovers is rarely witnessed. The Singapore’s “Code on Take-overs and Mergers” (hereafter referred to as the “Code”) is the main legislative guide for takeover and merger activities. According to Phan and Mak (1999) “The “Code” is non-statutory”, so this lack of the legislative enforcement may lead to a weak of the market for corporate control in Singapore. Firstly, the “Code” is issued by the Monetary Authority of Singapore under Section 321 of the Securities and Futures Act, and the “Code” is administered and enforced by the Securities Industry Council. The members of the Council are composed of representatives from the private sector and the public sector. Even though the Council has the power under the law to investigate any take-over and merger transactions, but it does not have the enforcement authority under the law. The main duty of the Council is restricted to the enforcement of good business standards, which is non-statutory. 15 The “Code” is divided into two parts: General Principles and Rules. The General Principles spells up the basic requirements for good commercial conduct. In addition, a series of Rules is included to supplement the General Principles with examples of their applications governing specific aspects of take-over procedure. Mr Ang Kong Hua (the Chairman of the Security Industrial Council) claimed, in “the Introduction Note of the Singapore Code of Take-overs and Mergers”, that “the two parts of the “Code” do not contain clear interpretation of the extent of or limitation 15 Source: The Singapore Code on Take-overs and Mergers. CHAPTER THREE-INSTITUTIONAL ENVIRONMENT AND CAPITAL MARKET IN SINGAPORE 47 on their application. The Council has the discretionary power to modify the precise meanings of the terms accordingly.” The high concentration of stockholdings and cross-share ownerships among public listed companies in Singapore render the market for corporate control ineffective. There are instances where common directors in both offorer and offeree companies are not unusual. A substantial shareholder in both cross-controlled companies may also appoint nominee in both companies. Therefore, a friendly merger rather than the hostile takeover is more preferred, if happened, between the two companies. 3.1.2 Financial Disclosure In December 1999, the Ministry of Finance, together with the Monetary Authority of Singapore and the Attorney-General's Chambers, set up three private sector-led committees to review corporate governance practices, disclosure and accounting standards, and corporate regulatory framework in Singapore. One of the committees is the Disclosure and Accounting Standards Committee whose major responsibility is to review the Singapore’s Statements of Accounting Standards ("SASs") with an objective of aligning them with the International Accounting Standards ("IASs"). However, as Phan and Mak (1999) commented, since IAS requirements are generally less detailed than the US’s Financial Accounting Standards Board (FASB) standards, financial disclosure in Singapore “tends to be lower than in more developed Western economies, such as the US, UK and Australia”. CHAPTER THREE-INSTITUTIONAL ENVIRONMENT AND CAPITAL MARKET IN SINGAPORE 48 Following the amendments to the Companies Act on 8 July 2002, the then Deputy Prime Minister and the Minister for Finance, Mr Lee Hsien Loong, also officiated the establishment of the Council on Corporate Disclosure and Governance ("CCDG") on 16 August 2002. The Council is tasked to prescribe new accounting standards for Singapore to replace the existing Institute of Certified Public Accountants of Singapore (ICPAS) standard. However, the ICPAS has played a pivotal role working in conjunction with the CCDG in the accounting standards setting process. With technical assistance of ICPAS, the CCDG has developed a set of Financial Reporting Standards (FRSs) and the Interpretation of Financial Reporting Standards (INT-FRSs). Both FRSs and INT-FRSs are prescribed in the Company Act. As a result, companies are obliged to comply with the newly changed accounting standards when preparing financial statements for the financial years beginning after January 1, 2003. In the US, a checklist is used by firms to ensure consistency in the disclosure of financial statement and proxy information by different companies (Phan and Mak, 1999). The authors point that “the checklist reduces variations in type of information disclosed,” and further more they standardize the format and structure of the information disclosed by different companies. The consistency and efficiency of the information in the capital market help the outside shareholders to better monitor the management of a firm. However, the similar checklist is not adopted in Singapore, which may be the reason why the levels of disclosure of information by firms are still varied (Phan and Mak, 1999). In 2001, the Singapore Exchange (SGX) revised its listing Manual. The Rule 710(2) of the SGX Listing Manual requires a listed company to describe and disclose its corporate governance practices with specific reference to the Code of Corporate Governance in its annual report. Prior to this revision, only few corporations disclosed their corporate governance activity in their annual CHAPTER THREE-INSTITUTIONAL ENVIRONMENT AND CAPITAL MARKET IN SINGAPORE 49 report. Goodwin and Seow (1998) pointed out that only 45.7% of companies classified the executive and non-executive directors in their annual report in 1996. 