Abstract
This study examines whether a stronger corporate governance enforcement regime influences the investment decisions of foreign portfolio investors in an emerging market context. Using a natural experiment provided by an Indian corporate governance regulatory reform introduced in 2000, but for which stricter sanctions for non-compliance were imposed in 2004 our results provide strong evidence that governance reforms that include stricter sanctions for non-compliance lead to higher foreign ownership. Depending on specifications, the difference-in-differences estimates show that, on average, the effect is up to 2.8% increased foreign ownership post regulatory reform of 2004. The paper adds to the debate on simultaneity between foreign ownership and corporate governance as we show that in the context of an emerging market corporate governance regulations are extremely important in attracting foreign investors. In the context of prevalence of weak enforcement (of existing regulations) in emerging markets, this study provides empirical support to the notion that strictly enforcing the existing governance regulations has the potential to attract higher level of foreign investment. The results suggest that policy measures aimed at attracting foreign investors in emerging markets should not only concentrate on adopting the best international corporate governance practices but should also signal strong enforcement of these regulations by assigning significant penalties for non-compliance.
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Notes
See, for example, Bekaert et al. (2005), Chan et al. (2009), and Stulz (1999). Market avoidance by foreign investors also has potential indirect cost to society as a whole. Lower equity prices as a result of lower foreign investments, which also reflect higher costs of capital, could decrease the investment activities of publicly listed firms as the value of projects with higher cost of capital does not justify economic worth of investments (Henry 2000).
“As new institutions develop and existing institutions strengthen, one ought to observe dynamic changes in ownership holdings of corporations in emerging economies…” (Armitrage et al. 2017).
The relevance of enforcement has severe implications for firms seeking and attracting external financing, including foreign investors (Berglof and Claessens 2004). Financial contracts imply the commitments made by the firm to honour obligations, predominantly to compensate the providers of external financing with an appropriate rate of return. However, a firm operating in a weak enforcement environment finds it difficult to communicate their commitment of honouring financial contracts and attract external financing. A weaker enforcement environment, through its effect on commitment to honour obligations, also affects ownership and control patterns. If commitment instruments are weak, it results in higher ownership concentration. Though higher ownership concentration may encourage better governance, it could also induce potential costs, including entrenchment of the manager and owner, poor performance of firms, limited risk diversification (among domestic and foreign investors), and higher liquidity costs.
Claessens and Yurtoglu (2013) note “that on average, enforcement is twice as high in advanced countries than in emerging markets and transition economies.”.
Dutcher (2009) also argues that personal financial fines may be a strong deterrent to financial crimes.
These criteria are: shock strength is strong which yields significant changes in FEO, the shock is exogenous with treated firms not allowed to self-select, thus the shock separate firms into treated and controls in a way that is deemed to be close to random, and the shock produces covariate balance between treated and controls (Atanasov and Black 2016).
Similarly, Ding et al. (2010) use a 2006 corporate governance reform in China which improved supervisory board’s monitoring over executive compensation as a quasi-experiment test.
Liang et al. (2012) find that the presence of foreign institutional ownership motivates Taiwan firms to increase voluntary disclosure by undertaking conference calls.
Claessens and Yurtoglu (2013) provide a review of recent literature on corporate governance in emerging markets and they argue that causality is still an issue. In a firm-level study of developed market Sweden, Giannetti and Simonov (2006) address the causality issue to some extent but they themselves acknowledge the shortcomings of their study because their proxies for corporate governance could be endogenous.
The latter problem, particularly relevant for corporate governance research, is related to the issue that the different features of the multi-dimension index may not be equally important, with some elements being either complements or substitutes.
In a study of governance reforms in Italy, Mengoli et al. (2009) argue that one of the impediments to the reforms leading to an increase in investor protection was weak enforcement.
An important aspect of Clause 49 is that it was applicable retrospectively. See Dharmapala and Khanna (2013) for the background to Clause 49.
At year-end 2000, 1 USD was roughly equal to INR 46; as at year-end 2016, 1 USD was approximately equal to INR 68.
These two groups by exogenous construction differ in size and we deal with this issue in Sect. 4.5.2.
Compared to delisting, which possesses elements of negative externality (in that shareholders at large would also suffer), the scope of additional sanctions (in the form of financial penalty and criminal proceedings against the directors themselves) can be considered relatively harsher. Our study assumes that that for insiders who are keen to control a firm (and who have the intention to keep on enjoying controlling stake), the significant reputation penalty of delisting, may not be a strong enough dissuading factor to adhere to the corporate governance rules and/convince FEO that they were adhering to the new regulations (Becker 1968) for further theoretical discussion on the role of stricter penalties). Further, the argument that the reformed set-up of the Clause 49 provisions in 2004 has led to greater enforcement is well established in existing literature (Dharmapala and Khanna 2013).
