Do Investors Really Value Corporate Governance? Evidence from the Hong Kong Market Yan-Leung Cheung Department of Economics and Finance, City University of Hong Kong, Tat Chee Avenue, Kowloon Tong, Kowloon, Hong Kong e-mail: efsteven@cityu.edu.hk J. Thomas Connelly Faculty of Commerce and Accountancy, Chulalongkorn University, Bangkok 10330, Thailand e-mail: fcomtcn@acc.chula.ac.th Piman Limpaphayom Sasin Graduate Institute of Business Administration, Chulalongkorn University, Sasa Patasala Building, Phyathai Road, Pathumwan, Bangkok 10330, Thailand e-mail: piman.limpaphayom@sasin.edu Lynda Zhou Department of Economics and Finance, City University of Hong Kong, Kowloon Tong, Kowloon, Hong Kong e-mail: lyndazhou@msn.com Abstract To examine the relation between corporate governance and firm value, we develop an instrument to assess the corporate governance practices of listed companies in Hong Kong. Based on the Revised OECD Principles of Corporate Governance (OECD) and the Code of Best Practices (HKEx), we construct a corporate governance index (CGI) for Hong Kong listed companies. Unlike measures used in other studies, the CGI score reflects the presence of good corporate governance practices as well as variation in the quality of corporate governance practices. Empirical evidence shows that a company’s market valuation is positively related to its overall CGI score, a composite measure of a firm’s corporate governance practices. We also find that the transparency component of the CGI score drives the relation with market valuation. In summary, this study provides supporting evidence for the notion that, in Hong Kong, good corporate governance practices are consistent with value maximization. The authors are indebted to Herbert Hui, Peter Wong, and the Hong Kong Institute of Directors for financial support, and Charnchai Charuvastr of the Thai Institute of Directors Association for providing technical assistance. This project was substantially supported by a grant from City University of Hong Kong (Project no. 7001912). We also thank Cindy Chen, Sam Lam, Simon Lam, Justin Liang, Sarah Wan, and Sam Yang for their research support. Journal of International Financial Management and Accounting 18:2 2007 r Blackwell Publishing Ltd. 2007, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA. 1. Introduction The financial crisis of 1997 that swept through most of East Asia accentuated the need for corporate governance reform in the region. As part of the clean-up effort, numerous corporate governance reform initiatives have been launched, including regional (PECC, 2001) and international efforts (OECD, 2004). These initiatives are not without controversy. Many, particularly corporate representatives, feel that the costs of practicing good corporate governance may outweigh the benefits. They argue that investors do not care about corporate govern- ance practices when determining stock prices and that good corporate governance practices do not necessarily lead to value maximization. Others argue that good corporate governance is related to better firm performance and that firms with better corporate governance practices should perform better than those with relatively worse practices. Numer- ous studies have examined the relation between corporate governance practices and firm performance, but mostly in developed markets. Hong Kong provides a unique setting to study. Although in East Asia, the Hong Kong stock market has many characteristics and practices observed in developed economies, and international rating agencies rank Hong Kong as one of the more advanced markets in the region. This may be due in part to the legacy of an Anglo-Saxon legal system that influences corporate governance and regulatory practices. Hong Kong also has a well-developed financial market infrastructure, known for close and careful regulatory supervision. In addition, local accounting standards are being harmonized with international standards, allowing firms to cross-list in other markets. On the other hand, the Hong Kong market has many characteristics more commonly observed in developing economies, especially in Asia. Unlike the more diffuse ownership structures frequently found in devel- oped economies, Hong Kong firms normally have a closely intertwined management and ownership structure, with firms quite often being family owned and managed. It is common to find that the chairman of the board is also the chief executive officer in Hong Kong listed companies. 1 A report of the Corporate Governance Working Group of the Hong Kong Society of Accountants in December 1995 remarked ‘‘almost 90 per cent of listed companies have a major shareholder who by himself or with family members owns 25 per cent or more of the share capital.’’ Ownership structures have changed little following the financial crisis. A corporate governance report published by Standard & Poor’s in Do Investors Really Value Corporate Governance? 87 r Blackwell Publishing Ltd. 2007. 2002 echoes the previous statement, noting ‘‘the main weaknesses in the Hong Kong governance environment are less at the legal and regulatory levels than at the individual firm level. Standard & Poor’s recognized that family domination of companies’ ownership structure and the limited (though growing) shareholder activism culture present particular chal- lenges.’’ This highly concentrated, family dominated ownership structure means that the classic agency problem stemming from the separation of ownership (shareholders) and control (managers) is rarely observed in Hong Kong. However, this type of ownership structure often results in an opaque rather than transparent shareholding structure, potentially leading to a unique agency conflict between owners who are also managers (insiders) and minority shareholders (outsiders). This also means that market-disciplining mechanisms such as hostile takeovers cannot function properly in Hong Kong. 2 In sum, Hong Kong is an international financial center that combines characteristics of both developed and developing economies: concen- trated ownership of listed companies, family owned and managed firms, an Anglo-Saxon legal and corporate governance system, strong regula- tory oversight, and a weak market for corporate control. Thus, Hong Kong is a good testing ground to examine whether corporate governance influences firm valuation in a market where family ownership and concentrated shareholdings predominate. The objective of this study is to investigate whether there is a relation between corporate governance practices and firm valuation in Hong Kong. Are investors concerned with the good corporate governance practices of Hong Kong firms? Do better-governed firms perform better than firms that are more poorly governed? A positive relation between corporate governance practices and firm value will provide supporting evidence to the potential benefit of good corporate governance. Using publicly available information from publicly traded companies in 2002, we rate the corporate governance practices of the 168 largest firms constituting the four major Hong Kong stock indices. While this sample is only 15 per cent of the total number of listed companies, the firms chosen account for almost 90 per cent of total market capitalization and almost 80 per cent of the total market turnover. Previous efforts to measure corporate governance practices used surveys with a binary scale to note the presence or absence of a practice. This ‘‘box-ticking’’ approach has been criticized for not measuring the quality of corporate governance practices. The present study uses a newly 88 Y L. Cheung, J. Thomas Connelly, P. Limpaphayom and L. Zhou r Blackwell Publishing Ltd. 2007. designed survey to measure corporate governance practices. This unique measurement tool permits assessment of both the quality and quantity of corporate governance practices. The quality of corporate governance practices is captured using information provided in source documents. The addition of qualitative measures leads to a richer understanding of the relation between corporate governance practices and firm perfor- mance. Survey questions are derived from the Revised OECD Principles of Corporate Governance (OECD, 2004) and the Code of Best Practices (HKEx, 1999a). The survey is comprised of 86 questions addressing the five categories of the OECD Principles of Corporate Governance: rights of shareholders; equitable treatment of shareholders; role of stake- holders; disclosure and transparency; and board responsibilities and composition. The survey responses and qualitative values are combined to create a corporate governance index (CGI) score for each surveyed firm. The findings show that listed Hong Kong firms exhibit a wide disparity in the quality of their corporate governance practices. Overall CGI scores range from a low of 32 (out of 100) to a high of 77 for firms with good practices. The empirical findings offer compelling evidence that good corporate governance practices do matter in Hong Kong. A positive and statistically significant relation is found between the performance measures and the CGI, even after the inclusion of firm characteristics as control variables. The results are robust whether market-to-book ratio (MTBV) or return on equity (ROE) is used as the performance indicator. The results are also robust to the number of survey questions used in the index, up to a random reduction of 10 of the 86 questions. Of the five categories of the OECD Principles of Corporate Govern- ance, we find that disclosure and transparency are highly correlated with market valuation. To further examine the effect of corporate disclosure and transparency on firm value, we construct sub-indices for transpar- ency and non-transparency and find a positive and statistically significant relation between the transparency index and market valuation. The findings provide empirical support for the notion that, for Hong Kong listed companies, good corporate governance practices are consistent with value maximization. The remainder of this paper is organized as follows: Section 2 frames the study through a literature review; the data sources and study methodology are described in Section 3; Section 4 presents the results; and Section 5 concludes the paper. Do Investors Really Value Corporate Governance? 89 r Blackwell Publishing Ltd. 2007. 