Effect of board structure on the association between ultimate ownership and firm value

1
Effect of board structure on the association
between ultimate ownership and firm value

• Dr. Cheng Few Lee
• Distinguished Professor of Finance
• Rutgers, The State University of New
  JerseyEditor of Review of Quantitative Finance
  and Accounting
• Editor of Review of Pacific Basin Financial
  Markets and Policies

2
Outline

• I. Prior research and hypotheses
  development
• II. Data and method
• III. Results
• IV. Conclusions

3
Abstract

• We examine the effect of board structure on
  the association between firm value and the
  separation of control rights from cash flow
  rights of the controlling shareholder. We find
  that firm value is negatively associated with
  separation of control rights from cash flow
  rights of controlling shareholders. The negative
  effect on firm value when control rights are
  separated from cash flow rights is reduced when
  there is a higher proportion of outside directors
  on the board. We also find that in firms in which
  the control rights exceed the cash flow rights in
  the hands of the largest shareholder, investors
  assign higher valuation to firms with outside
  directors holding higher equity ownership.
  Furthermore, the negative association between
  separation of control rights from cash flow
  rights and firm value is magnified in firms with
  longer board tenure. Overall, our results suggest
  that higher equity ownership by outside
  directors, higher board independence, and shorter
  board tenure, are associated with higher firm
  value, especially in firms with high expected
  agency costs arising from misalignment of control
  rights and cash flow rights.

4
Effect of board structure on the association
between ultimate ownership and firm value

• In Asia, corporate ownership concentration
  is high and many listed firms are controlled by a
  single large shareholder (LaPorta, Lopez and
  Shleifer (1999), Claessens, Djankov and Lang
  (2000)). Asian firms also show a high divergence
  between control rights and cash flow rights,
  which allows the largest shareholder to control a
  firms operations with a relatively small direct
  stake in its cash flow rights. Control is often
  increased beyond ownership stakes through pyramid
  structures, cross- holdings among firms and dual
  class shares (Claessens, Djankov and Lang
  (2000)). As a result of concentrated ownership,
  the main agency problem in listed firms is the
  conflict of interest between the controlling
  shareholder and minority shareholder because the
  controlling shareholder has the power to divert
  corporate resources for his private benefits
  (LaPorta, Lopez, Shleifer and Vishny (1998),
  LaPorta, Lopez and Shleifer (1999)). This agency
  conflict is more severe in countries that provide
  weak legal protection to minority shareholders
  (LaPorta, Lopez, Shleifer and Vishny (1998),
  Durnev and Kim (2005) and Pinkowitz, Stulz, and
  Williamson (2006)).

5
Effect of board structure on the association
between ultimate ownership and firm value

• Prior research shows that investors
  recognize the potential agency conflicts
  associated with corporate ownership structure
  that give controlling shareholders control rights
  that far exceed their proportional cash flow
  rights and thus, discount the valuation of firms
  with high separation of control rights and cash
  flow rights (La Porta et. al (2002), Claessens,
  Djankov, Fan and Lang (2002), Lins (2003) and
  Harvey, Lins and Roper (2004)). Using a sample of
  listed firms in eight East Asian economies,
  Claessens, Djankov, Fan and Lang (2002) find that
  firm value increases with the cash flow rights of
  the largest shareholder, consistent with a
  positive incentive effect. However, firm value
  falls when the control rights of the largest
  shareholder exceed its cash flow rights,
  consistent with an entrenchment effect. Lemmon
  and Lins (2003) examine the effect of ownership
  structure on the valuation of 800 East Asian
  firms during the 1997 East Asian financial
  crisis. They find that during the crisis period,
  stock returns are lower in firms where managers
  have high levels of control rights, but have
  separated their control and cash flow ownership.