Ding et al. (2010) argue that due to their lack of regulatory experience emerging markets usually take a “trial by error” approach when making corporate governance reforms.
“Promoter” is defined under Sect. 2(69) of the Companies Act, 2013 and Regulation 2(1) of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 to generally mean persons having some control over a company.
Transparency and other internal corporate governance related information of a firm is duly accessible to insiders compared to outside investors, which includes the foreign non-promoters. In fact the reforms were oriented to protect the interest of minority (outside) shareholders from the insiders. However, as a robustness check we test our empirical model including the non-promoters, and the results are virtually unchanged (for the Companies Act see: http://www.mca.gov.in/MinistryV2/companiesact.html).
Cross-listing data are from https://www.adrbnymellon.com/indices/adr-index/constituents and https://www.adr.com/Investors/Markets.
There are a number of firms that have zero FEO throughout the study period; their exclusion leads to even stronger results to support the findings of this study. These results are available on request.
As noted, by exogenous construction most of the treated firms are larger in size compared to control firms.
Other related studies tend to use market capitalization as a proxy of firm size, especially in relation to different countries, as the accounting standards are different across countries (Ammer et al. 2012).
Market capitalization could also be simultaneously determined with FEO (Aggarwal et al. 2005). Further, market capitalization could differ between two exchanges (BSE and NSE) whereas balance sheet size provides a consistent measure.
A table of the key variables with brief description on the sources, and how they are constructed, is provided in Appendix 2.
As noted there could be other potential factors that may drive this difference, particularly the role of differences in firm size could be key. We address this concern in Sect. 4.5.2.
S&P BSE Sensex increased from 3623 at the end of 2001 to 20,287 at the end of 2007; see http://www.bseindia.com/. During the corresponding period, the Dow Jones Industrial Average increased from 10,260 to 12,800; see www.djindexes.com.
The difference is not statistically significant at conventional significance levels.
Subsequent Hausman tests show appropriateness of fixed effects over random effects in our models.
This estimation technique basically relies on the difference between observed changes in treatment group firms before and after the cut-off date with that of control group firms.
The inclusion of time trend $$({Ϯ}_{j}y)$$ in our model above is a very conservative approach—as controls for possible determinants of FEO are already in place—and will put a downward pressure on $${\beta }_{1}$$.
Studies show that foreign investors in emerging markets are influenced by changes in pull (domestic) factors, such as inflation rate and economic growth rate, and push (global) factors, such as change in US Treasury Bill rates and global volatility measures (VIX) (Griffin et al. 2004; Ülkü 2015). Since we use annual firm level panel data in our estimation, all of these factors are weighed-in by the inclusion of year dummies (time fixed effects). Post-estimation tests show that year dummies are jointly significant.
This is based on the exchange rate of 45.32 INR/USD for 2004.
For illustration purposes, consider a firm with a net worth of INR 45 million and Paid up capital of INR 24 million. By definition, this firm would be in our control group. However, by a simple accounting change of transferring INR 5 million from general reserve to equity, their paid up capital would have been 29 million thus qualifying them as a treatment firm. In our data, 1305 treatment firms (roughly 53%) do not meet the threshold for net worth but exceed the threshold for paid up capital only; 16 treatment firms do not meet the threshold of paid up capital but meet the threshold for net worth.
We thank an anonymous referee for this suggestion.
Using triple DiDiD regression based approach we find similar results for leverage as the moderating factor. The results are available from the authors.
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Appendices
Appendix 1: The number of observations dropped from the data and the reasons for such omission
Initial number of observations (2001–2007) | 22,615 | |
Dropped | ||
Without obs. on either side of enforcement | 519 | |
Cross listed | 208 | |
Negative net worth | 4418 | |
Total number of observations dropped | 5145 | |
Number of observations used | 17,470 |
Appendix 2: Description of Variables Used in this Study
Variable | Description |
|---|---|
FEO | Number of equity shares held by foreign non-promoters scaled by total shares held by non-promoters. Source: Prowess, CMIE |
Clause | Dummy variable of 1 for years after 2003 (to coincide with the enforcement of Clause 49 law). Source: Dharmapala and Khanna (2013) |
