Corporate Governance Score and Firm Performance

Limited liability company structure is the most preferred structure for a large business. In this structure, a large number of investors provide the risk capital. They are called shareholders, the deemed owners of the company. They delegate the power to manage the company to board of directors. The board delegates the same to managers while retaining its role to monitor and control the executive management. Shareholders are viewed as the principal and the manager as their agents and this relationship is described as ‘principal-agent relationship’. The shareholders, of a widely held firm, practically do not have any control on the managers. They are only informed of the financial results on a periodical basis while the managers controls the firms’ assets. This structure provides an opportunity to the managers to expropriate shareholders’ wealth and misappropriate the funds by way of transfer of money as loans to his own companies, or sale of the company assets to themselves at a lesser price or pay themselves more perks. The divergence of interest between the owners and the managers, due to the separation of ownership from control, results in the agency costs.

It is not just separation of ownership and control that gives rise to the agency problem between shareholders and managers; but also the atomistic or diffused nature of corporate ownership, which is characterized by a large number of small shareholders. In such ownership structure, there is no incentive for any one owner to monitor corporate management, because the individual owner would bear the entire monitoring costs, yet all shareholders would enjoy the benefits. Thus, both the magnitude and nature of agency problems are directly related to ownership structures.

The fundamental theoretical basis of corporate governance is agency costs. The core of corporate governance is designing and putting in place disclosures, monitoring, oversight and corrective systems that can align the objectives of the shareholders and managers as closely as possible and hence, minimize agency costs. It deals with conducting the affairs of a company such that there is fairness to all stakeholders and that its actions benefit the greatest number of stakeholders.

There are two kinds of mechanisms to overcome the agency problem and hence, improve corporate governance viz., the internal control mechanisms and the external control mechanisms. Internal control mechanisms are internal to the functioning of a company and broadly consist of the board composition, the board size, the leadership structure and the managerial compensation. External control mechanisms are the mechanisms that are external to the functioning of the firm over which the firm has no control. An increasingly important external control mechanism affecting governance worldwide is the emergence of institutional investors as equity owners.

Although the role that the institutional investors can play in the corporate governance system of a company is a controversial question and a subject of continuing debate. While some believe that the institutional investors must interfere in the corporate governance system of a company, others believe that these investors have other investment objectives to follow. The group of observers who believe that institutional investors need not play a role in the corporate governance system of a company, argue that the investment objectives and the compensation system in the institutional investing companies often discourage their active participation in the corporate governance system of the companies. Institutional investors are answerable to their investors the way the companies (in which they have invested) are answerable to their shareholders. And the shareholders do invest their funds with the institutional investors expecting higher returns. The primary responsibility of the institutional investors is therefore to invest the money of the investors in companies, which are expected to generate the maximum possible return rather than in companies with good corporate governance records. While the other group strongly believes that if the corporate governance system in the companies has to succeed then the institutional investors must play an active role in the entire process. By virtue of their large stockholdings, they have the opportunity, resources, and ability to monitor, discipline and influence managers, which can force them to focus more on corporate performance and less on self-serving behavior. Most of the reports on corporate governance have also emphasized the role that the institutional investors have to play in the entire system.

Given the increasing presence of institutional investors in financial markets, it is not surprising that they have become more active in their role as shareholders. Activism by institutional investors has been both private and public, with the public activism being most visible in many countries. The role of institutional investors is visualized in two perspectives, the corporate governance and the firm performance.

7.2 Objectives of Study

In light of the above discussion, the present study attempts to achieve the following objectives:

• To construct the corporate governance score
• To establish relationship between institutional holdings and corporate governance score
• To establish relationship between institutional holdings and firm performance
• To establish relationship between corporate governance score and firm performance

In order to achieve the objectives stated above, the present study conceptualized the following null hypotheses for the validation of positive relationship between institutional holdings, corporate governance and firm performance

7.3 Hypotheses:

H01: Institutional/its components Holdings and Corporate Governance score are very closely related in a manner as to depict a positive relationship between the two

H02: Corporate Governance Score and Institutional/its components Holdings are also very closely related in a manner as to depict positive relationship between the two

H03: Institutional/its components Holdings and various measures of firm performance are very closely related in a manner as to depict positive relationship between the two

H04: Corporate Governance Score and various measures of firm performance are very closely related in a manner as to depict positive relationship between the two