6
Effect of board structure on the association
between ultimate ownership and firm value

• An important question is how effective are
  corporate governance mechanisms in mitigating the
  agency problems in Asia firms, especially in
  firms with concentrated ownership. Controlling
  shareholders in Asia typically face limited
  disciplinary pressures from the market for
  corporate control because hostile takeovers are
  infrequent (LaPorta, Lopez and Shleifer (1999),
  Claessens, Djankov and Lang (2000)). Furthermore,
  controlling shareholders face little monitoring
  pressure from analysts because analysts are less
  likely to follow firms with potential incentives
  to withhold or manipulate information, such as
  when the management group is the largest control
  rights blockholder (Lang, Lins and Miller
  (2004)). In these environments, external
  corporate governance mechanisms, in particular
  the market for corporate control and analysts
  scrutiny, exert limited disciplinary pressure on
  controlling shareholders. Consequently, internal
  corporate governance mechanisms such as the board
  of directors may be important to mitigate the
  agency costs associated with the ownership
  structure of Asian firms. Thus, the primary
  research question in this paper is Does board
  structure affect the valuation of firms with high
  expected agency costs arising from the separation
  of control rights and cash flow rights?

7
Effect of board structure on the association
between ultimate ownership and firm value

• Our central theme is that strong board
  monitoring reduces the valuation discount in
  firms where the controlling shareholder has high
  separation of control rights and cash flow
  rights1. Clearly, board structure is an
  important determinant of the effectiveness of
  board monitoring. In this paper, we focus on four
  important attributes of board structure (i)
  board independence, (ii) board size, (iii)
  outside directors equity ownership, and (iv)
  board tenure, and their interaction with the
  separation of control rights from cash flow
  rights of the controlling shareholder in
  affecting firm value. These board attributes are
  important for several reasons. First, outside
  directors perform a corporate governance role by
  mitigating managerial entrenchment and reducing
  expropriation of firm resources. The governance
  literature generally suggests that as boards
  become increasingly independent of managers,
  their monitoring effectiveness increases, thereby
  decreasing managerial opportunism and enhancing
  firm performance. Second, prior studies suggest
  that large board experience more coordination
  problems and are therefore less ineffective.
  Yermack (1996) finds that smaller boards are
  associated with higher firm value because they
  are more efficient. Third, prior studies document
  that equity ownership improves outside directors
  monitoring incentives by aligning their interests
  with those of shareholders (Shivdasani (1993) and
  Ryan and Wiggins (2004)). Fourth, Vafeas (2003)
  provides evidence that extended board tenure may
  reduce directors skepticism and oversight of
  managers2.
• 1 It is important to stress that ex ante, we do
  not expect strong board to completely eliminate
  the expropriation of corporate resources by the
  controlling shareholder in firms with a high
  separation of control rights and cash flow
  rights. Instead, our primary emphasis is that
  holding other factors constant, we expect a
  strong board to be more effective in mitigating
  the expropriation of corporate resources by the
  controlling shareholder relative to a weak board.
  
• 2 Similarly, the business community such as the
  National Association of Corporate Directors
  (1996) proposes that board service should be
  capped at a maximum of 10 to 15 years to obtain
  fresh ideas and critical perspective from new
  directors.

8
Effect of board structure on the association
between ultimate ownership and firm value

• Our sample consists of 4,287 firm-year
  observations for 913 listed firms in four Asian
  economies comprising Malaysia, Philippines,
  Singapore and Thailand during the period 2001 to
  2005. These countries provide a good setting to
  test the governance potential of the board of
  directors because shareholders in these countries
  typically suffer from misaligned managerial
  incentives, ineffective legal protection and
  under-developed markets for corporate control
  (LaPorta, Lopez and Shleifer (1999), Claessens,
  Djankov and Lang (2000) and Fan and Wong (2002)).
  
