Essays on corporate governance
Almaskati, N. (2021). Essays on corporate governance (Thesis, Doctor of Philosophy (PhD)). The University of Waikato, Hamilton, New Zealand. Retrieved from https://hdl.handle.net/10289/14317
Permanent Research Commons link: https://hdl.handle.net/10289/14317
Corporate governance refers to the various mechanisms governing the operations of corporations where the separation between ownership and management usually leads to the presence of different types of agency issues and costs. The different corporate governance mechanisms are looked at as the tools available to the owners of capital to protect their interests in corporations. The role of corporate governance mechanisms in controlling agency issues arising from the separation of the ownership and management of a firm has been long acknowledged by various stakeholders (Jensen and Meckling, 1976). Furthermore, several recent events have contributed to the rise of corporate governance as a mainstream topic that is discussed and debated in various boardrooms, academic seminars and policy meetings around the world. All financial and economic crises since the beginning of the 1990s have been linked in one way or another to failures of the corporate governance framework which have enabled corporations to engage in unwarranted activities that have endangered their local economies and, in many cases, the global economy. Recent scandals and insolvencies caused by the failure of the governance framework (e.g. Enron, WorldCom, Lehman Brothers) have led to widespread systemic consequences and diminished confidence in the corporate sector in many markets. Having a good and strong corporate governance framework is not only important to prevent the recurrence of such events; it is also vital to the health and sustainability of capital markets and overall economic activity (Claessens and Yurtoglu, 2013). The survival and growth of any capital market depends on the continuous flow of capital into corporations, which is also essential for economic growth and prosperity. However, the flow of capital into corporations cannot continue without the presence of strong corporate governance mechanisms to protect the rights of the providers of capital. As Shleifer and Vishny (1997) put it, corporate governance practices work to ensure that the money invested by capital providers is not pilfered by the firm’s management, and that profits are repatriated to the capital providers. This thesis contains three studies addressing three distinct topics related to corporate governance. The first study examines the role played by country-level factors in determining the characteristics of the corporate governance framework in each country. It also studies whether firm-level corporate governance mechanisms act as substitutes or complements to these country-level factors. We pay special attention to the role of financial development and firm-level financing needs in influencing the firm’s governance framework. To our knowledge this is the first study that examines the different causal relationship models used in the literature in order to answer the question of how to best represent the relationship between country-level factors and firm-level governance mechanisms and their joint effects on firm value and performance. Furthermore, our study differs from previous studies in the field in that it employs a wide range of publicly available indices as country-level factors to explain cross-country variations in firm-level governance. The study also addresses several pitfalls and methodological issues with prior studies by focusing on outcome-based external governance indicators and by employing the hierarchical linear modelling (HLM) approach and the Generalised Method of Moments (GMM) technique to account for the nested nature of the data and for potential endogeneity issues, respectively (see Aguilera et al., 2015; Essen et al., 2013; Schiehll and Martin, 2016). Overall, the study contributes to the ongoing debate on the nature of the relationships between country-level and firm-level factors and the effect of such relationships on firm value and performance. We find that country-level factors explain a large part of the variation in firm-level governance across countries. We also find strong evidence to suggest that models which assume that country-level mechanisms act as moderators of the relationship between firm-level governance and firm performance provide the best fit for the relationship between these two groups. Moreover, we find that in contrast to several prior studies (e.g. Chen et al., 2009; Chou et al., 2011; Klapper and Love, 2004), our findings support the proposition that firm-level and country-level governance are complementary. Furthermore, we find that stronger firm-level governance is associated with higher firm value for firms which have high financing needs, and which operate in countries with high financial development. This supports the argument that a firm’s governance framework is highly dependent on the financial development status of the country in which it operates, as well as its need for external financing. The second study examines the role of corporate governance variables in improving the predictive power of bankruptcy prediction models, while analysing the classificatory powers offered by the different estimation techniques. The study is among the first to comprehensively examine the nexus between bankruptcy, corporate governance, and estimation techniques. Most prior studies have primarily focused on examining the value of adding governance variables to a bankruptcy prediction model without considering comparability across the different models or estimation techniques (e.g. Daily and Dalton, 1994; Darrat et al., 2016; Elloumi and Gueyie, 2001; Fich and Slezak, 2008; Wang and Deng, 2006). Furthermore, recent studies by Chan et al. (2016) and Liang et al., (2016) cover a very limited set of bankruptcy models and estimation techniques. This limits the comparability of the results. We cover a more comprehensive set of models and estimation techniques. Also, we use larger sample and a longer timeframe to examine different combinations of models and estimation techniques, and this allows for better comparison of the predictive powers of these models, and of the classificatory ability of the different estimation methods. Moreover, our study focuses on examining the role of governance attributes in predicting bankruptcy, which is different to Ashbaugh Skaife et al. (2006) who examine the role of such attributes in influencing the firm’s credit rating. The present study also addresses endogeneity concerns, which is an important issue that has been largely overlooked in similar studies (Schultz et al., 2017). We find that the addition of governance variables that represent the firm’s board attributes significantly improves the classificatory power and predictive accuracy of the different bankruptcy prediction models covered in the study. We also find that the further away in time a firm is from bankruptcy, the greater the additional explanatory power provided by adding the governance measures. This implies that governance variables tend