Corporate Governance and Firm Value: The Case of ... - SSRN papers

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Corporate Governance and Firm Value: The Case of Venezuela Urbi Garay and Maximiliano González* ABSTRACT Manuscript Type: Empirical Research Question/Issue: We examine the relationship between corporate governance and firm value, and evaluate the relatively understudied governance practices in Venezuela. Research Findings/Results: We construct a corporate governance index (CGI) for publicly-listed firms that is free of self-selection and self-reported bias and find that its mean value is below the emerging market average in general, and below the Latin American average in particular. This weak investor protection environment makes Venezuela a good setting to study how corporate governance practices affect firm value. We show that an increase of 1 per cent in the CGI results in an average increase of 11.3 per cent in dividend payouts, 9.9 per cent in price-to-book, and 2.7 per cent in Tobin’s Q. These findings are robust after considering the potential endogeneity of our regression variables. Theoretical Implications: Results contrast to those reported in the US due to the higher interfirm variations in CGI. Our findings are consistent with the theoretical models that relate good corporate governance practices to higher investor confidence, and with the agency model of dividend payout. Furthermore, we conjecture that our results are generalizable mainly to other countries where investor protection is low. Practical Implications: Two direct insights to policy makers and practitioners follow from our analysis: first, managers in weak investor protection environments could differentiate their firms adopting corporate policies to improve their governance structure; and second, our measure of governance practices gives investors a quantitative tool to better assess Venezuelan firms. Keywords: Corporate governance rating/index, corporate performance, South America

INTRODUCTION

M

ore companies in a growing number of countries are increasingly attempting to adopt better corporate governance practices. In the case of Latin America, the Andean Development Corporation (Corporación Andina de Fomento – CAF) recently presented an outline for a corporate governance Andean Code (CAF, 2005). Furthermore, the larger companies of the region, especially those that belong to the financial sector, are in the process of adopting other international codes of best corporate governance practices, such as the Sarbanes-Oxley Act and the Principles of Corporate Governance developed by the Organization for Economic Co-operation and Development (OECD, 1999). It is not difficult to predict that the success or failure of these * Address for correspondence: Suite 11629, 6910 N.W. 50 Street, Miami, FL/33166. Tel: 571339 4999 (ext. 3369); Email: [email protected]

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initiatives will depend on the real impact that they may have on the financial performance and market valuation of the companies that adopt them. La Porta, López-de-Silanes, Shleifer and Vishny (1997, 1998, 2000a) show that the legal framework that firms and investors face differs significantly around the world, in part, because of differences in legal origin. They argue that investors are less protected in French Civil Law countries, compared with countries from the Common Law origin. All countries in Latin America have the same legal origin, which is French Civil Law. They also find that Latin American countries perform even worse than the average French Civil Law countries in terms of investor rights, and argue that this helps explain the low level of financial development and the small size of stock exchanges of these countries. Chong and López-de-Silanes (2007) confirm these findings for a more recent period. Furthermore, according to Djankov, La Porta, López-de-Silanes and © 2008 The Authors Journal compilation © 2008 Blackwell Publishing Ltd doi:10.1111/j.1467-8683.2008.00680.x

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CORPORATE GOVERNANCE AND FIRM VALUE

Shleifer (2008) Venezuela exhibits one of the worst scores in terms of investor protection. The weak investor protection inherent in many Latin American countries offers an opportunity for firms to differentiate themselves from the rest and to send strong and credible signals to attract investors by self-adopting good corporate governance practices and policies, thus partially compensating investors for the weak legal environment in which these firms operate. Klapper and Love (2004) and Durnev and Kim (2005) show that corporate governance provisions matter more in countries with weak legal protection. We know relatively little about the potential impact that the adoption of corporate governance practices may have on company value in Latin America (see Chong and López-deSilanes, 2007, for a recent review of this evidence). Measuring this effect is important for the region because the success or failure of implementing good corporate governance practices may be greater if the market rewards those companies that adopt them. In the case of the US, the empirical evidence shows either no effect or an economically small effect.1 Black (2001) argues that perhaps these weak results in the US arise because the variation in firm governance is small given that the minimum quality of corporate governance, which is set by law and by norms, is very high in that country. On the other hand, interfirm governance variation is found to be much larger in Venezuela. This should not come as a surprise, as a country with weaker laws and norms offers a wider range for governance differences between firms and, therefore, the potential for stronger results on the effects of governance on firm value. Furthermore, even though Venezuela is the fourth largest economy in Latin America (after Brazil, Mexico, and Argentina), relatively little is known about corporate governance practices in this country. In sum, Venezuela represents a very strong case study. We evaluate the current state of corporate governance practices in Venezuela by constructing a corporate governance index (CGI) for all firms listed in the Caracas Stock Exchange (CSE) as of the end of 2004 and comparing the results to other emerging and Latin American countries. We then evaluate whether firm dividend payout policies, price-to-book multiple, and Tobin’s Q (TQ) are related to our CGI. By undertaking a single country-study approach, we attempt to perform a straightforward empirical test that has the advantage of avoiding some of the potential econometric problems involved in cross-country studies such as the omitted variable bias and the usually high across-firm heterogeneity. In general, we find a positive and strong relation between our index of corporate governance and the payout ratio, price-to-book multiple, and TQ for firms in Venezuela. From the composition of the index, we find that the subindexes on ethics and conflicts of interest, composition and performance of the board of directors, and shareholders’ rights explain much of the cross-sectional difference in payout ratio; on the other hand, the subindex regarding ethics and conflicts of interest can explain much of the results when price-to-book and TQ are used as dependent variables. These results add to the growing literature that supports the idea that in countries with relatively low investor pro-

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tection, good corporate governance practices and policies could be used as an efficient mechanism for firms that want to distinguish themselves to attract investors. Although our results are tentative given the small size of the CSE, they passed a series of robustness checks that attempted to tackle, among other potential problems, the issue of endogeneity, a common concern found in this literature. Our paper is similar to Black (2001) and Judge, Naoumova and Koutzevol (2003) who tested the relation between corporate governance and firm value in Russia, a transition economy characterized by weak investor protection. Both papers have a small sample and Russia, like Venezuela, is also a country that scores low in terms of investor protection and exhibits a high interfirm variation in corporate governance practices. Our paper is also related to recent country studies done in Latin America2 and especially with Garay and González (2005), who also studied the case of Venezuela. The evidence reported in this paper is important not only for Venezuela but also for other emerging markets in the process of attempting to improve their corporate governance practices. The evidence we show here adds to the growing literature worldwide that indicates that firms can differentiate themselves by adopting better corporate governance practices and policies. That is, even in a weak investor protection environment, firms can increase their market value by adopting good corporate governance measures. The rest of the paper is organized as follows: first, we review the growing literature on corporate governance and market valuation, concentrating on recent papers that are based on Latin America. Second, we construct a CGI for Venezuela and compare it with other emerging economies and, more importantly, to other Latin American countries. Third, we present the data and conduct our econometric analysis testing the relation between a firm’s dividend payout ratio, price-to-book, and TQ, and our CGI. Fourth, we perform a number of robustness checks to our main findings. In the last section we present the conclusions and policy recommendations, as well as its potential practical applications and suggestions for future studies.