7.4 The Sample Design and Data:

To achieve the above objectives, a sample of 200 companies has been taken. The present study is based on the secondary data. It covers a period of five financial years from 1st April 2004 to 31st March 2008. Institutional holdings are further segregated into three constituents. The mutual funds being the first one. The second constituent includes various public and private sector banks, all the developmental financial institutions (like IFCI, ICICI, IDBI, SFC) and insurance companies like the LIC, GIC, and their subsidiaries. The last constituent comprise of foreign institutional investors. Data has been collected on the institutional holdings in total as well as on different constituents of institutional holdings from nseindia.com. The secondary data regarding annual reports to construct the corporate governance score have been collected from respective company websites and sebiedifar.com. . The firm performance measures have been divided into two categories, one being the accounting measures while others are based on market returns. The accounting return measures include (%) return on networth, (%) return on capital employed, Profit After Tax, (%) Return on Assets, Net Profit Margin and Earning Per Share. Whereas, market return based measures include Tobin’s Q, (%) Risk Adjusted Excess Return and (%) Dividend Yield. Data for the study period on financial performance measures have been collected from Prowess Database.

7.5 Statistical Tools:

Simple linear regression analysis has been used as a statistical tool to investigate the relationship between different variables. An attempt has been made to ascertain the causal effect of one variable upon another. Data has been assembled on the variables of interest and employed regression to estimate the quantitative effect of the causal variables upon the variable that they influence. The study also typically assesses the ‘statistical significance’ at 5 percent level of the estimated relationships, that is, the degree of confidence that the true relationship is close to the estimated relationship.

Section A

7.6 Construction of Corporate Governance Score

Review of Literature

Some researchers have used board characteristics as an effective measure of corporate governance as Hermalin and Weisbach (1998, 2003) have used board independence, Bhagat, Carey and Elson (1999) have used stock ownership of board members and Brickley, Coles and Jarrell (1997) have used the occupation of Chairman and CEO positions by the same or two different individuals. Whereas, Gompers, Ishii and Metrick (2003) have constructed a governance measure comprising of an equally weighted index of 24 corporate governance provisions compiled by the Investor Responsibility Research Center (IRRC), such as, poison pills, golden parachutes, classified boards, cumulative voting, and supermajority rules to approve mergers. Bebchuk, Cohen and Ferrell (BCF, 2004) created an ‘entrenchment index’ comprising of six provisions – four provisions that limit Shareholder rights and two that make potential hostile takeovers more difficult. While the above noted studies use IRRC data, Brown and Caylor (2004) used Institutional Shareholder Services (ISS) data to create their governance index. This index considered 51corporate governance features encompassing eight corporate governance categories: audit, board of directors, charter/bylaws, director education, executive and director compensation, ownership, progressive practices, and state of incorporation.

In the present study, Corporate Governance Score has been developed on the basis of key characteristics of Standard and Poor’s Transparency and Disclosure Benchmark. Standard and Poor’s provides a range of corporate governance analyses and services, the crux of which is the Corporate Governance Score. Corporate Governance Scores are based on an assessment of the qualitative aspects of corporate governance practices of a company. Information has been collected on the attributes from the latest available annual reports of sample companies. The methodology, with 98 questions in three categories and 12 sub-categories, is designed to balance the conflicting requirements of the range of issues analyzed and the tractability of the analysis. Transparency and Disclosure is evaluated by searching company annual reports for the 98 possible attributes broadly divided into the following three broad categories:

• Ownership structure and investor rights (28 attributes)
• Financial transparency and information disclosure (35 attributes)
• Board and management structure and process (35 attributes)

Resume

Various researchers have considered alternate measures of corporate governance. Some of them have used single measure, while others have used the multiple measures in the form of indices. In the present study, Corporate Governance Score has been developed on the basis of key characteristics of Standard and Poor’s Transparency and Disclosure Benchmark because two broad instruments that reduce agency costs and hence improve corporate governance are financial and non-financial disclosures and independent oversight of management. Improving the quality of financial and non-financial disclosures not only ensures corporate transparency among a wide group of investors, analysts and the informed intelligentsia, but also persuades companies to minimize value-destroying deviant behavior. This is precisely why law insists that companies prepare their audited annual accounts, and that these be provided to all shareholders is deposited with the Registrar of Companies. This is also why a good deal of effort in global corporate governance reform has been directed to improve the quality and frequency of disclosures.