• Consistent with prior studies (La Porta
  et. al (2002), Claessens, Djankov, Fan and Lang
  (2002), and Lins (2003)), we find that firm
  valuation is negatively associated with the
  separation of control rights from cash flow
  rights of the largest shareholder. More
  importantly, our result indicates the negative
  association between separation of control rights
  from cash flow rights and firm valuation is
  reduced as the proportion of outside directors on
  the board rises. Thus, in firms with high
  separation of control rights and cash flow
  rights, investors assign a lower valuation
  discount to firms with higher board independence.
  This result provides evidence supporting the
  corporate governance role of outside directors in
  constraining managerial discretion over corporate
  resources in firms with high levels of
  misalignment between control rights and cash flow
  rights. Our result is consistent with Fama and
  Jensens (1983) argument that outside directors
  have incentives to be effective monitors to
  maintain the value of their reputational capital.
  Furthermore, we also find that the negative
  association between separation of control rights
  from cash flow rights and firm valuation is less
  pronounced in firms with higher equity ownership
  by outside directors. This result suggests
  equity-based ownership improves the incentives
  and monitoring intensity of outside directors in
  firms with high expected agency costs arising
  from the divergence of control rights from cash
  flow rights. Our findings shed light on
  importance of equity incentives of the board as a
  channel to curb the diversion of corporate
  resources by controlling shareholders for their
  private benefits. We also document that in firms
  with high separation of control rights from cash
  flow rights, investors additionally discount the
  valuation of firms with longer board tenure. In
  other words, the combination of divergence of
  control rights from cash flow rights and longer
  board tenure exacerbates agency costs, which
  results in lower firm valuation. Our result is
  consistent with the finding in Vafeas (2003) that
  extended board tenure weakens directors
  monitoring effectiveness. Collectively, our
  results suggest that strong board structures can
  alleviate agency problems between the controlling
  shareholder and minority shareholders. More
  generally, our results highlight the interplay
  between board structure and corporate ownership
  structure in shaping firm valuation.

9
Effect of board structure on the association
between ultimate ownership and firm value

• We perform several robustness tests. Our
  results are robust across different economies. In
  addition, year-by-year regressions yield
  qualitatively similar results, suggesting our
  inferences are not time-period specific. We also
  include additional country-level institutional
  variables such as legal origin, country investor
  protection and enforcement of shareholder rights.
  Our results are qualitatively similar.
  Specifically, after controlling for country-level
  legal institutions, firm-specific internal
  governance mechanisms, namely board
  independence, outside directors equity ownership
  and board tenure continue to be important in
  affecting the negative effects of the divergence
  between control rights and cash flow rights on
  firm value.3
• Our study has several contributions.
  First, prior studies find that the divergence of
  control rights from cash flow rights reduces firm
  valuation (La Porta et. al (2002), Claessens et.
  al (2002) and Lins (2003)). Given this evidence,
  an important question is whether alternative
  governance mechanisms exist to reduce the
  discount in firm value associated with high
  expected agency costs. We extend these studies by
  demonstrating that strong board structures
  mitigate the negative association between firm
  valuation and divergence of control rights from
  cash flow rights. This result suggests that the
  board of directors play an important corporate
  governance role to alleviate agency problems in
  firms with entrenched insiders. Our findings also
  complement Fan and Wongs (2005) result that
  given concentrated ownership, a controlling owner
  may introduce some monitoring or bonding
  mechanisms that limit his ability to expropriate
  minority shareholders and hence mitigate agency
  conflicts. In the Fan and Wongs study, high
  quality external auditors alleviate agency
  problems in firms with concentrated ownership
  whereas in our study, a strong board of directors
  mitigates agency problems in firms with
  concentrated ownership.
• 3 An alternative argument is that a
  controlling shareholder has little incentive to
  mitigate his diversion of private benefits by
  appointing a strong board. If this is the case,
  there will be little or no association between
  board structure and the divergence between
  control rights and cash flow rights on firm
  value. In other words, if controlling
  shareholders dominate the board, this should bias
  against us from finding that stronger board
  structures mitigate the firm valuation discount
  associated with the separation of control rights
  and cash flow rights.