LITERATURE REVIEW Many definitions of corporate governance stress the potential conflicts of interest between insiders (managers, boards of directors, and majority shareholders) and outsiders (minority shareholders and creditors) of the company. The set of internal and external mechanisms to balance these conflicts of interest is what it is usually known as corporate governance. The effect that a set of good corporate governance practices may have on firm’s value is, however, an empirical question. Recently, different studies, trying to measure quantitatively the quality of corporate governance, have created indexes based on legal, accounting, and firm-level financial information. Gompers, Ishii and Metrick (2003) construct a CGI based on 24 governance rules for 1,500 large US firms, and show that firms with higher corporate governance scores had higher firm value. La Porta et al. (1997) study a sample of 49 countries and conclude that countries with legal systems based on Civil

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Law, especially the French legal system, provide less protection to investors and have less developed capital markets, particularly when compared with countries from the Common Law origin. These authors also conclude that dividend policy constitutes an essential tool to reduce agency conflicts to minority investors.3 These findings are consistent with the theoretical model presented in La Porta, López-de-Silanes, Shleifer and Vishny, (2002), where the positive effects of good corporate governance practices on firm valuation are explained by higher investor confidence. This situation lowers the cost of capital and, ultimately, increases firm value. Also, these results are consistent with the agency model of dividend payout in the corporate governance framework developed in La Porta, López-de-Silanes, Shleifer and Vishny (2000b). Since the seminal empirical papers of La Porta et al. (1997, 1998, 2000a) showing that laws that protect investors differ significantly across countries, in part because of differences in legal origin, the academic focus has shifted to study corporate governance in the international setting.4 Klapper and Love (2004) was among the first and more comprehensive papers focusing on corporate governance in emerging markets. Using firm-level evidence on corporate governance practices for 495 companies from 25 emerging markets, they show that better corporate governance is highly correlated with better operating performance and market valuation. Many country-studies have used a methodology that is very similar to that of Klapper and Love (2004). For example, Black, Jang and Kim (2006a) constructed a CGI for South Korea; and Black (2001) and Black, Love and Rachinsky (2006b) both studied how their CGI affects firm value in Russia. The empirical evidence for Latin America has also grown rapidly in recent years. Leal and Carvalhal-da-Silva (2005) studied Brazil, Chong and López-de-Silanes (2006) studied Mexico, Lefort and Walker (2005) studied Chile, and Garay and González (2005) studied Venezuela. All these papers show that, on average, a good set of corporate governance practices and policies is positively related to firm value. These findings in Latin America are especially important because the weak investor protection inherent in this region offers an opportunity for firms to differentiate themselves to attract investors by self-adopting good corporate governance practices. Easterbrook and Fischer (1991) argue that firms themselves, when it is optimal to do so, could offer private contracts with better terms than can be offered by the rigid legal system. In the same manner, Diamond (1989, 1991) presents a theoretical discussion of the effects of a firm’s reputation on its access to external financing, and Coffee (1999) argues for a “global convergence” in corporate governance that is independent of the local legal environment. Empirically, Klapper and Love (2004) and Durnev and Kim (2005) find that corporate governance practices play a more important role in countries where legal protection is weak. That is, firm-level improvements in corporate governance could, in some way, bypass the obstacles and inefficiencies of a country’s legal system. That makes Venezuela a good setting to corroborate the effect good corporate governance practices have on firm valuation, given the overall low scores this country exhibits in terms of investors’ protection and the high interfirm

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variation in corporate governance practices observed in this country. This suggests the following hypothesis: Hypothesis 1: Better corporate governance practices will be positively related to firm valuation in Venezuela. This paper is similar to Garay and González (2005) because both papers use firm-level data for Venezuelan listed firms. However, the two papers differ in three important aspects. First, we present a more detailed analysis of each of the questions in our CGI and exclude all questions that are not directly applicable to the Venezuelan market. In contrast, Garay and González (2005) used a standard and more general questionnaire that was very similar to the one used by Klapper and Love (2004). Second, we answered the questions directly and therefore our paper is less likely to suffer from self-selection and self-reported bias. Third, here we have directly addressed the endogeneity issue, a typical concern in this type of empirical analysis. Moreover, the focus in Garay and González (2005) was not to test whether corporate governance affects market valuation but if financial performance somehow affects CEO turnover.

Corporate Governance Index (CGI) Most studies on firm-level evidence on corporate governance practices gather their information using questionnaires filled by the companies themselves. This methodology presents various potential problems, among others: a low response rate, especially from those companies whose corporate governance practices are poor (self-selection bias); and, for the firms that do respond to the questionnaire, there is a tendency to present themselves not as they are at the moment when the questionnaire is being completed, but as they want to see themselves in the future (self-report bias). In our paper we follow a different route to construct our CGI. In the same spirit of Leal and Carvalhal-da-Silva (2005), we answer the questions ourselves using publicly available information. From Leal and Carvalhal-da-Silva (2005)’s 24 questions we ended up with 17 questions that are applicable to the Venezuelan setting.5 Each one of these 17 questions was answered using publicly available information. We then grouped the questions into four subindexes, namely: information disclosure (five questions), composition and performance of the board of directors (five questions), ethics and conflicts of interest (three questions), and shareholders’ rights (four questions). We report our results for each subindex in Table 1 for the 46 companies listed in the CSE in the year 2004.6 The disclosure subindex shows that only 19.6 per cent of the firms disclose penalties against management in case of deviating from the corporate governance policy; 82.6 per cent report their audited financial statements on time; only 17.4 per cent use international accounting standards; 84.8 per cent hire internationally recognized auditors; and 50 per cent disclose information on managerial compensation. The arithmetic mean for this subindex is 50.9 per cent. According to the composition and performance of the board of directors’ subindex, for 60.9 per cent of the firms in the sample, the chairman of the board is also the CEO or general manager; 56.5 per cent have monitoring committees;

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TABLE 1 Corporate Governance Index (CGI) These questions were answered by the authors for each of the 46 Venezuelan firms that were listed in the Caracas Stock Exchange (BVC) in 2004 to determine for each firm its CGI. The answer to each question is either “Yes” or “No.” If the answer is “Yes,” we add 1, and if the answer is “No,” we add 0. All answers are based on publicly available information. The primary sources of information are firms’ financial statements, bylaws, minutes of meetings, and annual reports available at the CNV. At the end of each question, there are remarks in italics on whether what is stated in the question is stipulated in the Venezuelan Code of Commerce. N

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Questions SUBINDEX – DISCLOSURE Does the company indicate in its charter, annual reports, or in any other manner, the penalties against the management in case of breach of its desired corporate governance practices? Required by Generally Accepted Auditing Standards. Does the company present reports of its audited financial statements on time? Required by the CNV. Does the company use international accounting standards? Required by Generally Accepted Auditing Standards. Does the company use any recognized auditing firm? Required by the CNV and by Generally Accepted Auditing Standards. Does the company disclose, in any form whatsoever, the compensation of the general manager and of the board of directors? Required by the CNV. SUBINDEX – COMPOSITION AND PERFORMANCE OF THE BOARD OF DIRECTORS Are the chairman of the board of directors and the general manager two different people? Not required by any legal instrument. Does the company have monitoring committees, such as appointment or compensation or auditing committees, or all of these? The auditing committee is established in the Venezuelan Code of Commerce. Is the board of directors clearly comprised of external directors and possibly independent ones? Stipulated in the Code of Commerce, but not limited to the fact that they be independent. Is the board of directors comprised of five to nine members, as per recommendation of good international corporate governance practices? Not required by any legal instrument or regulatory entity. Is there a permanent auditing committee? Stipulated in the Code of Commerce. SUBINDEX – EHTICS AND CONFLICTS OF INTEREST Is the company free of any penalty or fine for breach of good corporate governance practices or of any rules of the CNV during the last year? CNV rules. Taking into account the agreements among shareholders, are the controlling shareholders owners of less than 50% of the voting shares? Not established in any legal instrument or by any regulatory entity. Is the capital/voting rights ratio of controlling shareholders higher than 1? Not established in any legal instrument or by any regulatory entity. SUBINDEX – SHAREHOLDERS’ RIGHTS Does the company charter or any other verifiable means facilitate the voting process of the shareholders beyond that established by law? Stipulated in the Code of Commerce. Does the company charter guarantee additional voting rights to that established by law? Stipulated in the Code of Commerce. Are there pyramidal structures that reduce concentration of control? Not established in any legal instrument or by any regulatory entity. Are there agreements among shareholders that reduce concentration of control? Not established in any legal instrument or by any regulatory entity. AVERAGE CGI (equally weighting the four subindexes)

Arithmetic mean

Affirmative answers

50.9% 19.6%

9/46

82.6%

38/46

17.4%

8/46

84.8%

39/46

50.0%

23/46

54.4% 60.9%

28/46

56.5%

26/46

32.6%

15/46

73.9%

34/46

47.8% 39.9% 82.6%

22/46 38/46

30.4%

14/46

6.5%

3/46

16.3% 28.3%

13/46

13.0%

6/46

15.2%

7/46

8.7%

4/46

40.3%

Source: Comisión Nacional de Valores (CNV), Código de Comercio, www.economatica.com. The questionnaire is adapted from Leal and Carvalhal-da-Silva (2005) to the Venezuelan setting.