3.2 Corporate Structure in Singapore The strong presence and influence of government-linked companies (GLC) is a distinctive feature of the Singapore market. 16 Phan and Mak (1999) indicated that the Singapore’s government investments are channeled mainly via three vehicles, namely the Ministry of National Development Holdings (MND Holdings), Singapore Technology Holdings, and Temasek Holdings. There are more than 10% of the listed companies in Singapore are linked to the government, which holds almost more than 20% ownership in the companies. 17 These GLCs are often regarded as the market leaders in adopting new management practice in Singapore. As senior government officers are generally appointed to the senior management and the board in the GLCs, they are deemed to provide an indirect form of control and monitoring of the management in these companies. The indirect control through the presence of senior and experience government officers in the GLCs, may nonetheless create new and different types of governance issues in these GLCs vis-à-vis other non-GLCs. Firstly, according to Vernon and Aharoni (1981), GLCs must respond to a “set of signals from the government to which private managers are less alert. These signals are not related to profits but to goals associated with the well-being of the nation. These goals may be in conflict with the commercial objectives of the enterprise”. Secondly, since GLCs are usually funded by the government, and this may be deemed by many private lenders as a form of implicit guarantees of the liability of GLCs. Private lenders are less concerned about credit risks when they 16 In GLCs, the Singapore’s government is the largest controlling shareholder (20% or more ownership), and it is able to influence its governance, including its board composition. 17 Sources: the SGX website (www.singaporeexchange.com) and Financial Highlights of Companies on the Stock Exchange of Singapore (1991-1995), New York : Prentice Hall ; Singapore : Simon & Schuster CHAPTER THREE-INSTITUTIONAL ENVIRONMENT AND CAPITAL MARKET IN SINGAPORE 50 extend loan facilities to these GLCs. Therefore, GLCs are able to raise fund from the financial institutions and capital markets more easily compared to non-GLCs. The Business Times (4 March, 1997) reported that: “the fact that [GLCs] are part-owned by the Singapore government enables them to raise funds much more cheaply—by up to 4 percentage points lower—than others”. Finally, the government normally takes long-term objectives in the GLCs, especially in the strategic investments and businesses such as airline, telecommunications and others. These GLCs may be more protected in terms of external corporate control due to strategic nature of the businesses. The management may also adopt a more conservative and prudent approach in managing the investments. As a result, the GLCs are not fully exposed to the market competition, which may cause as a result the GLCs to be less efficient than other private companies, and they are also more prone to the agency problems. Another unique feature of the corporate structure in Singapore is the high concentration of ownership in a small number of shareholders, which is known as the blockholders. They are composed mainly of individuals, corporations, statutory boards and government (Low, 1999). The median proportion of shares owned by blockholders is 52.5% based on the financial information obtained from a sample of 228 SGX-listed firms in the financial year 2001. 18 The figure is high compared to many Western developed countries. In Japan and Germany, banks are prohibited to directly own a significant proportion of shares in companies. However, it is not uncommon for banks to crossly hold share in other listed companies, like the substation stake of UIC share held by the UOB bank. This situation is created partly because of the relatively undeveloped fund management industry and also the lack of interest of large international mutual funds in Singapore (Low, 1999). 