10
Effect of board structure on the association
between ultimate ownership and firm value

• Second, our results suggest that there is
  an incremental role for firm-specific internal
  governance mechanisms, beyond country-level
  institutions, in improving the firm valuation.
  Our study shows that after controlling for
  country-level institutions (such as legal origin
  and efficiency of judicial system), firm-specific
  internal governance mechanisms, namely board
  independence, outside directors equity ownership
  and board tenure continue to be important in
  constraining management opportunism in firms with
  high expected agency costs arising from the
  divergence between control rights and cash flow
  rights. To the extent that changes in
  country-level legal institutions are relatively
  more costly and more difficult than changes in
  firm-level governance mechanisms, our result
  suggests that improvement in firm-specific
  governance mechanisms can be effective in
  reducing the private benefits of control. Our
  results complement the finding of prior studies
  (Klapper and Love (2004) and Durnev and Kim
  (2005)) that firms can substitute weak
  country-level legal protection with strong
  firm-level internal governance mechanisms in
  order to attract investors. An important question
  is what specific factors may constrain managerial
  opportunism when country-level investor
  protection is weak? Because our sample consists
  of countries with generally weak investor
  protection, we shed light on this question by
  documenting that board structure matters in
  improving firm valuation in such countries.
• The rest of the paper proceeds as follows.
  Section I develops the hypotheses and places our
  paper in the context of related research. Section
  II describes the sample and method. Section III
  presents our results. Section IV contains our
  conclusions.

11
I. Prior research and hypotheses development

• A. Board independence
• B. Equity ownership of outside directors
• C. Board tenure
• D. Board size

12
I. Prior research and hypotheses development

• Prior research shows that in East Asia,
  corporate ownership is concentrated and the
  wide-spread use of pyramidal ownership structures
  and cross-holdings concentrates the control
  rights in the hands of a large shareholder,
  despite owning little cash flow rights (La Porta
  et. al (1999) and Claessens, Djankov and Lang
  (2000)). As a result of the separation of control
  rights and cash flow rights, controlling
  shareholders have the ability and incentives to
  expropriate corporate resources to increase their
  private benefits or perquisite consumption
  without bearing the full cost of their actions.
  Some mechanisms by which the controlling
  shareholder can divert corporate resources
  include outright theft, excessive compensation,
  dilution of outside investors through share issue
  to insiders, and transactions with related
  parties at favourable terms (Shleifer and Vishny
  1997). Investors recognize the agency conflicts
  associated with corporate ownership structure
  that give controlling shareholders control rights
  that far exceed their proportional cash flow
  rights and thus, price-protect themselves by
  discounting the valuation of firms with high
  separation of control rights and cash flow rights
  (La Porta et. al (2002), Claessens, Djankov, Fan
  and Lang (2002), Lins (2003) and Harvey, Lins and
  Roper (2004)).

13
I. Prior research and hypotheses development

• Consequently, firms with high separation of
  control rights and cash flow rights face high
  external financing costs to fund their growth
  opportunities and in the extreme, outside
  investors may completely avoid these firms. In
  addition, controlling shareholders also bear
  substantial losses if they sell their personal
  equity holdings in the firm at severely
  discounted prices. Prior studies (Klapper and
  Love (2004) and Durnev and Kim (2005)) suggest
  that firms located in countries with weak
  investor protection have incentives to reduce
  agency costs by employing strong firm-level
  corporate governance structures4. These studies
  also document that firms with high external
  financing needs in the future will find it most
  beneficial to adopt stronger governance
  structures.
• We posit that one mechanism for firms to
  mitigate the valuation discount associated with
  the separation of control rights and cash flow
  rights is to appoint a strong board to reduce
  potential diversion of corporate resources by the
  controlling shareholders5. Board structure is
  an important determinant of the boards
  monitoring effectiveness. In the following
  sections, we focus on four important attributes
  of board structure (i) board independence, (ii)
  board size, (iii) outside directors equity
  ownership, and (iv) board tenure, and their
  interaction with the separation of control rights
  from cash flow rights of the controlling
  shareholder in affecting firm value.
• 4 Specifically, Klapper and Love (2004) and
  Durnev and Kim (2005) examine the association
  between firm value and firm-level corporate
  governance proxied by a firm-specific corporate
  governance score the Credit Lyonnais Securities
  Asia corporate governance score and the Standard
  and Poors corporate transparency score. These
  corporate governance scores are composite scores
  based on the presence or absence of a specific
  firm characteristic such as the presence of
  independent directors. However, these corporate
  governance scores do not provide a finer measure
  of board attributes such as the proportion of
  outside directors on the board, equity ownership
  of outside directors and the average tenure of
  the board, which we provide in our study.
• 5 Other mechanisms to mitigate the valuation
  discount when controlling shareholders have
  control rights that exceed their proportional
  cash flow rights include appointing a high
  quality external auditor (Fan and Wong (2005))
  and issuing debt contracts that provide for
  intensive monitoring (Harvey, Lins and Roper
  (2004)).