2. Literature Review Numerous studies have examined the relation between corporate govern- ance practices and firm performance, primarily in developed countries. These prior studies often concentrate on a narrow aspect of governance such as ownership structure, board composition, executive compensa- tion, or disclosure and transparency. These studies, taken together, often show conflicting results, indicating that the link between good corporate governance practices and superior firm performance is not clear. Differ- ent aspects of corporate governance have complex interrelations and may be complementary. Therefore, the lack of a particular aspect may be offset by the presence of other aspects. Looking first at the relation between ownership characteristics and firm performance, Morck et al. (1988) and McConnell and Servaes (1990) document a non-linear relation between insider ownership and firm value. These authors argue that ownership by firm insiders aligns the interests of insiders with the interests of outside shareholders, increasing firm value. However, as inside ownership increases, the entrenchment effects of inside ownership dominate and higher inside ownership becomes associated with a lower firm value. In contrast, Himmelberg et al. (1999) suggest that managerial ownership and firm performance are determined by a common set of characteristics and question the causal relation between ownership and firm performance implied by Morck et al. (1988). A series of studies finds that concentrated ownership may lead to more active monitoring, resulting in better corporate governance (Hill and Snell, 1988; Weiss and Nikitin, 2004). 3 Bhagat et al. (2004), however, do not find evidence supporting a positive association between ownership concentration and firm performance. In East Asia, the concentration of insider ownership is higher than in other regions of the world, making ownership concentration a critical factor (Claessens et al., 2000). Another major topic in the corporate governance literature is board composition, especially the impact of outside directors, that is, indepen- dent non-executive directors (INEDs). In 2002, at the time of this study, the board of each listed company in Hong Kong is required to have at least two INEDs. Beginning in 2005, the number of INEDs required increased to a minimum of three per company. Agency theory suggests that outsiders are important monitors of management and providers of relevant expertise central to the effective resolution of agency problems between managers and shareholders (Fama, 1980; Fama and Jensen, 90 Y L. Cheung, J. Thomas Connelly, P. Limpaphayom and L. Zhou r Blackwell Publishing Ltd. 2007. 1983). Independent directors play major roles in US and UK public companies. Bhagat and Black (2002) report that most large US public companies have independent directors making up a high proportion of the board. Faccio and Lasfer (1999) report that on average, non-executive directors make up 43 per cent of boards in the United Kingdom. In contrast, several researchers have raised concerns that outside directors lack the necessary time, expertise, and incentives and thus may not be able to make a meaningful contribution to shareholder wealth creation (Mace, 1986; Patton and Baker, 1987). Agrawal and Knoeber (1996) find a negative relation between the proportion of outside directors and firm performance among US firms. They posit that a political process within firms influences the selection of outside directors, and the directors may be less effective as they are beholden through the selection process. Bhagat and Black (2002) investigate US firms and find no significant relation between board independence and long-term firm performance. Klein (1998) finds no association between a firm’s committee structure and firm value. Neither activism of institu- tional investors (Carleton et al., 1998) nor ownership by outside blockholders (Bhagat et al., 2004) is found to have an important effect on firm value. Disclosure and transparency practices can also influence the extent and quality of a firm’s corporate governance practices. Recently, much effort has been focused on increasing the quality of corporate disclosure and transparency in the Asia-Pacific region. Bushman et al. (2004) define corporate transparency as the availability of firm-specific information to outside investors and stakeholders. This information is needed to make investment and resource allocation decisions. The levels of corporate transparency depend on firms’ willingness to disclose relevant informa- tion to the public. Disclosure and transparency can help protect share- holders’ rights, helping them to feel confident that the firm is being managed with their interests in mind. The divergence of findings in these studies may be due to different proxies being used to measure corporate governance. 4 The lack of consistency may also be attributed to the narrow focus of previous studies. Typically, studies consider one or at most a few components constituting corporate governance instead of a composite measure. Studies on the association between overall corporate governance practice and firm market value are limited, but work by Gompers et al. (2003), Black (2001), Bebchuk et al. (2004), and Brown and Do Investors Really Value Corporate Governance? 