18 The data are obtained from the blockholders holdings in corporations, which are disclosed in the annual reports of the companies listed on SGX in the financial year 2001 CHAPTER THREE-INSTITUTIONAL ENVIRONMENT AND CAPITAL MARKET IN SINGAPORE 51 Shleifer and Vishny(1997) suggest, large shareholders can facility the monitoring of managements by better aligning the cash flow and their control rights. However, they also found that large shareholders may have the opportunity to represent their own interests at the expense of the interest of minority investors. The concentrated ownership makes it difficult to mount takeover attempts without the support of these shareholders. The corporate structure helps to explain why hostile takeovers are so rare in Singapore. Another limitation of the corporate governance in Singapore is the relative small size of the capital market. The capital market is still thin in Singapore. There are only 386 listed companies on the main board of SGX with a total market capitalization of S$332 billion at the end of 2001. The capital is tightly held by a small group of investors such as the government, family-controlled corporations and financial institutions. Therefore, takeovers, if occurred, tend to be friendly rather than hostile. Thus, the discipline of an external mechanism on poor management is weak in Singapore. 3.3 Summary The institutional environment within which corporate governance is enforced in Singapore is quite different from that of the Western developed economies, such as the US and the UK. The capital market is thin and equity is tightly held by the several large investors in Singapore. The takeover is primarily composed of friendly mergers rather than hostile takeovers. The disclosure regulation is not as strict as that in US. As a result, the quality of publicly available corporate information in Singapore is also relatively poorer. The above characteristics, the dominance of government linked companies and the Asian’s way of management that are less confrontational contribute to a relatively weak governance mechanisms structure. The market for corporate control is also inadequate to discipline errant managers. Corporate control mechanisms like the internal CHAPTER THREE-INSTITUTIONAL ENVIRONMENT AND CAPITAL MARKET IN SINGAPORE 52 monitoring and the incentive mechanisms would play a more significant role in alleviating the conflicts between agents and owners in the Singapore. Chapter Four SAMPLE SELECTION AND DATA DISCRIPTION In this chapter we will cover the following subjects: ▪ Data collection ▪ Definitions of variables ▪ Source of data ▪ Descriptive statistics ▪ The Spearman correlations This chapter provides details on the procedure of data collection, definitions of the study variables, sources of the data, and the descriptive statistics for empirical samples. CHAPTER FOUR-SAMPLE SELECTION AND DATA DISCRIPTION 54 Chapter Four SAMPLE SELECTION AND DATA DISCRIPTION 4.1 Data Collection Due to the unique characteristics of real estate investment and institutional environment in Singapore, this study is motivated to examine and compare the level of corporate governance between public listed property companies and non-property companies in Singapore. It also evaluates whether alternative control mechanisms should be installed to protect the minority shareholders in real estate related companies. In 2001, the Singapore Exchange revised its listing Manual. The Rule 710(2) of the SGX-ST Listing Manual requires a listed company to describe and disclose its corporate governance practices with specific reference to the Singapore’s “Code on Take-overs and Mergers” in its annual report. Before this revision, there is limited information about corporate governance available publicly. Therefore, this study focuses only on the 2001 cross-section data of the companies listed on the SGX Main Board and the Second Board. The following criteria are adopted for the selection of sample companies in this study: 1. The firms must have been listed on the SGX for at least 2 years by the end of 2001; 2. There are annual reports for the firms; 3. Only Singapore dollar denominated stocks are selected; and 4. Annual report of the firms must contain information on corporate governance, which includes identities of chairman and CEO or its equivalent, such as the managing director. CHAPTER FOUR-SAMPLE SELECTION AND DATA DISCRIPTION 55 The data collection process is divided into three steps. Initially, the collection covers only companies listed on the property section of the SGX, which consist of 29 companies as at end of 2001. Out of the 29 sample firms, two of the firms are listed for less than 2 years, six are traded in foreign denominated currency, and another firm does not have details on the firm’s chairman and CEO. They are eliminated based on the above sample selection criteria, which as a result leaves only 20 listed property companies in our sample. The small sample of firms listed in the property sector of SGX is acknowledged as a limitation for the empirical analysis. In order to expand the sample size, “property intensive” non-real estate firms 