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32.6 per cent have external directors7; 73.9 per cent have a board composed of between 5 to 9 members; and 47.8 per cent have a permanent audit committee. The arithmetic mean for this subindex is 54.4 per cent. The ethics and conflicts of interest’s subindex shows that 82.6 per cent of the companies are free from penalties or fines on the part of the regulatory agency (the Comisión Nacional de Valores); there exists a shareholder that controls less than 50 per cent of the firm’s shares in 30.4 per cent of the firms in the sample; and in 6.5 per cent of the firms, the capital to voting rights ratio of majority shareholders is higher than 1. The arithmetic mean for this subindex is 39.9 per cent. Finally, the shareholders’ rights subindex shows that only 28.3 per cent of the firms in the sample facilitate the voting process beyond what is required by law; only 13.0 per cent have voting rights beyond that required by law; only 15.2 per cent do not exhibit a pyramidal structure that reduces the concentration of control8; and 8.7 per cent report special agreements among shareholders that reduce the concentration of control. The arithmetic mean for this subindex is a very low 16.3 per cent. Taking together these averages, we can conclude that only around half of the firms in our sample comply with the requirements of the disclosure of the composition and performance of the board of directors and more work needs to be done in terms of ethics and conflicts of interest, and, especially, in terms of shareholders’ rights. At the firm level the highest overall CGI was 71.7 per cent and the lowest was 16.7 per cent. We found a much larger variation in Venezuelan firms’ corporate governance practices when compared with the US (results are not reported here). The average CGI in the sample is a low 40.3 per cent. In Table 2 Panel A we compare our CGI with the results reported by Klapper and Love (2004) who analyzed 495 firms in 25 emerging countries,9 Lefort and Walker (2005) who studied 181 firms in Chile, and Leal and Carvalhal-daSilva (2005) who studied 214 firms in Brazil. Table 2 shows that Venezuela is 14 percentage points below the emerging market average and 19 percentage points below Chile, which is the leading country in Latin America in terms of financial development and investor protection (Chong and López-deSilanes, 2007). The Venezuelan average is closer to the one reported for Brazil. In Panel B we summarize the results obtained for each subindex and compare them with the results presented in Garay and González (2005) and in Lefort and Walker (2005) for Venezuela and Chile, respectively. Overall, the CGI we obtained produces a score 14 percentage points below the CGI reported by Garay and González (2005). As mentioned before, this difference could represent an overestimation on that paper due to the self-selection and self-reported bias generated when firms’ executives completed the questionnaires. Only in the composition and performance of the board of directors (Board) subindex do we find similar results. We also include in this panel the score reported by Lefort and Walker (2005) for Chile. The CGI for Chile is close to 20 percentage points higher than the CGI for Venezuela. Only in the subindex of ethics and conflicts of interest (Ethics) are the scores relatively close. Finally, in Table 2 Panel C we show the correlation matrix among the subindexes. As expected, all subindexes are posi-

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tively and significantly related to the overall CGI. Chong and López-de-Silanes (2006) report a similar finding for Mexico, even though their corporate governance components are not exactly comparable to ours, and Leal and Carvalhal-da-Silva (2005) do not provide a correlation matrix for Brazil. On the other hand, each of our subindexes shows little correlation with the other subindexes (none of the correlation coefficients are statistically different from zero). Interestingly, each subindex seems to be taking into account a different dimension of the overall governance of the firm. Overall, these results confirm that Venezuela represents a good case study to test whether firms can somehow bypass a poor investor protection environment by voluntarily adopting good corporate governance practices. A relatively high CGI is an indicator that firms can use to attract investors. We want to verify whether investors in Venezuela recognize this signal by assigning a higher market valuation to such firms.

DATA Having shown that Venezuela is a strong case study to test whether corporate governance is related to firm valuation and dividend payout, in this section we present the dependent, independent, and control variables used to formally test our hypothesis.

Dependent Variables We use three alternative dependent variables to test our hypothesis. First, we use the dividend payout ratio (DPR), which is measured as the quotient between cash dividends and net earnings. La Porta et al. (2000b) show that firms in countries where investors are better protected exhibit higher dividend payouts than firms in countries where investors are poorly protected. On the other hand, Black et al. (2006a) and Leal and Carvalhal-da-Silva (2005) do not find support for this hypothesis in the cases of South Korea and Brazil, respectively. The second dependent variable is the price-to-book ratio (price-to-book value or PBV), measured as the quotient between per share market price and book value. The priceto-book is a valuation measure that has been used in corporate governance studies by authors such as Leal and Carvalhal-da-Silva (2005) for Brazil. Finally, we use the TQ as the third of our dependent variables. This variable was computed as the market value of the firm’s assets (book value of assets - book value of equity + market value of equity) divided by the book value of assets. TQ can be considered the classic valuation measure and has been used extensively in the corporate governance literature (see, for instance, Morck, Shleifer and Vishny, 1988; La Porta et al., 2002; Gompers et al., 2003). Information regarding each one of these variables was obtained from the CSE Anuario (2004 – yearbook) and corresponds to year-end values. Economatica’s database was also used in some cases to confirm the validity of stock market prices data.

Independent Variables As we mentioned in the previous section, the CGI was constructed based on 17 questions pertaining to different

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TABLE 2 Comparative Analysis In this table we compare our corporate governance index (CGI) to similar studies done in other emerging markets. Panel A presents basic statistics comparing 25 different emerging markets (Klapper and Love, 2004) together with the CGI calculated for Chile (Lefort and Walker, 2005) and Brazil (Leal and Carvalhal-da-Silva, 2005). Panel B divides the CGI into its four subindexes and compares the values with a similar study for Venezuela (Garay and González, 2005) and Chile (Lefort and Walker, 2005). Panel C shows the correlation matrix of each of the subindexes (p-values are reported below each correlation coefficient). Panel A: Comparative statistics for the Venezuelan CGI versus other emerging market studies

Description

This paper

Klapper and Love (2004)

Lefort and Walker (2005)

Leal and Carvalhal-da-Silva (2005)

Mean Median Standard deviation Minimum Maximum Country Observations

40.34 40.47 12.11 16.67 71.67 Venezuela 46

54.11 54.97 14.00 11.77 92.77 25 EM 374

58.86 NR NR NR NR Chile 181

41.67 41.67 8.33 16.67 79.17 Brazil 214

Source: The above-mentioned papers. All numbers (except the number of observations) are expressed in percentages. EM = Emerging Markets; NR = not reported.

