Corporate Governance and Financial Distress: Evidence from Taiwan

Tsun-Siou Lee and Yin-Hua Yeh

2002 NTU International Conference On Finance

Introduction Why do companies fall into financial distress or even

bankruptcy? Can we develop an early warning system that is powerful in predicting corporate financial distress?

Corporate governance has been regarded as one of the key factors that caused Asia financial crisis in 1997.

Johnson, et al. (2000) further documented that corporate governance variables provide better explanatory power for the Crisis than macroeconomic variables.

Ownership Structure around the World

On the average, more than 60% of public traded companies around the world have an ultimate owner except in the US, UK and Japan.

Taiwanese listed companies are characterized as mostly family controlled with a high degree of ownership concentration that is similar to the findings in the prior studies.

Incentive Effect Under Concentrated Ownership Under concentrated ownership environment, it is important to

provide enough financial incentives for the controlling shareholder in order to reduce expropriation.

Cash flow ownership of the controlling shareholder is an important source of such incentives.

La Porta et al. (2002) also provided evidence supporting the positive incentive effect of cash flow ownership by a controlling shareholder on the valuation of firm

Agency Problem Under Concentrated Ownership

Under concentrated ownership, conflicts of interests arise between minority shareholders and the controlling shareholder.

The larger the deviation between voting and cash flow rights, the stronger the ultimate owners’ motivation to expropriate minority interests.

Research Issue Although empirical results support that the threats of expr

opriation by the controlling shareholder tend to reduce corporate value, whether it will lead to a higher probability of financial distress remains an open question.

Financial distress may lead to bankruptcy, liquidation or significant changes in control that may truncate the stream of expected rents from expropriation.

Research Issue Misconduct worsens the firms’ financial performance and

hurt the firms’ competitiveness. In the wake of an economic recession or severe competition, these firms tend to become the victims of financial distress.

Furthermore, the ultimate owner may use corporate funds for stock churning and fail to recover the funds after the stock market turns bearish. The firm in turn falls into liquidity difficulty followed by financial distress.

However, a controlling insider may desire to go on expropriating wealth for a very long time.

For example, Claessens, et al. (1999) found that East Asian firms controlled by management/family groups were less likely to file for bankruptcy during the crisis.

If so, expropriating insiders and weak governance should be associated with a smaller probability of financial distress.

Therefore, we need to consider both the cost and benefit for the controlling shareholder to file financial distress in developing our empirical model.

The Measurement of Corporate Governance

Following Claessens et al. (2002): the smaller the ratio of cash flow rights to control rights, the higher the tendency of the controlling shareholder to expropriate minority wealth.

Following Yeh, Lee and Woidtke (2001)The higher the percentage of board seats occupied by controlling shareholder, the higher the tendency of the controlling shareholder to expropriate minority wealth.

The Measurement of Corporate Governance We have seen more than thirty Taiwanese listed

companies that experienced financial distress in 1998 and 1999. The controlling shareholders of these companies were accused of over-leveraging and over-investment in the stock market.

It is reasonable to suspect more serious wealth expropriation to be associated with higher percentage of shares pledged for funds from financial institutions by the controlling shareholders.

Research PurposesWe add to this literature by examining:

the possible connection between prior corporate governance and financial distress through additional variables in previous studies, the board structure and stock pledge ratio of the controlling shareholder.

the predictability of corporate governance models toward financial distress.

the prediction power of corporate governance models among various sub-samples classified with financial performances.

Empirical Methodology We collect the data of Taiwan listed companies that

encountered financial distress between January 1996 and December 1999, together with a matching sample consisting of non-distress companies.

Definitions of financial distress samples Defaults on loan principal / interest payments,

renegotiated loan terms Companies are traded at 100% margin We have 45 companies in our financial distress

sample and 88 non-distress companies.

Logistic Regression The dependent variable takes the value of one if the c

ompany encountered financial distress, and zero otherwise.

The controlling shareholders We traced the voting rights, cash flow rights and board se

ats occupied by the largest shareholder for each sample company according to the concept of ultimate control proposed by La Porta et al. (1999).

The controlling shareholders In the majority of cases, the immediate shareholders of a

corporation are themselves corporate entities, or investment companies and other legal entities. We then identify their owners, the owners of their owners, etc.

We use the total ownership by each family group, defined as a group of people related through blood or marriage, as the unit of analysis.

X Family

Firm A

Firm B

Firm C

30%

20%12%

25%

Voting B = 32%

Cash flow B = 9%

Board Composition The ratio of board seats (directors and supervisors) held b

y the largest shareholders.

Management participation: a dummy variable that takes the value of one if the controlling shareholder (including its members) also serves as the chairman and president of the company, and takes the value of zero, otherwise.