19 are included in the sample in the second step of the data collection. These “property intensive” non real estate companies are expected to share some similar characteristics of the property firms because of the high level of property assets in their balance sheets. There are 357 companies (excluding property companies) listed on the SGX main board and 106 companies listed on the Stock Exchange of Singapore Dealing and Automated Quotation (Sesdaq) at as December 2001. Due to the highly regulated nature of the business operation, companies listed on the finance sector are excluded. Following the idea of Liow (2002), the 20 per cent of property assets’ holding is used as a criterion for the selection of these “property intensive” companies. The total number of companies under this category is 102, which represents 20.73 per cent of the total SGX listed companies. The total gross property holdings of these companies amount to S$27.47 billion as in 2001, which constitutes 46.62% of these non-real estate companies’ total assets. The property companies and the property intensive non real estate companies are collectively known as “property related companies” in this study. The total sample size is composed of 122 property-related companies. 19 Liow (2002) defines property asset intensity as the proportion of total fixed assets represented by property in a non real estate company’s asset structure. The cut-off point to identity “property intensive” non real estate firms is 20%, which is guided by several research studies to the effect that a benchmark portfolio should hold 20% real estate (Firstenburg, Ross, and Zisler, 1988). CHAPTER FOUR-SAMPLE SELECTION AND DATA DISCRIPTION 56 The 102 property intensive non-real estate companies are further divided into two categories based on three asset types held in their balance sheets, that are fixed properties, investment properties, and development properties. Some companies are willing to take significant property market risk by holding investment properties and/or development properties. Because of those property market risks, the day-to-day decisions made by the management of these companies are more similar to those involved in the property companies compared to other “property intensive” companies. The proportion of real estate held as both investment properties and development properties (PIDP) is computed as the ratio of the real estate holdings held as both investment properties and development properties over the average total assets. A 20 per cent cut-off point is used for the categorization purposes. 31 companies with higher property market risk exposure by holding more than 20% investment properties and/or development properties in their total property portfolio are classified into the group “taking property risk” companies. The remaining 71 property intensive non real estate companies are then classified into the “fixed property intensive” groups with lower property market risk exposure. Table 4.1.1 reports a summary of property asset holdings of the property intensive companies included in this study. Table 4.1.1 Property Asset Holdings of the SGX Non-real Estate Segments Segments Number of Take Property Risk Companies Fixed Property Intensive Companies Overall Average Property Asset Intensity (%) PIDP (%) Multi-industry Manufacturing Commerce Transportation/Storage /Communication 7 3 10 42.00 39.60 6 40 46 33.05 39.65 7 11 18 45.00 51.56 1 3 4 31.00 23.46 Construction Hotel/Restaurant Services Total 8 5 13 43.00 41.10 2 4 6 68.83 48.36 0 5 5 63.46 0 31 71 102 46.62 46.62 CHAPTER FOUR-SAMPLE SELECTION AND DATA DISCRIPTION 57 The third step of the data collection process includes the remaining firms listed on the SGX that meet the above four criteria, but not qualified as “property intensive” firms, to form a benchmarking group of companies for the comparative analysis. These “other companies” belong to the group with less than 20% property assets in their balance sheets and they have lower level of exposure to property market risk. There are 106 “other companies” listed on SGX. Therefore, the complete sample consisting of 228 firms listed on the SGX will be used in the subsequent empirical works. Following diagram shows the procedure in the data collection: Listed in Property Sector Property Related 20% Property Holdings Total Sample 228 Less 20% Property Holdings Listed Property Companies N=20 Property Intensive Companies N=102 Other Companies N=106 Higher Risk Lower Risk Take Property Risk N=31 Fixed Property Intensive N=71 4.2 Definitions of Variables In the empirical analysis, four sets of variables are categorically defined. Table 4.2 summarizes the definitions of the variables. CHAPTER FOUR-SAMPLE SELECTION AND DATA DISCRIPTION 58 Table 4.2.1 Definition of Variables: Variable Symbol A) Board Composition and Independence 1 2 3 4 Proportion of Outside (Independent) Directors Board Size Leadership Structure Proportion of executive directors OUTDIR BSIZE CEODUAL EXEDIR Definition Number of outside (independent) directors on the board divided by total number of directors. Total number of directors on board 1 where chairman is also the CEO or Managing Director, and 0 for dual leadership structure Number of executive directors on the board divided by total number of directors B) CEO Characteristics and Ownership Structure 1 CEO Ownership CEOWN 2 3 4 CEO Tenure Outsider Ownership Insider Ownership CEOTEN OUTOWN INOWN 5 Blockholders Ownership BLOWN Percentage of ordinary shares held directly and deemed by CEO or Managing Directors Number of years served by current CEO or Managing Director Percentage of ordinary shares held by outside directors Percentage of ordinary shares held by directors excluding CEO and outside directors Percentage of ordinary shares held by block shareholders who own 5% or more of these shares C) Firm Performance 1 Tobin’s Q Q Sum of market value of ordinary shares issued, book value of total debt, and book value of preference capital, divided by book value of total assets D) Other Firm Specific Variables 1 2 Firm Size Market-to-Book Value FSIZE MKTBOOK 3 4 DR GLC 5 Debt Ratio Government Linked Company Industry Dummy 1 ID1 6 Industry Dummy 2 ID2 7 Industry Dummy 4 ID3 Natural log of total market capitalization Market value of equity divided by book value, which presents the growth opportunity of the firm Total debt divided by total assets 0 where government holds a significant portion of shares (20% or more ownership) in a firm and 1 otherwise. 1 where the listed property companies, and 0 for the other property related companies 1 where the company belongs to “higher property market risk exposure companies”, and 0 for the other property related companies 0 where the company is property related companies, and 1 for other companies. 4.3 Source of Data There are two types of data used in this study that are the financial statement data and the corporate governance data. Cross sectional financial statement data for the 228 sample firms for the financial year 2001 are collected from DataStream®. These data include market-to-book value (MKTBOOK), debt ratio (DR), net income per share, book value per share, total market capitalization, and average total assets. Corporate governance data such as number of independent CHAPTER FOUR-SAMPLE SELECTION AND DATA DISCRIPTION 59 directors (OUTDIR), characteristics of CEO, shareholding of management (INOWN), ownership by outsiders and blockholders (OUTOWN and BLOWN), proportion of executive directors on the board, total number of directors on the board, and leadership structure of the board are taken from the annual reports of the sample companies. 4.4 Descriptive Statistics The summary statistics for the data are presented in Table 4.4.1. In addition, the comparative statistics of “other” companies and “property related” companies are presented and consolidated descriptive statistics for the total 228 sample companies are summarized in Table 4.4.5. Table 4.4.1 Descriptive Statistics (I): a) Listed Property Companies (N=20) Variable Mean Median Std Dev. Minimum Maximum OUTDIR BSIZE CEODUAL EXEDIR CEOWN CEOTEN OUTOWN INOWN BLOWN Q FSIZE MKTBOOK DR GLC 0.430 8.700 0.350 0.307 0.151 6.600 0.009 0.123 0.639 0.648 19.614 0.583 0.380 0.150 0.414 8.000 0.000 0.286 0.000 5.500 0.000 0.007 0.684 0.653 19.677 0.575 0.425 0.000 0.145 2.055 0.489 0.192 0.264 6.684 0.033 0.218 0.136 0.133 1.415 0.250 0.181 0.366 0.250 5.000 0.000 0.083 0.000 1.000 0.000 0.000 0.338 0.312 17.699 0.150 0.000 0.000 0.714 12.00 1.000 0.714 0.760 27.000 0.150 0.622 0.831 0.867 22.301 1.220 0.608 1.000 CHAPTER FOUR-SAMPLE SELECTION AND DATA DISCRIPTION 60 Table 4.4.1 Descriptive Statistics (II): b) Non-real estate companies with high property market risk exposure (N=31) Variable Mean Median Std Dev. Minimum 0.427 0.375 0.173 0.182 OUTDIR 8.258 8.000 2.160 5.000 BSIZE 0.484 0.000 0.508 0.000 CEODUAL 0.386 0.375 0.191 0.083 EXEDIR 0.202 0.153 0.231 0.000 CEOWN 10.194 8.000 8.750 1.000 CEOTEN 0.008 0.000 0.030 0.000 OUTOWN 0.212 0.177 0.240 0.000 INOWN 0.497 0.555 0.221 0.000 BLOWN 0.735 0.697 0.417 0.236 Q 18.694 18.430 1.364 16.320 FSIZE 0.977 0.750 0.853 0.080 MKTBOOK 0.292 0.304 0.161 0.000 DR 0.032 0.000 0.180 0.000 GLC c) Non-real estate companies with only intensive fixed property asset (N=71) Maximum Variable OUTDIR BSIZE CEODUAL EXEDIR CEOWN CEOTEN OUTOWN INOWN BLOWN Q FSIZE MKTBOOK DR GLC 0.833 13.000 1.000 0.750 0.750 31.000 0.150 0.900 0.889 2.410 21.502 3.610 0.589 1.000 Mean Median Std Dev. Minimum Maximum 0.413 6.817 0.549 0.439 0.279 12.254 0.003 0.255 0.429 0.720 17.638 0.926 0.242 0.042 0.400 7.000 1.000 0.500 0.290 8.000 0.000 0.201 0.463 0.656 17.488 0.720 0.229 0.000 0.129 1.815 0.501105 0.173 0.234 9.358 0.013 0.283 0.236 