91 r Blackwell Publishing Ltd. 2007. Caylor (2006) examine this connection for US firms while Black (2001), Drobetz et al. (2003), and Black et al. (2006) do the same for non-US firms. Gompers et al. (2003) construct a governance index to proxy the level of shareholder rights with respect to takeovers. Their data are derived from Investor Responsibility Research Center (IRRC) publications that track 22 measures such as company charter provisions, bylaw provisions, and other firm-level rules, plus coverage under takeover laws of six states. Gompers et al. (2003) identify 24 unique provisions and build an index. They find evidence that firms with stronger shareholder rights have a higher firm value, higher profits, and lower capital expenditures. How- ever, they only consider takeover defense provisions and other provisions related to shareholder rights. Although their study makes an important contribution to the literature on takeover defenses in the United States, it is of limited relevance to Asian markets where hostile takeovers seldom occur. Bebchuk et al. (2004) construct an entrenchment index based on six provisions: staggered boards, limits to shareholder bylaw amend- ments, supermajority requirements for mergers, supermajority require- ments for charter amendments, poison pills, and golden parachute arrangements. The first four provisions measure the rights and participa- tion of shareholders and the last two provisions cover hostile takeovers. These measures are selected from a total of 24 governance provisions developed by the IRRC. They find that increases in the level of the entrenchment index are monotonically associated with significant reduc- tions in firm valuation. These authors also find higher firm valuation, as measured by Tobin’s Q, at firms with stronger shareholders’ rights. Brown and Caylor (2006) create a CGI based on 51 corporate governance provisions propounded by Institutional Shareholder Services. They find that better-governed firms are associated with both higher returns on equity and higher returns on assets. Compared with US market studies, recent research on emerging markets generates results that generally support a link between corporate governance practices and firm valuation. For Russian firms, Black (2001) finds a positive relation between corporate governance behavior and market performance; however, his result is based on a small sample of 21 firms. Drobetz et al. (2003) follow the approach of Gompers et al. (2003), developing a governance index and linking it to the performance of German firms. As with the original study, the conclusions from this takeover defense study for German firms throw limited light on Asian markets. Ho and Wong (2001) compare the effectiveness of different 92 Y L. Cheung, J. Thomas Connelly, P. Limpaphayom and L. Zhou r Blackwell Publishing Ltd. 2007. corporate disclosure practices in Hong Kong and identify ways to enhance communication between corporations and investors. Leung and Horwitz (2004) find that: (1) concentrated board ownership is correlated with low voluntary disclosure, and this negative relation is stronger when firm performance is very poor; (2) non-executive directors enhance voluntary disclosure for firms with low director ownership but not for firms with concentrated ownership. Black et al. (2006) create a governance score using a survey conducted by the Korean Stock Exchange and find that firms with higher scores have a higher market value. However, their survey relies on companies’ responses that could generate a selection bias in the data. There are other studies examining the relation between corporate governance and firm performance for Asian markets. Durnev and Kim (2005) use the Credit Lyonnais Securities Asia (CLSA, 2002) governance index and the S&P disclosure score (Standard and Poor’s, 2002) to measure corporate governance practices for a sample of 859 large firms in 27 countries. In their theoretical model, they identify three firm attributes (investment opportunities, external financing, and ownership structure) that relate to corporate governance and conclude that firms with higher scores carry higher stock market valuations. Klapper and Love (2003) use the CLSA governance index and find a positive correlation between market value and corporate governance for 374 firms in 14 countries. They also document a positive relation between governance and operat- ing performance as measured by return on assets (ROA). Mitton (2004) also uses the CLSA governance index to show that firms (365 firms from 19 countries) with stronger corporate governance have higher dividend payouts. However, despite its frequent use, the CLSA index has a fundamental limitation. The index is based on the judgment of security analysts, who would naturally be subjective, potentially creating bias in the data. From the literature review, measuring the quality of corporate governance practices is clearly an important issue. Previous studies only identify the presence of certain practices without considering the variation among those practices. Previous studies also narrowly define corporate governance and are thus applicable only to some parts of the world. Our study seeks to resolve these issues by creating a measurement scale that can detect variation in corporate governance quality. The measurement scale is also comprehensive, incorporating aspects of corporate governance practices accepted and recognized by international organizations. Do Investors Really Value Corporate Governance? 