Panel B: Comparative subindex for the Venezuelan CGI versus other studies in Venezuela and in Chile This paper (46 firms) Subindex Ethics Board Shareholders Disclosure Overall CGI

Questions 3 5 4 5 17

Score (%) Questions Score (%) 39.9 7 46.0 54.4 25 56.0 16.3 24 54.0 50.8 14 60.8 40.3 70 54.3 Panel C: Subindex correlation matrix CGI

CGI Disclosure Board of directors Ethics and conflicts of interest Shareholders’ rights

Garay and González (2005)

1 0.41 0.02 0.75 0.00 0.41 0.02 0.34 0.05

Disclosure

Questions 7 26 20 14 67

Ethics

Score (%) 37.6 64.9 59.7 73.4 58.9

Shareholders

1 0.29 0.10 -0.12 0.56 -0.27 0.13

corporate governance practices. We answered these questions for each of the 46 Venezuelan firms that were listed in the CSE in 2004 to determine for each firm its CGI. The answer to each question is either “Yes” or “No.” If the answer is “Yes,” we add 1 and if the answer is “No,” we add 0. All

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Board

Lefort and Walker (2005)

1 0.12 0.53 -0.18 0.31

1 0.09 0.64

1

answers are based on publicly available information. These 17 questions were answered after reviewing each firm’s financial statements, bylaws, minutes of the boards of directors and shareholders’ meetings, and annual reports available at the Comisión Nacional de Valores library.

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We then grouped the questions in four subindexes: information disclosure (DIS, five questions), composition and performance of the board of directors (BOA, five questions), ethics and conflicts of interest (ETH, three questions), and shareholders’ rights (SHA, four questions).

Control Variables We use the following three variables as controls: company size (CS), measured as the natural logarithm of the book value of assets, return on assets (ROA), measured as operating earnings (EBIT) divided by total assets, and leverage (LEV), measured as the quotient between total debt and total assets. Information regarding each one of these variables was obtained from the CSE Anuario (2004 – yearbook) and corresponds to year-end values.

ECONOMETRIC ANALYSIS In order to perform the statistical tests and the multivariate regressions, a preliminary analysis of the information available was carried out following a procedure similar to that used by Black et al. (2006a), in order to exclude from the sample all those companies with missing information or whose standardized errors exceeded the standard deviations in +/- 1.96 in each of the variables used. Also, companies without any market transaction during the year were deleted from the sample. From this analysis a total of 13 companies were excluded, therefore the sample was reduced to 33 companies.10 Of these 33 companies, 12 were banks, 2 were bank-related financial institutions, and 19 were firms that belonged to the industrial and service sectors. In Table 3 we report the descriptive statistics for the variables used in the analysis that follows. Panel A includes statistics for the complete sample of 33 firms, while panel B shows the descriptive statistics for the reduced sample of 19 nonfinancial institutions. In our complete sample the average firm pays 20 per cent of its net income in dividends, has a price-to-book multiple equal to 1.07 and a TQ equal to 0.95. When we restrict our sample to only nonfinancial firms, the mean values of these three variables decline slightly to 16 per cent, 0.85 per cent, and 0.90 per cent, respectively. In terms of our CGI, the reduced sample of 33 firms shows an average value equal to 8.30 over a maximum of 17 points (one point for each question answered as “yes”), or 49 per cent in percentage terms.11 For the nonfinancial sample, the CGI declines to 7.95; this is consistent with the fact that financial institutions are more regulated and are subject to more scrutiny in terms of information disclosure and other legal requirements. The nonfinancial sample tends to be more profitable in terms of ROA. The firms included in the complete sample tend to be larger and, as expected, more leveraged. In Table 4 we report a pair-wise correlation matrix for the variables used in this study. It shows that the CGI is positively correlated to the three alternative dependent variables previously defined (dividend payout, price-to-book, and TQ), not only in the complete sample (Panel A), but also in the sample restricted to nonfinancial institutions (Panel B).

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In the first case, the correlation is always statistically significant, and in the second case, it is statistically significant for the dividend payout. With respect to the firm’s size (CS), consistent with the findings obtained by Leal and Carvalhal-da-Silva (2005), we obtain a positive and significant coefficient for both samples. That is, larger firms tend to exhibit better corporate governance practices. In Panel C we also report the correlation coefficients between the performance measures and each of the corporate governance subindexes. The Board, the Ethics and Conflicts of Interest, and the Shareholders’ rights subindexes are positive and significantly related to dividend payout. For the other two performance measures, only the Ethics and Conflicts of Interest subindex shows a significant correlation coefficient. The Disclosure subindex did not show significant coefficients in any of the three performance measures.

Dividend Payout Ratio In Table 5 we show the results of Ordinary Least Squares (OLS) regressions for the dividend payout ratio on the CGI, and the control variables for 2004. Model 1 includes the CGI as the sole explanatory variable.12 Here, an increase of one point in the CGI causes an increase of 11.3 per cent in the dividend payout ratio. This result is statistically significant (t = 3.69, p < .01) and almost triples the 4.32 per cent increase found by Garay and González (2005), also for Venezuela. However, this result differs from that of Leal and Carvalhalda-Silva (2005) for Brazil, who did not find a significant relation between these parameters. Models 2, 3, and 4 include one control variable in the estimation. In each case the positive sign and the statistical significance of CGI is preserved (t = 3.50, p < .01; t = 2.93, p < .01; and t = 3.99, p < .01, respectively). Model 5, which includes all control variables considered together, also shows a positive and statistically significant sign for CGI (t = 3.69, p < .05).13 Table 5 also shows that results are maintained and that the economic impact is stronger when financial institutions are excluded from the sample (Panel B). Also, in both samples we reject the hypothesis that dividend payout and CGI are independent variables using a nonparametric test (Spearman). Finally, we regressed dividend payout for the whole sample with each of the subindexes (Panel C) and also considering the four subindexes together (we show in Table 2 Panel C that there was very little correlation among the subindexes). These results confirm that three of the subindexes (board of directors, ethics and conflicts of interest, and shareholders’ rights) independently affect, in a positive and statistically significant way, the firm’s dividend payout (t = 1.91, p < .05; t = 2.19, p < .05 and t = 2.33, p < .05, respectively). On the other hand, the disclosure subindex does not affect in any significant way the dividend payout. These results serve as a preliminary evidence to conclude that the factor driving CGI are the subindexes on board of directors, ethics and conflicts of interest, and shareholders’ rights.

Price-to-Book Value In Panel A of Table 6 we present our OLS estimation of price-to-book on the CGI, and the control variables for 2004.

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TABLE 3 Descriptive Statistics The variables are identified as follows: dividend payout ratio (DPR), price-to-book value (PBV), Tobin’s Q (TQ), corporate governance index (CGI), return on assets (ROA), company size (CS), and leverage (LEV). The total sample is composed of 33 companies (Panel A) and it is reduced to 19 companies (Panel B) when financial firms are excluded. All numbers represent 2004 values. Panel A: Complete sample Variable

Observation

Dependent variables DPR PBV TQ Independent variable CGI CGI01 Control variables ROA CS LEV

Mean

Standard deviation

Minimum

Maximum

33 33 33

0.20 1.07 0.95

0.39 0.48 0.16

0.00 0.13 0.71

1.86 2.43 1.35

33 33

8.30 0.49

1.90 0.11

5.00 0.29

13.00 0.76

33 33 33

0.08 26.88 0.59

0.09 2.09 0.29

-0.01 22.15 0.02

0.34 30.47 0.90

Panel B: Sample excluding financial institutions Variable

Observation

Dependent variables DPR PBV TQ Independent variable CGI CGI01 Control variables ROA CS LEV

Mean

Standard deviation

Minimum

Maximum

19 19 19

0.16 0.85 0.90

0.45 0.40 0.19

0.00 0.13 0.71

1.86 1.60 1.35

19 19

7.95 0.47

1.81 0.11

5.00 0.29

13.00 0.76

19 19 19

0.14 26.08 0.43

0.15 2.06 0.24

0.01 22.15 0.02

0.55 29.52 0.85

Model 1 includes the CGI as the sole explanatory variable. An increase of one point in the CGI causes an average increase of 9.9 per cent in the PBV. This result is statistically significant (t = 2.37, p < .05), and its magnitude more than doubles the 4.2 per cent increase calculated by Garay and González (2005) also for Venezuela. Leal and Carvalhal-da-Silva (2005) did not find a significant relationship between these two variables in Brazil. Models 2, 3, and 4 include one control variable. In each of these models, CGI maintains the sign and its statistical significance in Model 2 (t = 2.17, p < .05) and Model 4 (t = 2.19, p < .05), and it is marginally statistically significant in Model 3 (t = 1.70, p < .10). Model 5, which includes all control variables together, also shows a statistically significant sign for CGI (t = 2.08, p < .05). Using a nonparametric test (Spearman) we reject, at the 5 per cent confidence level, the hypothesis that PBV and CGI are independent.