Treat | Dummy variable of 1 for firms that are subject to Clause 49 law. Source: Dharmapala and Khanna (2013) |
Insider | Equity held by promoters as a share of total equity shares. Source: Prowess, CMIE |
Insider2 | Squared form of Insider (Insider * Insider). Source: Own calculation; raw data from Prowess |
Size | Balance sheet size of a firm (in USD million) taken in natural log form. Source: Prowess, CMIE |
Dividend | Dummy variable of 1 for firms that paid dividend in a given year. Source: Prowess, CMIE |
Return | Annual stock returns in INR; includes dividends earned and any gain or loss to the investor arising out of capital actions of the firm. Source: Own calculation; raw data from Prowess |
Price/Book | Ratio of market price of a share to book value of share. Prowess, CMIE |
Turnover | Annual stock turnover is the combined number of equity shares traded annually in BSE and NSE, scaled by total number of outstanding equity shares of the firm. Own calculation; raw data from Prowess |
Leverage | Long term debt scaled by shareholders’ equity. Own calculation; raw data from Prowess |
GrFEO | Yearly growth rate of FEO to allow for time trend, taken as natural log of (FEO / FEO of previous year) interacted with time period (year). Own calculation; raw data from Prowess |
Appendix 3: Summary Statistics of Control and Treatment Groups: Similar Industry and Net worth. This table presents the mean and number of observations of all variables used in this study, compared by treatment and control group firms from different samples (Panel A, Panel B, and Panel C) and showing statistical differences between the two groups. Panel A is for the overall sample. Panel B reports results for firms in similar industry and Panel C exhibits differences between treatment and control firms having similar net worth, as discussed in Sect. 4.5.2. FEO is the number of equity shares held by foreign non-promoters scaled by total number of equity shares held by all non-promoters. Insider is the number of equity shares held by promoters as a share of total number of equity shares. Size is the total assets from balance sheet of firms in million USD. Dividend is a yearly dummy variable of 1 for firms that paid dividend during that year, zero otherwise. Return is the annual stock return for investors. Price/Book is market price of equity divided by book. Turnover is the number of equity shares traded in a year scaled by the total number of equity shares of firms. Leverage is long term debt divided by total equity. Statistical significance is reported against 10% (*), 5% (**) and 1% (***) significance levels
Control | Treatment | Difference | Std. Error | No. of Observations | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
Panel A: All firms in the sample | |||||||||||||
Number of Firms | 393 | 2438 | |||||||||||
FEO | 0.55 | 3.21 | −2.66*** | 0.20 | 17,470 | ||||||||
Insider | 54.38 | 48.64 | 5.75*** | 0.47 | 17,470 | ||||||||
Size | 2.20 | 238.28 | −236.07*** | 50.72 | 16,538 | ||||||||
Dividend | 0.24 | 0.39 | −0.15*** | 0.01 | 17,470 | ||||||||
Return | 60.54 | 56.31 | 4.23 | 9.85 | 14,209 | ||||||||
Price-Book | 1.29 | 1.59 | −0.30* | 0.16 | 14,071 | ||||||||
Turnover | 0.12 | 1.17 | −1.05 | 1.85 | 14,209 | ||||||||
Leverage | 0.03 | 0.04 | −0.00 | 0.03 | 13,838 | ||||||||
Panel B: Firms from similar industries | |||||||||||||
Number of Firms | 389 | 1932 | |||||||||||
FEO | 0.56 | 2.49 | −1.93*** | 0.17 | 14,249 | ||||||||
Insider | 54.55 | 47.98 | 6.57*** | 0.49 | 14,249 | ||||||||
Size | 2.22 | 54.00 | −51.78*** | 5.07 | 13,455 | ||||||||
Dividend | 0.24 | 0.34 | −0.10*** | 0.01 | 14,249 | ||||||||
Return | 59.76 | 57.66 | 2.10 | 10.98 | 11,241 | ||||||||
Price-Book | 1.28 | 1.57 | −0.29* | 0.16 | 11,115 | ||||||||
Turnover | 0.12 | 1.32 | −1.20 | 2.12 | 11,241 | ||||||||
Leverage | 0.03 | 0.03 | 0.01 | 0.01 | 10,902 | ||||||||
Panel C: Firms having similar net worth | |||||||||||||
Number of Firms | 389 | 579 | |||||||||||
FEO | 0.56 | 0.30 | 0.26*** | 0.07 | 5845 | ||||||||
Insider | 54.55 | 42.49 | 12.06*** | 0.59 | 5845 | ||||||||
Size | 2.22 | 2.67 | −0.45*** | 0.11 | 5468 | ||||||||
Dividend | 0.24 | 0.06 | 0.18*** | 0.01 | 5845 | ||||||||
Return | 59.76 | 55.80 | 3.95 | 8.02 | 3586 | ||||||||
Price-Book | 1.28 | 1.75 | −0.47* | 0.28 | 3500 | ||||||||
Turnover | 0.12 | 0.25 | −0.13*** | 0.02 | 3586 | ||||||||
Leverage | 0.03 | 0.03 | 0.00 | 0.01 | 3801 | ||||||||
Appendix 4: Yearly average foreign ownership of foreign insiders and foreign outsiders
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Bhatta, B., Marshall, A., Neupane, S. et al. Foreign ownership and the enforcement of corporate governance reforms. Rev Quant Finan Acc 58, 541–580 (2022). https://doi.org/10.1007/s11156-021-01002-2
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DOI: https://doi.org/10.1007/s11156-021-01002-2
Keywords
- Corporate governance reform
- Stricter sanctions
- Foreign equity ownership
- Panel data
- Difference-in-differences