0.343 1.154 0.818 0.165 0.203 0.200 4.000 0.000 0.091 0.000 1.000 0.000 0.000 0.000 0.098 15.781 -2.050 0.000 0.000 0.800 12.000 1.000 0.750 0.716 39.000 0.095 0.986 0.871 2.276 20.679 4.050 0.575 1.000 Median Std Dev. Minimum Maximum d) Other Companies (N=106) Variable OUTDIR BSIZE CEODUAL* EXEDIR CEOWN CEOTEN OUTOWN INOWN BLOWN Q FSIZE MKTBOOK DR GLC* Mean 0.391 0.375 0.124 0.200 0.833 7.311 7.000 1.753 4.000 12.000 0.321 0.000 0.469 0.000 1.000 0.397 0.400 0.188 0.083 0.778 0.178 0.053 0.221 0.000 0.710 8.736 5.000 8.353 1.000 32.000 0.001 0.000 0.006 0.000 0.050 0.222 0.089 0.257 0.000 0.970 0.497 0.523 0.235 0.000 0.896 0.858 0.698 0.689 0.251 5.616 18.219 18.002 1.524 15.538 24.068 1.471 0.905 1.983 0.220 12.960 0.192 0.156 0.166 0.000 0.675 0.123 0.000 0.330 0.000 1.000 * For the dummy variables, the mean represents the proportion of firm with value equals to 1 for the variable. CHAPTER FOUR-SAMPLE SELECTION AND DATA DISCRIPTION 61 For the listed property companies, the number of shares owned by the CEO as a percent of the total number of common shares outstanding, ranges from 0% to 76.0%, with a mean and a median of 15.1% and 0% respectively. INOWN is the number of shares owned by insiders excluding the CEO, which is expressed as a proportion of outstanding shares. These inside directors own, on average, 12.3% of the outstanding shares. In the maximum, the insiders could hold over 62.2% of the outstanding shares. Compared to the shareholdings by insiders, the level of the outside ownership in property companies is low with a mean of 0.09%. However, the blockholder ownership is quite high with an average of 63.9% and a maximum of 83.1%. This study employs two proxies to measure the board independence. The first one is OUTDIR, which is the number of independent directors as a percentage of all directors in the board. Independent directors are identified based on the definition in the Singapore’s Code of Corporate Governance. The Code states that “an independent director is one who is free form any business or other relationship which could, or could reasonably be perceived to, materially interfere with the exercise of independent judgment and the ability to act with a view to the best interests of the company.” The proportion of independent directors in the listed property companies’ board stood at 43.0% on average. The second board independence variable is CEODUAL, the leadership structure of the board. More than half of the listed property companies (65.0%) adopt a dual leadership structure. The firm size ranges from S$ 17.699 million to S$ 22.301 million, with a mean of S$ 19.614 million. The market-to-book value (MKTBOOK) represents the growth prospects of the firms. The average market-to-book value is 0.583 with the maximum of 1.220 for property companies as of the financial year-ending 2001. The firm performance measured by Tobin’s q ranges from 0.867 to 0.312, with an average of 0.648. Three (15%) of the firms are government-linked company. CHAPTER FOUR-SAMPLE SELECTION AND DATA DISCRIPTION 62 For the non-real estate companies with “high property market risk exposure,” two outstanding share ownership related variables of these companies are higher than those of the listed property companies. The average CEO ownership is about 20.2% with a maximum of 75.0%, and the mean of the insider ownership is 21.2%. However, the blockholder ownership and outside shareholding level for this sub-sample are lower than property companies with a mean of 49.7% and 0.08% respectively. The average value for the proportion of the independent directors is 42.7%, with a minimum of 18.2% and a maximum 83.3%. Similar to the listed property companies, nearly half of these higher property risk companies’ board leadership structure is of dual type. The average service period of the CEO is about 10 years, which is longer than property companies’ CEO tenure ship. The average firm size is S$18.694 million and the range is from S$16.320 million to S$ 21.502 million. Only one company is government-linked company. The statistics of Property-intensive companies with only fixed property asset show that this sub-sample of the property related companies has the lowest level of the outside ownership with an average of 0.03%. However, it has the highest level of inside ownership and the CEO ownership of 25.5% and 27.9% on average respectively. The proportion of independent directors in the boardroom of this sample companies ranges from 20% to 80%, which is consistent with the numbers for other types of property related companies. The average service period of the CEO of more than 12 years is the longest among the three types of property related companies. Furthermore, the number of the “fixed property intensive” companies adopting the dual leadership structure is less than that of other types of property related companies. The influence