© 2008 The Authors Journal compilation © 2008 Blackwell Publishing Ltd

Results using the reduced sample of nonfinancial institutions were not included because the regression, as a whole, was not statistically significant in any of the models. The small size of the CSE may help explain the lack of statistical power. We also regressed PBV on each of the subindexes and considering the four subindexes together (results available from the authors). Although all subindexes were positive, only ethics and conflicts of interest was statistically significant. In the case of Brazil, although Leal and Carvalhal-da-Silva (2005) also found that the coefficients of each of the subindexes were positive, these authors also found that none of the components of the CGI was statistically significant explaining PBV. Similar results were obtained by Chong and López-de-Silanes (2006) for the case of Mexico, although we must advise that their CGI components classification is different (more disaggregated) than

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TABLE 4 Correlation Matrix This table presents the pair-wise correlation matrix for the variables used in this study. The variables are identified as follows: Dividend payout ratio (DPR), price-to-book value (PBV), Tobin’s Q (TQ), corporate governance index (CGI), return on assets (ROA), return on equity (ROE), company size (CS), and leverage (LEV). Panel A presents the results using all firms in the sample; Panel B presents the results excluding financial firms; and Panel C presents the correlation coefficients of each performance measure with each of the subindexes. p-values are reported below each correlation coefficient. Panel A: Complete sample DPR DPR PBV TQ CGI ROA ROE CS LEV

1 0.37 0.04 0.50 0.00 0.55 0.00 -0.11 0.56 -0.10 0.59 0.33 0.06 -0.17 0.36

PBV

TQ

CGI

ROA

ROE

CS

LEV

1 0.64 0.00 0.39 0.03 -0.18 0.34 0.20 0.26 0.28 0.11 0.27 0.13

1 0.32 0.07 -0.07 0.72 0.14 0.44 0.17 0.34 0.26 0.15

1 -0.17 0.34 0.10 0.60 0.54 0.00 0.14 0.45

1 0.62 0.00 -0.49 0.00 -0.37 0.04

1 0.06 0.74 0.37 0.04

1 0.55 0.00

1

ROE

CS

LEV

Panel B: Sample excluding financial institutions DPR DPR PBV TQ CGI ROA ROE CS LEV

1 0.40 0.09 0.48 0.04 0.74 0.00 -0.17 0.49 -0.22 0.36 0.41 0.08 -0.22 0.36

PBV

TQ

CGI

ROA

1 0.74 0.00 0.27 0.26 -0.01 0.96 -0.01 0.70 -0.01 0.96 -0.31 0.20

1 0.32 0.18 0.04 0.86 0.02 0.93 0.04 0.86 0.11 0.66

1 -0.17 0.49 -0.16 0.51 0.55 0.01 -0.19 0.43

1 0.94 0.00 -0.48 0.04 -0.17 0.49

1 -0.35 0.14 0.06 0.81

1 0.31 0.20

1

Panel C: Performance variables correlation with subindexes

Disclosure Board of directors Ethics and conflicts of interest Shareholders’ rights

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DPR

PBV

TQ

-0.01 0.94 0.33 0.07 0.38 0.04 0.39 0.03

0.18 0.33 0.16 0.37 0.41 0.02 0.14 0.44

0.15 0.40 0.19 0.28 0.34 0.05 0.02 0.92

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TABLE 5 Dividend Payout Regressions Ordinary Least Squares regressions results of the dividends payout ratio (DPR) on the corporate governance index (CGI) for five different model specifications. The variables are identified as follows: return on assets (ROA), company size (CS), leverage (LEV), disclosure subindex (DIS), board of directors subindex (BOA), ethics and conflicts of interest subindex (ETH), and shareholders’ rights subindex (SHA). Panel A presents the results using all firms in the sample; Panel B presents the results excluding financial firms; and Panel C presents the results using as independent variable each subindex coefficients. †p < .10, *p < .05, **p < .01. The t-values are reported below each estimated coefficient. Panel A: Complete sample Variables CGI

Model 1

Model 2

Model 3

Model 4

Model 5

0.11** (3.69)

0.11** (3.50) -0.44 (-0.91)

0.11** (2.93)

0.12** (3.99)

-0.33† (-1.69) 0.60* (2.24) 33 8.61** 0.36 0.32

0.09* (2.58) -0.45 (-.91) 0.05 (1.12) -0.53* (-2.25) -1.44 (-1.56) 33 5.24** 0.43 0.35

ROA CS

0.01 (0.24)

LEV Cons. Obs. F R2 Adj. R2 Spearman’s rho

-0.74** (-2.82) 33 13.60** 0.31 0.28 0.58**

-0.66* (2.38) 33 7.18** 0.32 0.28

-0.92 (-1.17) 33 6.62** 0.31 0.26

Panel B: Sample excluding financial institutions Variables CGI

Model 1

Model 2

Model 3

Model 4

Model 5

0.18** (4.51)

0.18** (4.35) -0.34 (-0.68)

0.18** (3.64)

0.18** (4.24)

-1.30 (-1.32) 19 9.59** 0.55 0.49

-0.16 (-0.50) -1.19** (-3.03) 19 9.87** 0.55 0.50

0.18* (2.91) -0.34 (-0.58) 0.00 (0.02) -0.17 (-0.42) -1.13 (-0.92) 19 4.55* 0.57 0.44

Model 3

Model 4

Model 5

ROA CS

0.00 (0.01)

LEV Cons. Obs. F R2 Adj. R2 Spearman’s rho

-1.29** (-3.92) 19 20.38** 0.55 0.52 0.56**

-1.22** (-3.48) 19 10.11** 0.56 0.50

Panel C: Subindexes Variables DIS

Model 1

Model 2

0.01 (0.07)

BOA

0.10* (1.91)

ETH

0.23* (2.19)

SHA Cons. Obs. F R2 Adj. R2 Spearman’s rho

0.23 (0.71) 33 0.01 0.00 -0.03 0.16

© 2008 The Authors Journal compilation © 2008 Blackwell Publishing Ltd

-0.08 (-0.51) 33 3.67* 0.11 0.08 0.48**

0.15* (2.33) 0.08 (0.97) 33 5.45* 0.15 0.12 0.19

-0.06 (-0.45) 33 4.78* 0.13 0.11 0.25†

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0.02 (0.18) 0.11* (2.31) 0.18† (1.92) 0.16** (2.82) -0.52 (-1.61) 33 4.51** 0.39 0.31

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TABLE 6 Price-to-Book Value (PBV) and Tobin’s Q (TQ) Regressions Ordinary Least Squares regressions results of PBV and TQ on the corporate governance index (CGI) for five model specifications. The variables are identified as follows: return on assets (ROA), company size (CS), and leverage (LEV). †p < .10, *p < .05, **p < .01. The t-values are reported in the parenthesis behind each estimated coefficient. Panel A: Dependent variable PBV

CGI

Model 1

Model 2

Model 3

Model 4

Model 5

0.10* (2.37)

0.09* (2.17) -0.82 (-1.27)

0.09† (1.7)

0.09* (2.19)

0.37 (1.35) 0.08 (0.21) 33 3.79* 0.20 0.15

0.11* (2.08) -0.84 (-1.17) -0.04 (-0.71) 0.44 (1.30) 1.12 (0.84) 33 2.23† 0.24 0.13

ROA CS

0.02 (0.50)

LEV Cons.