Section B

Relationship between Institutional Holdings and Corporate Governance:

Review of Literature

Coombes and Watson (2000) on the basis of a survey of more than 200 institutional investors with investments across the world showed that governance is a significant factor in their investment decision. McCahery, Sautner and Starks (2009) have relied on the survey data to investigate governance preference of 118 institutional investors in U.S. and Netherlands. The study found that the majority of institutions that responded to the survey take into account firm governance in portfolio weighting decisions and are willing to engage in activities that can improve the governance of their portfolio firms. Chung, Firth, and Kim (2002) hypothesized that there will be less opportunistic earnings management in firms with more institutional investor ownership because the institutions will either put pressure on the firms to adopt better accounting policies. Hartzell and Starks (2003) provided empirical evidence suggesting institutional investors serve a monitoring role with regard to executive compensation contracts. One implication of these results, consistent with the theoretical literature regarding the role of the large shareholder, is that institutions have greater influence when they have larger proportional stakes in firms. .

Denis and Denis (1994) found no evidence to suggest that there is any relationship between institutional holdings and corporate governance. They stated that if companies that create shareholders’ wealth are the ones with poor corporate governance practices, and then one really cannot blame the institutional investors for having invested in such companies. For, after all, a fund manager will be evaluated on the basis of stock returns he creates for the unit holders and not on the basis of the corporate governance records of the company he invests the money in. If however, one finds that companies with poor corporate governance practices are the ones, which have consistently destroyed shareholders’ wealth, then the contention that the institutional investors need not look at corporate governance records cannot be justified. David and Kochhar (1996) provided empirical evidence regarding impact of institutional investors on firm behaviour and performance is mixed and that no definite conclusions can be drawn. They argued that various institutional obstacles, such as barriers stemming from business relationships, the regulatory environment and information processing limitations, might prevent institutional investors from effectively exercising their corporate governance function.

Almazan, Hartzell and Starks (2003) provided evidence both theoretical and empirical that the monitoring influence of institutional investors on executive compensation can depend on the current or prospective business relation between the institution and the corporation. They concluded that the monitoring influence of institutions is associated more with potentially active institutions (investment companies and pension fund managers who would be less sensitive to pressure from corporate management due to lack of potential business relations) than with potentially passive institutions (banks and insurance companies who would be more pressure-sensitive). Davis and Kim (2006) found that mutual funds with conflicts of interest (based on management of pension assets) more often vote with management in general. On the other hand, mutual funds have more incentive and power to oppose management in firms in which they have a larger stake.

Marsh (1997) has argued that short-term performance measurement does work against the active monitoring by institutional investors. The performance of fund managers is evaluated over a shorter time period. Hence, they act under tremendous pressure to beat some index. So, when they find a case of bad governance, they find it economical to sell the stock rather than interfere in the functioning of the company and incur monitoring costs. Ashraf and Jayaman (2007) examined mutual funds’ trading behavior after the release of voting records. The study found that funds that support shareholder proposals reduce holdings after the release of voting records. Since the time of releasing voting records could be very far from the shareholder meeting date, mutual funds’ trading behavior after the release of voting records may be unrelated to the votes cast in the meeting. Aggarwal, Klapper and Wysocki (2003) found that U.S. mutual funds tend to invest greater amounts in countries with stronger shareholder rights and legal frameworks (controlling for the country’s economic development). In addition, within the countries, the mutual funds also discriminate on the basis of governance in that they allocate more of their assets to firms with better corporate governance structures.

Payne, Millar, and Glezen (1996) focussed on banks as one type of institutional investor that would be expected to have business relations with the firm’s in which they invest. They examined interlocking directorships and income-related relationships, and noticed that when such relations exist; banks tend to vote in favor of management anti-takeover amendment proposals. When such relations don’t exist, banks tend to vote against the management proposals. Brickley, Lease and Smith (1988) found evidence supporting the hypothesis that firms with greater holdings by pressure-sensitive shareholders (banks and insurance companies) have more proxy votes cast in favor of management’s recommendations. Moreover, firms with greater holdings by pressure-insensitive shareholders (pension funds and mutual funds) have more proxy votes against management’s recommendations. The authors differentiated between the different types of institutional investors, noting the difference between pressure-sensitive and pressure-insensitive institutional shareholders and arguing that pressure-sensitive institutions are more likely to ‘go along’ with management decisions.

Dahlquist et al. (2003) analyzed foreign ownership and firm characteristics for the Swedish market. The study found that foreigners have greater presence in large firms, firms paying low dividends and in firms with large cash holdings. Haw, Hu, Hwang and Wu (2004) found that firm level factors cause information asymmetry problems to FII. It found evidence that US investment is lower in firms where managers do not have effective control. Foreign investment in firms that appear to engage in more earnings management is lower in countries with poor information framework. Choe, Kho, Stulz (2005) found that US investors do indeed hold fewer shares in firms with ownership structures that are more conducive to expropriation by controlling insiders. In companies where insiders are dominating information access and availability to the shareholders will be limited. With less information, foreign investors face an adverse selection problem. So they under invest in such stocks. Leuz, Lins, and Warnock (2008) found that foreign institutional investors prefer to invest in firms with better governance practices.