14
I. Prior research and hypotheses development

• A. Board independence
• There is considerable literature on the role
  of outside directors in reducing agency problems
  between managers and shareholders. Fama and
  Jensen (1983) argue that outside directors have
  strong incentives to be effective monitors in
  order to maintain their reputational capital.
  Prior studies show that board effectiveness in
  protecting shareholders wealth is positively
  associated with the proportion of outside
  directors on the board. Weisbach (1988) finds a
  positive relation between CEO turnover following
  poor performance and the fraction of outside
  directors. Similarly, Rosenstein and Wyatt (1990)
  find a positive stock price reaction to the
  election of outside directors.
• We extend this notion to posit that the
  greater monitoring efforts from a higher
  proportion of outside directors on the board are
  likely to mitigate the negative effects of the
  separation of control rights from cash flow
  rights on firm valuation. Thus, we predict that
• H1 The negative association between separation
  of control rights from cash flow rights and firm
  valuation is mitigated by the proportion of
  outside directors on the board.

15
I. Prior research and hypotheses development

• B. Equity ownership of outside directors
• There is a stream of research that examines
  the association between outside directors equity
  incentives and firm performance. The central
  theme in this body of research is that incentive
  compensation leading to share ownership improves
  the outside directors incentives to monitor.
  Mehran (1995) finds firm performance is
  positively associated with the proportion of
  directors equity-based compensation. Perry
  (2000) finds that the likelihood of CEO turnover
  following poor performance increases when
  directors receive higher equity-based
  compensation. Shivdasani (1993) finds that
  probability of a hostile takeover is negatively
  associated with the percentage of shares owned by
  outside directors in target firms. He interprets
  this finding as suggesting that board monitoring
  may substitute for monitoring from the market of
  corporate control. Hermalin and Weisbach (1998)
  and Gillette, Noe and Robell (2003) develop
  models where incentive compensation for directors
  increases their monitoring efforts and
  effectiveness. Ryan and Wiggins (2004) find that
  directors in firms with entrenched CEOs receive a
  significantly smaller proportion of compensation
  in the form of equity-based awards. Their result
  suggests that compensation contracts that provide
  directors with weaker incentives to monitor
  management are associated with higher CEO
  entrenchment.

16
I. Prior research and hypotheses development

• The preceding discussion suggests that higher
  equity ownership for outside directors improves
  their monitoring efforts. Greater monitoring
  from outside directors reduces expropriation of
  corporate resources by controlling shareholders
  for personal consumption. We posit that the
  benefits of more effective monitoring arising
  from higher equity-based compensation are likely
  to be more important in firms with high agency
  problems arising from the separation of control
  rights from cash flow rights. Thus, we predict
  that
• H2 The negative association between separation
  of control rights from cash flow rights and firm
  valuation is less pronounced in firms whose
  outside directors hold higher equity ownership.

17
I. Prior research and hypotheses development

• C. Board tenure
• Vafeas (2003) argues that board tenure is an
  important determinant of director quality. He
  proposes two competing views relating the effect
  of director tenure on the effectiveness of board
  monitoring. Under the expertise hypothesis,
  extended board tenure is associated with greater
  experience, commitment, and competence, because
  it provides directors with important knowledge
  about the firms and its business environment.
  Extended tenure enhances organizational
  commitment and willingness to expend effort
  toward organizational goal. Thus, if longer board
  tenure is associated with more firm-specific
  expertise and more effective oversight of
  managers, there should be a positive association
  between board tenure and firm performance.
• In contrast, under the management
  friendliness hypothesis, extended board tenure
  reduces intra-group communication and isolates
  the board from key information sources. Longer
  board tenure can weaken directors independence
  because a directors objectivity about the
  management is reduced with passage of time. If
  long-tenured directors are less likely to monitor
  managers, there should be a negative association
  between board tenure and firm performance.