0.24 (0.65) 33 5.59* 0.15 0.13 0.36*

Obs. F R2 Adj. R2 Spearman’s rho

0.39 (1.03) 33 3.66* 0.20 0.14

-0.27 (-0.25) 33 2.85† 0.16 0.10

Panel B: Dependent variable TQ

CGI

Model 1

Model 2

Model 3

Model 4

Model 5

0.03† (1.85)

0.03 (1.67) -0.25 (-1.12)

0.03 (1.53)

0.03 (1.68)

0.04* (2.00) -0.30 (-1.25) -0.03 (-1.26) 0.19 (1.59) 1.27** (2.79) 33 1.89 0.21 0.10

ROA CS

0.00 (0.02)

LEV Cons.

0.73** (5.84) 33 3.43† 0.10 0.07 0.33†

Obs. F R2 Adj. R2 Spearman’s rho

0.77** (5.92) 33 2.35 0.14 0.08

ours, making comparisons between the two works more difficult to interpret.

Tobin’s Q Ratio Panel B of Table 6 shows the results of the TQ regressions on the CGI and the control variables. In Model 1 we report, using the CGI as the sole explanatory variable, that an increase of one point on the CGI causes an average increase of 2.7 per cent in the TQ. This result is marginally statistically significant (t = 1.85, p < .10), being consistent with the results obtained by Garay and González (2005) for Venezuela and by Leal and Carvalhal-da-Silva (2005) for Brazil, who found an increase in TQ of 2.24 per cent and 3.1 per cent, respectively. Klapper and Love (2004) also found a positive and

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0.72† (1.93) 33 1.66 0.10 0.04

0.12 (1.29) 0.68** (5.21) 33 2.58† 0.15 0.10

significant relation between the TQ and the CGI for their sample of emerging market firms. Models 2, 3, and 4 include one control variable in the estimation and Model 5 includes all the control variables considered together. The CGI maintains the sign in each of the models but the coefficient is statistically significant only in Model 5 (t = 2.00, p < .05). Also, using a nonparametric test (Spearman), we marginally reject the hypothesis that the TQ and CGI are independent at the 10 per cent confidence level. We do not show the results of the sample excluding the financial institutions because they were not statistically significant in any of the models. Once again, the small size of the CSE may help explain the lack of statistical power. We also regressed the TQ to each of the subindexes and also considering the four subindexes together (results available from the authors). Although all subindexes were posi-

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tive, and as it was the case when PBV was used as the dependent variable, only the ethics and conflicts of interest subindex was statistically significant. There exists a vast literature on the potential effects of conflicts of interest between controlling and outside shareholders on firm value and profitability. For instance, Morck et al. (1988) find, for a sample of US firms, that profitability first rises as ownership concentration increases (a finding that is consistent with the incentive hypothesis), and then falls after a certain point. These authors contend that this fall in profitability is due to an “excessive” voting power concentration or entrenchment, which leads to a fall in corporate value as the likelihood of expropriation increases. Lins (2003) analyzes 18 emerging markets and finds that the evidence in favor of entrenchment is stronger than it is for incentives. This author also argues that, in countries were legal protection is weak, the existence of large nonmanagerial block holders helps mitigate the potentially negative effect of control concentration on firm value. In the case of Brazil, although Leal and Carvalhal-da-Silva (2005) also found that the coefficients of each of the subindexes were positive, they reported that only the disclosure component of the CGI was statistically significant explaining TQ. Similar results were obtained by Chong and López-deSilanes (2006) for Mexico. Overall, we find a positive and significant relation between dividend payout ratio and firm valuation (PBV and TQ) and our CGI. Firms with a better CGI tend to pay more dividends and are more valuable for investors in terms of their price-to-book multiple and their TQ ratio. Results also suggest that in a weak investor protection environment such as Venezuela’s, firms are able to send strong signals to the market by voluntarily improving their corporate governance practices, something that allows them to differentiate from the rest.

ROBUSTNESS CHECKS In this section we perform several robustness checks to validate our previous results.

Huber/White/Sandwich Estimator of Variance The first robustness check we perform consists in estimating once again all the regression coefficients but this time using the Huber/White/Sandwich estimator of variance. This procedure generates larger standard errors and, therefore, the estimated t-values are much smaller than those obtained by the traditional OLS procedure. The signs and the statistical significance of the main results remain (results are not shown but are available upon request).

Endogeneity Many empirical studies on corporate governance are subject to criticism, given the likely endogeneity of the CGI that is present in this type of studies.14 For example, firms that need to finance their growth could be tempted to improve their corporate governance practices in order to reduce their cost of capital. This expected growth should therefore be

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priced in the firm’s valuation, creating a positive correlation between the CGI and value ratios such as TQ. If this occurs then valuable firms will choose to adopt better governance practices and not the other way around. In the previous section we attempted to mitigate this problem by adding several control variables that could proxy for growth opportunities such as size, operating performance, and leverage to our regression model and showed that our results were not spuriously caused (at least not by these omitted variables). However, including control variables in the regressions is not enough to dissipate the likely endogeneity between a firm’s value and its CGI. The first step we followed to tackle the possible existence of endogeneity in our model consisted in estimating all the regressions but this time using financial information corresponding to the year 2005. In this approach, we regressed the three alternative dependent variables (dividend payout, price-to-book, and TQ) for 2005 against the 2004’s CGI. Signs for all coefficients were preserved but statistical significance was lost, something that can be understandable given the small sample size.15 The second step was to construct the CGI for the year 2006, even though we were only able to compute a preliminary index for that year given that not all the necessary information was either still available or was final. Following the approach of Chong and López-de-Silanes (2006), we averaged the CGI for 2004 and 2006 and run each model again. In this new set of results we obtained smaller coefficients. For example, when estimating dividend payout we obtained a statistically significant lower coefficient, 0.0945 (t = 2.50, p < .05), versus the original 0.1135 shown in Table 5; when estimating PBV we obtained a marginally statistically significant lower coefficient, 0.901 (t = 1.85, p < .10), versus the original 1.1484 shown in Table 6; and, when estimating TQ, we obtained also a marginally statistically significant lower coefficient, 0.0293 (t = 1.78, p < .10), versus the original 0.0271 shown also in Table 6. Although the coefficients obtained under this approach were somehow smaller, they were all positive and kept their statistical significance. Although this set of results somehow reduced our endogeneity concerns, they were not able to eliminate them given the low statistical power of the model. However, the fact that both the positive signs of our CGI were preserved and that similar statistical significance was verified when we used the average CGI provides a base to be optimistic regarding the direction of the causality of our test. The next step we followed to tackle the endogeneity problem was to find instruments or a group of exogenous variables which are related to CGI but that are not necessarily related to any of the three alternative dependent variables. More specifically, we used the following three measures: first, a dummy variable called ADRUSA that takes the value of 1 if the company had American Depositary Receipts (ADRs) outstanding in the period 2000–2002 and 0 otherwise. The second measure is a variable called CHAIND, which is the percentage change in board independence from the year 2000 to the year 2002. We proxy board independence, following Garay and González (2005), as the difference between the fraction of outside directors minus the fraction of inside directors in the board. A director is