93 r Blackwell Publishing Ltd. 2007. 3. Data and Methods Our sample consists of the 168 largest companies 5 constituting the four major Hong Kong Exchange and Clearing Limited (HKEx) indices: Hang Seng Index (HSI), Hang Seng Hong Kong Composite Index (HSHKCI), Hang Seng China-Affiliated Corporate Index (HSCCI), and Hang Seng China Enterprise Index (HSCEI). The HSI is the most widely quoted performance indicator of the Hong Kong stock market. It currently has 33 constituent stocks, which cover about 70 per cent of the market capitalization of all eligible stocks listed on the Main Board of the HKEx. Constituents of the HSHKCI include the HSI constituent stocks plus the largest Hong Kong companies. The HSCCI and HSCEI constituent stocks are China-related companies; the HSCCI is for red- chip companies, while the HSCEI is for H-share companies. 6 Both H-share and red-chip companies are listed in Hong Kong. H-share companies are incorporated in mainland China while red-chip companies are incorporated in Hong Kong but are controlled (at least 35 per cent owned) by state, provincial, or municipal-owned organizations in China. The constituents of these four indexes are representative of all Hong Kong shares. Although the firms in the four indices account for 15 per cent of all listed companies, they account for almost 80 per cent of the Hong Kong market turnover and almost 90 per cent of the total market capitalization. Based on the Revised OECD Principles (OECD, 2004) and the Code of Best Practices (HKEx, 1999a), we develop a survey composed of 86 questions. 7 The question classification scheme matches the five OECD Principles: rights of shareholders; equitable treatment of shareholders; role of stakeholders; disclosure and transparency; and board responsi- bilities and composition. From the five OECD Principles, the questions are modified to be consistent with the Code of Best Practices (HKEx, 1999a) and make the questionnaire more applicable to Hong Kong firms. 8 The corporate governance practices of listed companies are examined from an outside shareholder’s perspective, using publicly available information an investor would use to make an investment decision. Our data sources include annual reports, articles of association, memor- andums of association, notices to call shareholders’ meetings, annual general meeting minutes, company websites, analyst reports, and other sources. After gathering the data, we rate each company on the 86 survey questions. To construct a CGI, each question within a specific survey category is weighted, as is each category: rights of shareholders (15 per 94 Y L. Cheung, J. Thomas Connelly, P. Limpaphayom and L. Zhou r Blackwell Publishing Ltd. 2007. cent); equitable treatment of shareholders (20 per cent); role of stake- holders (5 per cent); disclosure and transparency (30 per cent); and board responsibilities and composition (30 per cent). 9 Major questions under each category are equally weighted, and sub-questions under each major question are equally weighted as well. 10 We combine question scores within the five category sub-indices, which are then combined into an overall score. A total CGI value, ranging from 0 to 100, is then calculated for each company. The majority of questions (87 per cent) have a binary (yes, no) response. For the remaining questions, clear standards are used to evaluate the quality of corporate governance practices. There are three quality levels based on practices observed: good, matching international standards or best practice for Hong Kong firms; fair, that the practice meets but does not exceed the required standard; or poor, that the practice is below standard or missing. This feature of the questionnaire represents a major improvement in measuring the quality of corporate governance practices because it can capture variation in degrees of corporate governance practices. In addition, each company is assessed by two different raters to ensure consistency. The final results are cross- checked and audited by the research team. Once individual firm scores are complete, we examine the relation between the overall CGI scores and firm performance. A series of regression analyses are performed using both accounting performance and market performance as dependent variables. The regression model is given by MTBV ¼ a þ b 1 CGI þ b 2 ROA þ b 3 LnðTAÞþb 4 Current þ b 5 D=E þ b 6 BOUT þ b 7 BEXC þ b 8 Top5 þ b 9 DummyCEO & Chairman þ b 10 DummyAudit þ b 11 DummyCompensation þ b 12 DummyADR þ b 13 DummyMSCI þ b 14 DummyHshares & redchips þ e ð1Þ The dependent variable is a proxy of market valuation, the MTBV. This ratio provides an estimate of the total value of a firm (including intangible assets such as monopoly power, goodwill, high-quality man- agers, and growth opportunities) and reflects firm performance (Tobin and Brainard, 1968). MTBV is considered a better measure of firm performance than accounting measures (e.g., ROE or ROA) because it is based on market value, not just accounting earnings and is not affected by earnings management or accounting manipulations. The explanatory variable of interest is the CGI. The control variables used include Do Investors Really Value Corporate Governance? 