to provide earlier and more accurate warnings of the firm’s bankruptcy potential. Lastly, our analysis of six of the most frequently used estimation methods in the literature shows that regardless of the bankruptcy model used, hazard analysis provides the best classification and out-of sample forecast accuracy among the parametric methods, the other methods being multiple discriminant analysis and regression analysis. Nevertheless, non-parametric methods such as neural networks, data envelopment analysis and classification and regression trees appear to provide better classificatory accuracy regardless of the model selected (Cielen et al., 2004; Desai et al., 1996; Malhotra and Malhotra, 2003; Premachandra et al., 2009; Wilson and Sharda, 1994; Zhang et al., 1999). Overall, hazard analysis, data envelopment analysis, neural networks and classification and regression trees add the most economic value through reducing the potential costs arising from either lending to firms that will go into bankruptcy soon and thus incurring a loss in principal (classifying bad cases as good), or not lending to healthy firms and thus foregoing the investment opportunity (classifying good cases as bad). The last study extends the previous literature by examining the role of corporate governance mechanisms in influencing investors’ initial and subsequent reactions to earnings announcements, with special attention to one of the most persistent market anomalies, namely the post-earnings announcement drift (PEAD). When investigating the relationship between corporate governance and investor responses to earnings announcements, we control for market conditions that have been found to impact on this response, with a particular focus on market uncertainty and investor sentiment. While several explanations for PEAD based on the rational expectations model or some behavioural observations are provided in the literature (see Bartov et al., 2000; Mendenhall, 2004, Sadka, 2006), the prevailing market conditions such as market uncertainty and investor sentiment have received increasing attention in recent years as possible contributing factors to PEAD (Bird et al., 2014; Bird and Yeung, 2012; Francis et al., 2007; Ozoguz, 2009; Williams, 2015). This study is the first to look at the nexus between corporate governance, market uncertainty, investor sentiment, and PEAD, and it adds to a growing stream of research focusing on increasing our understanding of the responses of market participants to different types of news and events. The study also supplements previous attempts to understand the initial and subsequent market responses to earnings releases by providing evidence on the contributing role played by corporate governance through the effect that it has on information uncertainty. In a sample of quarterly announcements made by US public firms between January 2006 and December 2016, we find that better governance significantly strengthens the magnitude of the initial market reaction to both positive and negative earnings announcements. This contrasts with the impact of either market uncertainty or investor sentiment which will have different effects depending on whether the response is to good news or bad news. An important finding is that during the post-announcement period the level of governance plays no role in explaining movements in share prices that are attributable to any reassessment of the initial announcement. This contrasts with the findings for uncertainty and sentiment which are both found to have an ongoing influence on the market response to an earnings announcement during the postannouncement period. Significantly, it is changes in either the level of uncertainty or sentiment, and not the level itself, that explain post-announcement drift. The implication is that corporate governance plays no role in explaining PEAD because it remains relatively stable over the post-announcement period. Our findings suggest that the immediate impact of an earnings announcement on investor expectations is conditioned by the environment existing at the time of the announcements which is determined by a number of factors including the level of corporate governance, market uncertainty and investor sentiment. One of our more important findings is that investors only revisit their initial response to an earnings announcement if there is a change in this environment. Our findings further suggest that any correction to the initial reaction is not inevitable but rather is a response to post-announcement movements in factors such as market uncertainty and sentiment. Consistent with previous findings that (i) better corporate governance reduces information uncertainty, and (ii) a reduction in information uncertainty increases investors’ initial responses to earnings announcements, we find that information uncertainty is the major channel through which corporate governance operates to increase the market’s initial reaction to earnings announcements. Overall, this result suggests that better corporate governance increases the credibility of the information which translates into a greater acceptance of, and so a response to, the information by investors (Francis et al., 2007; Kanagaretnam et al., 2007; Zhang, 2006). We are also the first study to show that investors exhibit a very different reaction to market uncertainty than they do to firm-level information uncertainty. Consistent with previous studies on macro-level uncertainty, we show that a high level of market uncertainty can assert an asymmetric effect on investors’ reactions to earnings news, reducing reaction to good news but increasing their reaction to bad news. For firm-level information uncertainty, however, our results show that a high level of information uncertainty diminishes investor reaction to both good and bad news. Further, this apparent reluctance to act on information continues in the post-earnings period with high levels of information uncertainty significantly reducing PEAD. The studies included in this thesis examine the role and characteristics of the firm’s corporate governance framework from two main angles: its impact on the firm’s value and returns, and its role in impacting the firm’s information environment. While the results from the first study confirm the important role played by the firm’s governance mechanisms in determining its value and returns, as well as its ability to access financing opportunities, the second study revisits this role by examining its impact on the firm’s health. Further, the second and third studies share similar motivations regarding the role of the firm’s governance framework in improving the firm’s information environment and reducing uncertainty. The second study finds that weak governance can lead to misleading disclosures about the firm’s poor financial health, and may thus prevent any intervention by the shareholders, causing further deterioration in the firm’s health. In the third study corporate governance is seen as playing a part in influencing how investors perceive and respond to the firm’s earnings announcements through its role in reducing information uncertainty.
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