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classified as an outsider if he or she does not hold any administrative position in the firm (e.g., any management or consulting duties) or if his or her last name was the same as the last name of the CEO or the Chairman of the Board. Finally, we constructed a dummy variable called FORCED which takes the value of 1 if there is a CEO turnover between the years 2002 and 2004 and the departing CEO did not remain in the board afterwards.16 Reese and Weisbach (2002) argue that the better a firm’s corporate governance is, the more likely it will issue ADRs in the US. Therefore, we predict a positive relation between ADRUSA and CGI. On the other hand, we argued that the change in board independence (CHAIND) and the power of the board to remove nonperforming CEOs (FORCED) should be positively related to our CGI (Weisbach and Hermalin, 2003). Although there is a clear relation between these three instruments and our measure of corporate governance, we do not see any strong theoretical or empirical justification to argue that these instruments are also related to dividend payout and the other two valuation variables. In Panel A of Table 7 we show the regression results. In the first stage, FORCED had the greater impact in the estimation of CGI with a coefficient of 3.573 (t = 2.24, p < .05). The other two variables did not behave as well: the coefficient of ADRUSA, although positive, was not significant (t = 1.55) and the coefficient of CHAIND was negative and marginally significant (t = –1.84, p < .10).17 For the second stage, we use the instrumented CGI (CGI_hat) as an independent variable to estimate DPR, PBV, and TQ. Results are shown in Panel B. In all three cases we obtained a positive and statistically significant relation between the dividend payout ratio and our three valuation measures with the instrumented CGI. In the case of DPR, the coefficient was equal to 0.166 and it was statistically significant (t = 2.92, p < .01). For PBV, the coefficient we obtained was 0.118 and it was statistically marginally significant (t = 1.87, p < .10). Finally, in the case of TQ the coefficient was equal to 0.071 and it was statistically significant (t = 2.38, p < .05). Taking into account the small number of observations used (only 23 firms) and the resulting low statistical power of our estimates (results were also confirmed using the nonparametrical Spearman’s test), the results reported in Table 7, although tentative, give some additional evidence that the causality goes from CGI to DPR, PBV, and TQ, and not the other way around.

Different Definitions of the CGI The CGI used in this paper was computed as the arithmetic sum of the points received by each question in the questionnaire. Since each subindex has a different number of questions, CGI is not equally weighted. In fact, the weight implicitly assigned to each subindex is as follow: disclosure subindex, 0.2941 (5 out of 17 questions); composition and performance of the board of directors, 0.2941 (5 out of 17 questions); ethics and conflicts of interest, 0.1765 (3 out of 17 questions); and shareholders’ rights, 0.2353 (4 out of 17 questions). To verify that our results are not driven by this particular weighting, we run our regressions again but this time using

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TABLE 7 Instrumental Variable Regressions In Panel A we use percentage change in board independence from year 2000 to 2002 (CHAIND), a dummy variable that measures whether the firm had American Depositary Receipts (ADRs) outstanding in the US during the period 2000–2002 (ADRUSA), and a dummy variable whether the CEO had been removed from office in the period 2000–2002 and whether he or she had not remained on the board of directors (FORCED), to estimate the corporate governance index (CGI). In Panel B we use the instrumented CGI (CGI_hat) to estimate dividend payout ratio (DPR), price-tobook value (PBV), and Tobin’s Q (TQ). †p < .10, *p < .05, **p < .01. The other variables are defined in Table 5. The t-values are reported in the parenthesis below each estimated coefficient. Panel A: Fist stage, estimation of CGI_hat Variables CHAIND

Estimation -1.24† (-1.84) 1.26 (1.55) 3.57* (2.24) 7.84** (16.27) 23 4.09* 0.30

ADRUSA FORCED Cons. Obs. F R2 Adjusted

Panel B: Second stage, estimation using CGI_hat

Variables CGI_hat Cons. Obs. F R2 Robust standard errors Spearman’s rho

DPR

PBV

TQ

0.17** (2.92) -1.19** (-2.45) 23 8.54** 0.30 No 0.34†

0.12† (1.87) 0.11 (0.21) 23 3.50† 0.09 Yes 0.40*

0.07* (2.38) 0.35 (1.49) 23 5.68* 0.25 Yes 0.44**

three different specifications: first, we construct an equally weighted CGI, that is, we assign a weight of 0.25 to each subindex; second, we construct a CGI for the year 2006 and run this index with 2004 financial data. Although all coefficients in the regressions were still positive, we ended up losing much of the statistical significance; third, we average the 2006 and 2004 CGI (valued-weighted and equally weighted) and run the results with 2004 financial data,

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recovering all the previous results.18 These different definitions of our CGI show that our results are not driven by the way we construct the index. Overall, although we recognize that our findings are still tentative given the small number of observations, the main results that indicate a positive and significant relation between our CGI and the three alternative dependent variables (dividend payout, price-to-book, and TQ) are robust. These results suggest that corporate governance has a strong effect in firm valuation in the case of Venezuela. Moreover, firms could benefit from voluntary improvements in their own corporate governance practices as this allows them to differentiate themselves from other firms and send strong signals to attract investors (see Klapper and Love, 2004; Durnev and Kim, 2005). These results are important not only for Venezuelan firms but also for firms in other emerging economies that offer weak investor protection.

CONCLUSIONS AND POLICY RECOMMENDATIONS Until now, firm-level data on corporate governance practices in Latin America has been almost nonexistent. In this paper we have documented the state of the understudied corporate governance in Venezuela. To this end, we constructed an index of corporate governance practices for listed firms in this country and found a very large variation in corporate governance practices among firms. At the firm level, the highest score was 71.67 per cent and the minimum value was 16.67 per cent. The mean CGI value was 40.34 per cent, which gives Venezuela a score below the emerging market average. Our study also suggests that certain governance practices need to be urgently improved, particularly in the shareholders’ rights category. Scores on the other three corporate governance subindexes (disclosure, composition and performance of the board of directors, and ethics and conflicts of interest) were also low. These results are also consistent with the finding that Latin American financial markets in general and, Venezuelan markets in particular, have been characterized as having the weakest legal protection to outside investors and where the problems of investor expropriation are most severe. Our hypothesis was supported by the data. Results presented here suggest that firms in Venezuela may reduce their cost of capital and enhance their market valuation when they improve their corporate governance practices, a finding that is consistent with the theoretical model presented in La Porta et al. (2002), where the positive effects of good corporate governance practices on firm valuation are explained by the higher confidence of investors that controlling shareholders will have fewer means to expropriate the firm’s cash flows. This higher investor confidence makes them more willing to provide capital to the firm and at a lower cost, something that it is ultimately reflected in higher valuation. The empirical evidence presented for Venezuela also provides support to the outcome agency model of dividend payments specified by La Porta et al. (2000b), where firms with better corporate governance practices should distribute more profits to shareholders and thus exhibit higher dividend payouts. More specifically, results showed a positive and strong relation between the CGI we computed and the market valu-