95 r Blackwell Publishing Ltd. 2007. [...]... the ordinary least squares regression results using (i) market- to-book value (MTBV) and (ii) return on equity (ROE) as the dependent variables MTBV is the market value divided by the book value of common stock ROE is net income after taxes divided by the book value of equity CGI is the Corporate Governance Index; ROA is return on assets, Ln(TA) is the natural logarithm of total assets, Current is the. .. 45 50 55 60 65 70 75 80 Corporate Governance Index Figure 1 The relation between market value and corporate governance index (CGI) The correlation is statistically significant at the 5 per cent level r Blackwell Publishing Ltd 2007 Do Investors Really Value Corporate Governance? 103 CGI and the market value This implies that companies with higher corporate governance scores also have higher MTBVs,... firm values in Hong Kong Regression analyses between the CGI measure and explanatory and control variables should provide an additional insight Figure 1 provides the first indication of a possible relation between corporate governance practices and market valuation Using the MTBV as a proxy for market value, Figure 1 shows a positive and statistically significant correlation between the 10 9 8 Market Value. .. distinctions between H-shares and non-H-shares, leading us to argue that the differences in corporate governance between H-shares and non-H-shares are exogenous In order to be a valid instrumental variable, the H-share dummy (DummyH) needs to satisfy two conditions in the regression model First, r Blackwell Publishing Ltd 2007 Do Investors Really Value Corporate Governance? 113 the covariance between DummyH... overseas or dual listing could serve as an indicator of internationally accepted corporate governance practices.15 r Blackwell Publishing Ltd 2007 Do Investors Really Value Corporate Governance? 107 These dual-listed firms may need to comply with more stringent corporate governance rules when listing in a foreign market, which, in turn, can lead to higher market valuation The results do not support... incremental increases in CGI and the change in market value of the firm Notes 1 For example, for almost one-third of the 168 companies in our sample, the same person serves as the chief executive and the board chairman This figure for Hong Kong is quite different from the frequency of dual positions in the United Kingdom, despite the fact that the two economies have governance structures arising from Anglo-Saxon... instrumental variable to minimize endogeneity Each of these approaches will be discussed in the following sections describing the robustness tests Furthermore, we examine the relation between each of the five sub-indices of the CGI and market valuation to test whether any one of these sub-components is more significantly driving the relation To perform the analyses, the overall CGI scores are replaced in the. .. 1.99) The results show that the original ordinary least squares model does not suffer from endogeneity 5 Conclusion Considerable attention has been given recently to improving corporate governance practices among public firms in the Asia-Pacific region However, the critical question is whether enhanced corporate governance practices will benefit investors and companies and whether investors really value. .. and zero otherwise; DUMMYC equals 1 if the firm has a board compensation committee and 0 otherwise; DummyADR equals 1 if the firm has ADRs trading in the United States and 0 otherwise; DummyMSCI equals 1 if the firm is included in an MSCI index and 0 otherwise; and DummyHR equals 1 if the firm is a red chip or H-share and 0 otherwise The second-stage regression uses market- to-book value (MTBV) as the dependent... with the scores from the five survey sub-indices In their study on the association between overall corporate governance practice and firm market value for US firms, Bebchuk et al (2004) construct an entrenchment index based on six governance provisions out of a larger set of 24 The six chosen provisions are negatively correlated with firm value during the 1990–2003 sample period and better explain the relation . Do Investors Really Value Corporate Governance? Evidence from the Hong Kong Market Yan-Leung Cheung Department of Economics and Finance, City University of Hong Kong, Tat Chee. on the firms’ fiscal year ends. Firm market values and other performance data are Do Investors Really Value Corporate Governance? 97 Table 1. Variable Definitions Variables Descriptions CGI Corporate. (ROE) as the dependent variables. MTBV is the market value divided by the book value of common stock. ROE is net income after taxes divided by the book value of equity. CGI is the Corporate Governance