of the debt holder is less significant for the “fixed property intensive” companies given an average debt ratio of 24.2%. CHAPTER FOUR-SAMPLE SELECTION AND DATA DISCRIPTION 63 Compared with the “property related” companies, the sample of “other companies” contains significant differences in several governance variables. Firstly, the level of shareholdings by the CEO of 17.8% on average in this sample is lower than that of the “property related” companies. With the exception of the insider ownership (INOWN), statistics for other ownership variables, like BLOWN and OUTOWN, are also smaller compared to “property related” companies. Secondly, given that the average proportion of the independent directors on the board is only about 39.1%, the influence of outsiders on the boardroom is relatively weaker in these sample companies. Another indicator of the board independence, CEODUAL, shows that more companies in this sample employ dual leadership structure than “property related” companies with a mean of 67.9%. Finally, the average debt ratio in this sample companies is less than 20% of total asset, which is lower than the 24% average debt ratio recorded by the “property related” companies. The above variables play a critical role in controlling the principal-agent problems. Differences in the governance variables between the “property related companies” and “other companies” are expected to have significant influence on the performance of these two groups of companies. The following Table 4.4.2 summarizes a consolidated descriptive statistics of the governance variables for the 228 sample companies. There are some features of the variables, which are not commonly observed in the Western markets. Based on the previous literatures, there are five major differences between the Singapore market and other developed market such as the US and European. CHAPTER FOUR-SAMPLE SELECTION AND DATA DISCRIPTION 64 Table 4.4.2 Consolidated Descriptive Statistics for Total Sample Firms: (n=228) Variable Mean Median Std Dev. Minimum Maximum 0.406 0.388 0.135 0.182 0.833 7.408 7.000 1.941 4.000 13.000 0.417 0.000 0.494 0.000 1.000 0.401 0.400 0.186 0.083 0.778 0.210 0.131 0.234 0.000 0.760 9.842 7.000 8.745 1.000 39.000 0.003 0.000 0.017 0.000 0.150 0.222 0.097 0.261 0.000 0.986 0.489 0.525 0.232 0.000 0.896 0.780 0.681 0.535 0.098 5.616 18.224 18.024 1.485 15.538 24.068 1.156 0.750 1.491 -2.050 12.960 0.238 0.217 0.174 0.000 0.675 0.088 0.000 0.284 0.000 1.000 * For the dummy variables, the mean represents the proportion of firm with value equals to 1 for the variable. OUTDIR BSIZE CEODUAL* EXEDIR CEOWN CEOTEN OUTOWN INOWN BLOWN Q FSIZE MKTBOOK DR GLC* Firstly, the average shareholdings by the CEO is about 21.0% in the Singapore companies, whereas, according to Denis and Sarin (1999), the CEO only holds 7.22% of company’ shares on average in the US. Secondly, the boards of listed companies in Singapore have a large proportion of outside directors with a mean of 40.6%. In comparison, Li (1994) has shown that in some developed countries such as the US, Canada, France, and Australia, companies have more than 60% outside directors on the board. The proportion of the independent directors in the Singapore boards is still more than those in listed companies in the UK and Japan. This indeed is a unique phenomenon in the Asian business context, where personal relationships and networks are common in the business dealings. One possible explanation is that because of the lack of market for corporate control in Singapore, the outside directors have greater responsibility to provide alternative governance mechanisms via outside independent directors. Thirdly, there is a high incidence of the separation of chairman and CEO positions in Singapore. Up to 58.3% of the sample companies report that they separate the chairman and CEO positions. By contrast, the study by Ghosh and Sirmans (2003) showed that most boards of REITs do not separate the chair and CEO positions. Only 38.5% of REITs have dual leadership structure. Fourthly, there is a large CHAPTER FOUR-SAMPLE SELECTION AND DATA DISCRIPTION 65 proportion of blockholder ownership with a mean of over 48.9% in Singapore market. This is much higher than the mean of 5.7% (Ghosh and Sirmans, 2003) for REITs in US. Finally, the board size in the sample companies in this study is small, ranging from a minimum of four to a maximum of 12. However, the banks’ boards in US can be as large as 30 or more (Phan and Teen, 1999). 4.5 The Spearman Correlations Some of the variables such as CEO ownership, CEO tenure, and insiders’ ownership have positively skewed distributions. This study employs the Spearman’s rs to test the correlation among the study variables. The Spearman correlations results are shown in Table 4.5.1. Table 4.5.1 reports several significant relationships. Firstly, the proportion of the independent directors on the board (OUTDIR) is positively related to the proportion of the shareholdings owned by the outsiders (r=0.264, p[...]