In the present study, the analysis has been conducted in three perspectives:

Dynamics of institutional holdings and its composition

(2) Relationship between Institutional Holdings (explanatory variable)

and the Corporate Governance Score (dependent variable)

(3) Relationship between the Corporate Governance Score (explanatory variable)

and Institutional Holdings (dependent variable)

The major findings of the present study on the above aspects are summarized as under:

The results outputs of the first segment depict that the institutional investors have increased their proportional holdings in the companies over the years. The number of sampled companies with higher institutional holdings has increased where as the number of companies with lower proportions of institutional holdings has decreased over the study period. Hence, institutional holdings have shown an increasing trend of investment in the sampled companies over the study period. As far as the dynamics of components of institutional investors is concerned, no specific trend is observed in investments of mutual funds. On the other hand Banks, Financial Institutions and Insurance Companies have shown declining trends of investments over the same period. Where as, foreign institutional investors have shown the increasing trends of investments in line with institutional holdings.

The results outputs pertaining to the analysis of relationship between institutional holdings and corporate governance state that the larger proportions of institutional holdings have higher corporate governance scores in sampled companies and the smaller proportions of institutional holdings have lower governance scores in the sampled companies over the study period. Thus, very strong and positive relationship is established between institutional holdings and corporate governance. Hence, H01 is accepted. The results outputs of the section analyzing the relationship between corporate governance score and institutional holdings describe that the companies with higher governance scores have larger proportions of investments from institutional investors than the companies with lower governance scores. Therefore, very strong and positive relationship also exists between corporate governance score and institutional holdings. Hence, H02 is accepted. The inference can be drawn that institutional holdings pre-empts good corporate governance still at other times, good corporate governance endues institutional investment in the firm.

The results outputs pertaining to the analysis of relationship between mutual funds and corporate governance reveal out that smaller proportions of mutual funds holdings have higher governance score in the sampled companies and larger proportions of mutual funds holdings have lower governance scores in the sampled companies over the study period. Therefore, weak relationship exists between mutual funds holdings and corporate governance score. Hence, H01 is rejected. Alternatively, the results outputs pertaining to the analysis of relationship between corporate governance and components of institutional holdings reveal out that the companies with lower governance scores have larger proportions of mutual funds holdings to the companies with higher governance scores over the study period. Hence, weak relationship also exists between corporate governance score and mutual funds holdings. Hence, H02 is rejected. It can be inferred from the above outcomes that mutual funds companies do not observe good governance practices in companies and simultaneously, good governed companies also do not attract higher mutual funds investments.

The results outputs as to the relationship between Banks, FIs and ICs and corporate governance depict that larger proportions of Banks, Financial Institutions and Insurance Companies holdings have higher governance score and smaller proportions of holdings have lower governance score in the sampled companies over the study period. Therefore, very strong and positive relationship is established between Banks, Financial Institutions and Insurance Companies holdings and corporate governance score. Hence, H01 is accepted. Similarly, the sampled companies with higher governance scores have larger proportions of Banks, FIs and ICs holdings to the companies with lower governance scores. Thus, very strong and positive relationship also exists between corporate governance score and Banks, FIs and ICs holdings. Hence, H02 is also accepted. The inference can be drawn on the basis of above results that Banks, FIs and ICs consider governance practices in companies while taking investment decision and alternatively, good governed companies also attract these investments.

The results outputs pertaining to the relationship between FII holdings and corporate governance reveal out that the companies in which FIIs have larger proportions of holdings have higher governance score to the companies in which FIIs have smaller proportions of holdings. Therefore, very strong and positive relationship is observed between FII holdings and corporate governance score. Hence, H01 is accepted. Likewise, the sampled companies with higher governance scores have also larger proportions of Foreign Institutional Investors holdings. Thus, very strong and positive relationship also exists between corporate governance score and FII holdings. Hence, H02 is accepted. It can be inferred on the basis of above result that foreign institutional investors prefer to invest in firms with better governance practices and their investment do improve the governance practices in the companies.

Resume

The theoretical and empirical literature provides mixed evidence as to the relationship between institutional holdings and corporate governance. Some of the studies put forth the evidence that corporate governance is the significant factor for institutional investment decision and their significant investment improve the governance practices in companies, while the other studies state otherwise. Where as the research findings of the present study further validate, support and enrich the literature on positive association between institutional holdings and corporate governance.