Table 1: Basic Statistics of Ownership structure and board compositions one andtwo years before the financial distress

one year before two years beforeaverage (%) average (%)

distressedfirms

healthyfirms

t-statistics distressedfirms

healthyfirms

t-statistics

A. Ownership structurecontrol rights 24.80 27.72 -1.125 26.45 30.71 -1.392

stock pledge ratio 37.32 15.15 4.050*** 46.27 16.06 5.130***ratio of cash flow to

control rights 47.92 63.13 -2.382** 62.27 63.22 -0.136

ownership of thesecond largest

shareholder0.93 3.74 -2.756*** 1.107 2.992 -1.745*

ownership ofinstitutional investors 9.73 15.93 -2.579*** 9.36 14.05 -1.660*

B. Board structuredirectors held by thelargest shareholder 73.74 59.98 3.166*** 66.19 59.23 1.455

supervisors held by thelargest shareholder 69.63 49.75 2.779*** 52.14 48.56 0.419

directors held by non-large shareholder 19.21 34.41 -3.921*** 28.55 37.24 -1.962*

supervisors held non-large shareholder 27.07 43.69 -2.389** 44.02 46.78 -0.351

managementparticipation 60.00 44.32 1.722* 58.97 40.00 1.942*

founder participation 64.44 90.91 -3.942*** 76.92 90.67 -2.023*****: significant at 1% level **: significant at 5% level *: significant at 10% level

Table 2: Regression coefficients of logistical models - the year prior to financialdistress, all samples

Independent variable Dependent variable =1, if financial distress occurs0, otherwise

Intercept9.825

(2.346)(1)9.337

(2.106)13.273(3.971)

10.468(2.635)

Adjusted control rights-0.059

(8.806)***-0.054

(7.785)***-0.063

(9.334)***-0.054

(7.833)***

Cash-control right ratio-0.110

(3.719)*-0.103

(3.220)*-0.120

(4.292)**-0.103

(3.239)*Shareholding of the secondlargest shareholder

-0.051(0.949)

-0.058(1.087)

-0.082(2.441)

-0.072(1.689)

Shareholding of institutionals-0.001(0.002)

-0.008(0.184)

0.007(0.109)

-0.009(0.257)

Directors assumed by thelargest shareholder

0.023(3.454)*

Supervisors assumed by thelargest shareholder

0.010(2.506)

Directors held by non-largeshareholder

-0.034(6.198)**

Supervisors held by non-largeshareholder

-0.008(1.472)

Management participation0.812

(2.235)1.002

(3.504)*0.647

(1.333)0.982

(3.372)*

Founder participation-1.498

(5.307)**-1.453

(4.973)**-1.317

(3.965)**-1.056

(5.318)**

Debt ratio0.044

(7.967)***0.046

(8.432)***0.041

(6.394)**0.044

(7.844)***

Ln (market value)-0.138(0.276)

-0.090(0.123)

-0.131(0.231)

-0.088(0.116)

RDA(2) -0.060(0.217)

-0.085(0.382)

-0.044(0.121)

-0.083(0.403)

H0: β =0Chi-square

58.157*** 57.230*** 61.476*** 56.148***

Concordant ratio 86.2% 86.0% 87.4% 85.5%**: significant at 1% level **: significant at 5% level *: significant at 10% level

The Estimated and Holdout Samples

The first two thirds of our sample is grouped into an estimated sample. Similar logistic regressions are run on the estimated sample using the data one-year before the distress to generate parameter estimates.

The data of the holdout sample one-year before the crisis are then plugged into the estimated model. A simple transformation of the following form gives us the estimated probability of financial distress,

where Pi = the estimated probability of financial distress for firm i of

holdout sample

= the vector of estimated regression coefficients by using the estimate sample

xi = the vector of the values of independent variables for firm i

by using the data of holdout sample

i

i

x

x

ie

eP '

'

1

Table 4: Estimated probabilities of financial distress for the holdout sample - oneyear before the financial distress

Estimated probability of financial distressIndependent variablein the estimated

model(1) financial distressed firms financially healthy firms t-statistics(3)

% of director occupiedby the largest

shareholder, and otherindependent variables(2)

0.7237 0.3198 5.487***

% of supervisorsoccupied by the largestshareholder, and otherindependent variables

0.6171 0.2273 5.458***

% of director held bynon-large shareholdersand other independent

variables

0.5899 0.1937 4.879***

% of supervisors held bynon-large shareholdersand other independent

variables

0.5929 0.2063 5.441***

Average 0.6309 0.2368

***: significant at 1% level

Table 5: Misclassification of the holdout samples

holdout sampleIndependent variable

in the estimatedmodel(1)

number offirms

misclassified

percentage offirms

misclassifiednumber of

distressed firmsmisclassified

number ofhealthy firmsmisclassified

% of director occupiedby the largest

shareholder, and otherindependent variables

8 17.77% 3 5

% of supervisorsoccupied by the largestshareholder, and otherindependent variables

8 17.77% 6 2

% of director held bynon-large shareholdersand other independent

variables

9 20.00% 7 2

% of supervisors heldby non-large

shareholders and otherindependent variables

9 20.00% 7 2

Control Financial Performance

For the good performance sample, board structure

variables are more capable of explaining the occurrence

of financial distress.

Specifically, when the controlling shareholder holds more

seats on the board, even good performance companies

receive a higher probability for distress next year.

As to the bad performance sample, the ownership and

debt ratio represent the more powerful explanatory.

Conclusion The argument that the controlling shareholder may desire to

prolong the expropriation honeymoon suggests that poor

governance may not lead to higher probability of financial

failure.

However, since our sampling period essentially covers the

Taiwan serious economic recession, poor macroeconomic

factors might have speeded up the occurrence of financial

distress even if the controlling shareholders tried to prevent it

from happening.

Conclusion An early warning system cannot be complete

without incorporating the characteristics of

corporate governance.

Strengthening the mechanism of corporate governance would help to reduce the likelihood of financial failures, especially in an environment of weak corporate governance.