... corporate governance as an instrument that assures the suppliers of finance to corporations of getting a return on their investment Robert and Nell (2001), present the definition of corporate governance as a relationship among various participants in determining the direction and performance of corporations In Organization for Economic Co-operation and Development’s (OECD) definition, corporate governance. .. corporate insiders and Tobin's Q, using cross-section data of 371 fortune 500 firms in 1980 The Tobin’s Q fist increases as insider ownership increases up to 5%, then falls as ownership increases to 25% and increases CHAPTER TWO-LITERATURE REVIEW 24 again slightly at a higher ownership level McConnell and Servaes (1990) examine a larger set of Fortune 500 firms than those examined by Morck et al and they find... corporate governance? ▪ What constitutes corporate governance? ▪ The endogeneity issue ▪ Governance literature on real estate investment ▪ Corporate governance literature on Singapore Market This literature review chapter sets up the framework for the theory of the corporate governance It covers the following questions: What causes the governance issue? What is the definition of the theory of corporate governance? ... is introduced by Coase (1937) In his seminar paper, he suggested that the introduction of the firm was mainly because of the existence of marketing costs There are costs incurred when operating in a market Forming an organization and allowing entrepreneur to directly allocate the resources can reduce some marketing costs He also emphasized that an entrepreneur must exert efforts to reduce cost in operations... is invariably dependent on the emergence and the form of business organization of a corporation of firms An understanding of the nature of the firm is essential in studying the question of why corporate governance matter There are many definitions of a firm in the economic and legal literature These definitions have been used in neoclassical economic theories that explain the transaction cost and principle-agent... seen as mechanisms for making decisions that have not been specified by contract between principals and agents Since it is costly to set up a comprehensive contract on exact tasks for the latter, Zingales (1998) defined the corporate governance as a complex set of constraints that shapes the ex-post bargaining over the quasi-rents generated by a firm Within his definition, the corporate governance is considered... heteroscedasticity in the model, when governance mechanisms are jointly included to explain the variations in firm performance Finally, by comparing the results from both OLS and 2SLS estimations, we can isolate the problem of endogeneity between governance mechanisms and firm performance, and evaluate how these determinants affect the explanatory relationship between the corporate governance and firm performance... of insiders and the hiring of outsiders Since poor performance is an indication of ineffectiveness management behavior, there is a need for greater monitoring of management Therefore, poor performance will cause insiders to leave the board and outsiders to join the board Although, the authors provide the agency explanations for the factors that lead to changes among corporate directors, they also point... providing the information they analyze If management incentives are not aligned with those of shareholders, they will nominate outside directors who are more inclined to support CHAPTER TWO-LITERATURE REVIEW 30 their decisions 10 Secondly, interlocking 11 directorship may reduce the willingness of outside directors to challenge the CEO Finally, outside directors who are appointed for their expertise in. .. of directors, it will be easy for the management to act in ways benefiting itself personally and/or not engaging in value-maximizing investments Therefore, the value of a firm can be affected by each of these actions Firms with well-disciplined management will not experience these distortions in their cash flows Consequently, if outside directors are useful in disciplining management, there should be ... other real estate scholars also recognize that since Quasi-rent is a common element in real estate investment, there may be an opportunity for the slack in strict governance in real estate investment. .. for the lack of strict governance in real estate investments compared to investments in other asset types (Sirmans, 1999) Ghosh and Sirmans (2002) empirically examine the governance in real estate. .. method, the governance may be more problematic in real estate than in other type industries Therefore, real estate investment must be a significant determinant for some particular governance practices