Likewise, the studies provide inconclusive evidence as to the relationship between mutual funds holdings and corporate governance. But the findings of present study state that neither the mutual funds care about the governance practices of companies or their presence improve them. Similarly, the empirical literature provides indeterminate evidence on the relationship between Banks, FIs and ICs and corporate governance. But the findings of present study observe very strong and positive relationship between the two.

The empirical studies observe consistent results as to foreign institutional investors invest in better-governed companies but lacks evidence that their significant presence result in better governance. The findings of present study indicate that FIIs do not care for the corporate governance only, rather their higher stake ensure better governance too.

Section C

7.8 Relationship between Institutional Holdings and Firm Performance:

Review of Literature

Pound (1988) explored the influence of institutional ownerships on firm performance and proposed three hypotheses on the relation between institutional shareholders and firm performance: efficient-monitoring hypothesis, conflict-of-interest hypothesis, and strategic-alignment hypothesis. The efficient-monitoring hypothesis says that institutional investors have greater expertise and can monitor management at lower cost than the small atomistic shareholders. Consequently, this argument predicts a positive relationship between institutional shareholding and firm performance. Holderness and Sheehan (1988) found that for a sample of 114 US firms controlled by a majority shareholder with more than 50% of shares, both Tobin’s Q and accounting profits are significantly lower for firms with individual majority owners than for firms with corporate majority owners. McConnell and Servaes (1990) found a strong positive relationship between the value of the firm and the fraction of shares held by institutional investors. They found that performance increases significantly with institutional ownership.

Majumdar and Nagarajan (1994) found that levels of institutional investment are positively related to the current performance levels of firms. However, a less-stronger, though positive, effect is established between changes in performance levels and changes in institutional ownership. The results are based on a study investigating U.S. institutional investors’ investment strategy. Han and Suk (1998) found (for a sample of US firms) that stock returns are positively related to ownership by institutional investors, thus implying that these corporate owners are actively involved in the monitoring of incumbent management. Douma, Rejie and Kabir (2006) investigated the impact of foreign institutional investment on the performance of emerging market firms and found that there is positive effect of foreign ownership on firm performance. They also found impact of foreign investment on the business group affiliation of firms. Investor protection is poor in case of firms with controlling shareholders who have ability to expropriate assets. The block shareholders affect the value of the firm and influence the private benefits they receive from the firm. Companies with such shareholders find it expensive to raise external funds.

Studies examining the relationship between institutional holdings and firm performance in different countries (mainly OECD countries) have produced mixed results. Chaganti and Damanpour (1991) and Lowenstein (1991) find little evidence that institutional ownership is correlated with firm performance. Seifert, Gonenc and Wright (2005) study does not find a consistent relationship across countries. They conclude that their inconsistent results may reflect the fact that the influence of institutional investors on firm performance is location specific. The above studies generally consider institutional investors as a monolithic group. However, Shleifer and Vishny’s (1986) as well as Pound’s (1988) theorizations and later empirical examinations by McConnell and Servaes (1990) suggest that shareholders are differentiable and pursue different agendas. Jensen and Merkling (1976) also show that equity ownerships by different groups have different effects on the firm performance. Agrawal and Knoeber (1996), Karpoff et al. (1996), Duggal and Miller (1999) and Faccio and Lasfer (2000) find no such significant relation between institutional holdings and firm performance.

In the present study, the analysis has been conducted in two perspectives:

Institutional Holdings and Firm performance

(b) Constituents of institutional holdings and Firm performance

The major findings of the present study on the above aspects are summarized as under:

The results outputs of the first segment indicate that there is no conclusive evidence as to larger proportions of institutional holdings in sampled companies have higher average return on networth or average net profit margin and smaller proportions of institutional holdings in sampled companies have lower average return on networth or average net profit margin over the study period. To the contrary, strong and positive relationship is observed between institutional holdings and return on capital employed as well as institutional holdings and earning per share. As the average return on capital employed and average earning per share are higher in the sampled companies with higher proportions of institutional holdings and lower in the sampled companies with lower proportions of institutional holdings over the study period. Therefore, it is stated that institutional holdings and two accounting returns (return on capital employed and earning per share) are significantly correlated where as institutional holdings and other two accounting returns (return on networth and net profit margin) are not related. Hence, there is no clear evidence that institutional holdings and accounting returns are related.

Likewise, strong and positive relationship is observed between institutional holdings and Tobin’s q. But on the other hand, weak relationship is observed between institutional holdings and risk adjusted excess return. Therefore, institutional holdings and one market-based return are significantly correlated while the institutional holdings and another market-based return are not. Thus, the findings depict contradictory results as to the relationship between institutional holdings and market