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ation variables. For example, an increase of 1 per cent in the CGI index would result in an increase of 11.3 per cent in the dividend payout ratio, 9.9 per cent in the price-to-book multiple, and 2.7 per cent in the TQ. These findings are very strong and contrast to those reported in studies done in the US, where the high average firm level of corporate governance practices and the low variation in intrafirm governance has made it difficult for researchers to disentangle the effects between corporate governance practices and firm value. We conjecture that our results are generalizable mainly to other countries where investor protection is low. In countries where investor protection is high (mainly developed countries, particularly Common Law origin countries), firms have significantly less ability to reduce their cost of capital by voluntarily improving their corporate governance, thereby sending a signal to investors. This is because the positive role for firm-level efforts to improve governance practices is helpful precisely when a firm is trying to escape a poor institutional environment. We ran a series of robustness checks to validate our findings attempting to tackle the possible existence of endogeneity in our results and confirmed that the relation goes from better CGI to higher dividend payout and higher market valuation. Even though these results seem to confirm that better corporate governance is valued by the market in Venezuela, we are conscious of the limitations that a small stock exchange (and the resulting small sample size) such as the CSE impose on an econometric study such as ours. Also, the relative illiquidity and inefficiency of emerging stock markets documented by Demirguc-Kunt and Levine (1995) and Harvey (1995), among other authors, reduces the power of market-related variables such as price-to-book and TQ when used in studies performed on these markets. Improvements in investor protection will be crucial to attract the increasing amounts of capital needed to sustain the high rates of growth of emerging economies in the 21st century. The success of the recently created Novo Mercado (New Market) in Brazil is a step in that direction (see Leal and Carvalhal-da-Silva, 2005). Firms that choose to list their stocks on the Novo Mercado must adhere to a set of corporate governance practices, which are more rigid than those required by the Brazilian legislation. As Chong and Lópezde-Silanes (2007) argue, integration to international financial markets does not exclude the need for broader local financial markets, as access to international markets (through the issuance of ADRs, for example) is not appropriate for all firms. As more knowledge of the positive effects of corporate governance practices on firm value become available in countries with weak investor protection such as Venezuela, firms interested in raising capital may decide to voluntarily improve their governance structures. Moreover, the large value impacts of governance behavior has the practical implication that investors should pay close attention to firm-level corporate governance practices, measured by our index, to obtain another quantitative measure to assess firm value in Venezuela. As more years of corporate governance data become available in Venezuela, studies that employ these larger databases may help to shed further light on these important issues, and may allow a more careful analysis on which risk factors more strongly affect firm value. It would also be interesting to

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analyze the effect of corporate governance practices on performance-related variables, such as ROA, return on equity, and gross margin (see, for instance, Bhagat and Black, 1999; Klapper and Love, 2004; Judge et al., 2003). We can also envision a study across countries and legal systems, similar to that performed by Klapper and Love, but constructing a CGI using the methodology we have followed here. A disadvantage of our method is that it may require visits, or at least direct inquiries, to the securities and exchange commissions of the respective countries, as we did in the case of Venezuela, as the information required to answer some of the questions is generally not readily available. Finally, analysts in Venezuela expect investor protection to continue to worsen since President Hugo Chavez still has five more years left of his constitutional term and has promised a radicalization of his so-called “Socialism of the 21st Century”, which has been weakening property rights (see, for example, The Economist, November 29, 2007 and December 6, 2007). In this deteriorating environment, we conjecture that the signaling effect that a firm may send to investors by improving its corporate governance practices would be more appreciated by the market as investor protection worsens in Venezuela (i.e., we would expect to see a higher effect of GCI on TQ and price-to-book). This conjecture is based on the results reported by Klapper and Love (2004), in which the authors find that firm-level corporate governance practices matter more in countries with weak legal frameworks, as firms need to adapt to overcome an institutional environment that places them at a disadvantage in terms of their ability to attract capital. Companies in Venezuela would therefore need to work harder to raise capital by offering a better “package” of protective measures to investors as the institutional environment deteriorates in the country.

6.

7. 8. 9. 10.

11. 12.

13.

ACKNOWLEDGEMENTS We acknowledge the helpful comments and suggestions received from two anonymous referees, Chris Mallin (former Editor), William Judge (current Editor), participants in the 2006 Business Association of Latin American Studies conference, and participants in the 2007 Financial Management Association conference. Germán González, Yelhis Hernández, and Jacelly Céspedes provided excellent research assistance. We also thank Econoinvest for financial support.

14.

NOTES

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1. See Bhagat and Black (1999) and Weisbach and Hermalin (2000) for a summary of the empirical findings in the US. 2. See Chong and López-de-Silanes (2007) for a summary of these papers. 3. The tension between minority and controlling shareholders is typical of French Civil Law countries given the high level of firm’s ownership, pyramidal structures, and family management that is common in these countries (La Porta, López-deSilanes, Shleifer and Vishny, 1999). 4. See Shleifer and Vishny (1997) and Denis and McConnell (2003) for a survey of the international evidence. 5. For example, question 15 in Leal and Carvalhal-da-Silva (2005) asks: “Does the company use arbitration instead of (a)

18.

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normal legal procedure in case of bad corporate governance practices?” Venezuelan firms do not use arbitration to solve any legal dispute; therefore, if we apply this question, all the firms in our sample will have a “no” answer. This and other six questions were dropped from our questionnaire for similar reasons. According to Standard and Poor’s Emerging Stock Markets Factbook (2004) there were 59 firms listed in the CSE in 2004. The factbook does not provide the names of these companies. However, the Anuario de la Bolsa de Valores de Caracas (2004) presents the names and financial information of the 46 firms whose stocks were listed on the CSE in 2004. We suspect the difference between the two publications arises because Standard and Poor’s may be counting twice those companies that have two stock classes. It is difficult to conclude from public information that external directors are truly independent. Information regarding the ownership structure of Venezuelan firms was obtained from Garay and González (2005). The only two Latin American countries included in their study were Brazil and Chile. We decided to run the regressions with the smaller and cleaner data set although results do not change significantly when all companies for which the necessary data could be found are included in the regressions. Note that considering the 46 firms listed on the CSE and reported in Table 2, the mean value for the CGI was 40.34 per cent. We run these and the other regressions (using PBV and TQ as alternative dependent variables) assigning different weights to each component of the CGI (see the section on robustness checks). Basic results remain. Note that CGI is correlated to CS (rho = 0.539) and CS is correlated to LEV (rho = 0.554). This situation makes the interpretation of Models 3 and 5 problematic because of the potential presence of multicollinearity in the regressors. However, even if multicollinearity is present, these models are still Best Linear Unbiased Estimators (BLUE) although they would have a large variance, making precise estimation of the coefficients more difficult (Gujarati, 2003). This is a serious problem because it violates the crucial assumption that the regressors are either no stochastic or, if stochastic, are distributed independently of the stochastic disturbance term. Therefore, when endogeneity is present, the estimated coefficients are not only biased but are also inconsistent (Gujarati, 2003). To save space, all results for this set of robustness checks are not shown in tables. However, they are available from the authors. The corporate governance variables were taken from the database used in Garay and González (2005) from the year 2000 to the year 2002. Ten firms in our database were lost due to missing information. Taking out ADRUSA or CHAIND from the regression equations does not affect the main results. All these results are available from the authors.

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Urbi Garay is a Full Professor of Finance at the Instituto de Estudios Superiores de Administración (IESA) in Caracas, Venezuela. He has a Ph.D. in Finance from the University of Massachusetts, Amherst (2000), a Master in International and Development Economics from Yale University (1994), and received his undergraduate degree in Economics from Universidad Católica Andrés Bello (1991) in Caracas. Dr. Garay teaches Investments, Derivatives, International Finance, and Research Seminar in Finance. He has published articles in Emerging Markets Finance and Trade, the Journal of Alternative Investments, and Derivatives Use, Trading and Regulation, among other journals, and has a chapter (coauthored with Maximiliano González) on corporate governance in Venezuela in Investor Protection and Corporate Governance (edited by Alberto Chong and Florencio Lópezde-Silanes, 2007). Maximiliano González is an Associate Professor of Finance at the Universidad de los Andes in Bogotá, Colombia. He has a Ph.D. in Finance from Tulane University (2002), an MBA from IESA (1998) in Caracas, Venezuela, and received his undergraduate degree in Management Science from Universidad Metropolitana (1994) in Caracas. Dr. González teaches Corporate Finance, Derivatives, Applied Game Theory, and Research Seminar in Finance. He has published articles in Emerging Markets Finance and Trade, International Review of Financial Analysis, Corporate Governance: An International Review, and Derivatives Use, Trading and Regulation, among other journals, and has a chapter (co-authored with Urbi Garay) on corporate governance in Venezuela in the book Investor Protection and Corporate Governance (edited by Alberto Chong and Florencio López-de-Silanes, 2007).

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