18
I. Prior research and hypotheses development

• Vafeas (2003) provides evidence that longer
  board tenure may be detrimental to the interest
  of shareholders. He finds that directors with
  longer board service are more likely to be
  classified as grey directors and are preferred
  for serving on nominating and compensation
  committees. The participation of directors with
  longer board service on the compensation
  committee is associated with higher CEO
  compensation, consistent with CEO entrenchment.
• Ex ante, the effect of board tenure on firm
  performance depends on whether the expertise
  hypothesis or the management friendliness
  hypothesis dominates. If, as suggested by prior
  empirical evidence (Vafeas 2003) that longer
  board tenure is associated with weaker monitoring
  of the management, we expect
• H3 The negative association between separation
  of control rights from cash flow rights and firm
  valuation is more pronounced in firms with longer
  board tenure.

19
I. Prior research and hypotheses development

• D. Board size
• Lipton and Lorsch (1992) and Jensen (1993)
  propose that larger boards are less effective
  than smaller boards because as board size
  increases, there are more coordination problems
  and directors free-riding. These arguments imply
  that the CEOs power increases with the number of
  directors on the board. Supporting this premise,
  Yermack (1996) and Eisenberg, Sundgren and Wells
  (1998) find that smaller boards are associated
  with higher firm value.
• However, recent studies (Boone, Field,
  Karpoff and Raheja (2007) and Coles, Daniel and
  Naveen (2008)) find that complex firms (such as
  large firms, diversified firms, and high-debt
  firms) have greater advising requirements and
  thus, have larger boards6. Consistent with the
  greater advisory needs of complex firms, Coles,
  Daniel and Naveen (2008) find that firm valuation
  increases in board size for complex firms.
• Thus, the effect of board size on firm
  performance is mixed. If there are more
  inefficiencies and coordination problems
  associated with larger boards, we expect
• H4 The negative association between separation
  of control rights from cash flow rights and firm
  valuation is more pronounced in firms with larger
  boards.
• 6 Specifically, complex firms have larger
  boards because larger boards bring more
  experience and expertise and offer better advice.
  For example, as a firm increases its product
  lines or geographical boundaries, its demands for
  specialized board services also increase because
  new directors may have specialized knowledge that
  applies to the new growth areas.

20
II. Data and method

• A. Sample Construction
• B. Model Specification

21
II. Data and method

• A. Sample Construction
• We begin with the Worldscope database to
  identify listed firms in four Asian countries
  comprising Malaysia, Philippines, Singapore and
  Thailand during the period 2001 to 2005. We
  exclude financial institutions because of their
  unique financial structure and regulatory
  requirements. We eliminate observations with
  extreme values of control variables such as sales
  growth and firm size (discussed in section 3.2
  below). We obtain annual reports for fiscal year
  2001 and 2005 from the Global Report database and
  company websites. Our final sample consists of
  913 firms for 4,287 firm-year observations during
  the period 2001 to 2005 in four Asian countries
  (Malaysia, Philippines, Singapore and Thailand).
  We collect data on the board characteristics such
  as board size, the number of independent
  directors and equity ownership of directors from
  the annual report. An estimate of the control
  divergence of the controlling shareholders
  requires data on the control rights and cash flow
  rights of the ultimate owners. We consider the
  shareholder of Company X to be the ultimate owner
  when the shareholder is an individual or a
  family, a privately held company, a privately
  held financial firm, or a government. The
  procedure of identifying ultimate owners is
  similar to the one used in La Porta et al.
  (1999)7. For example, if the ultimate owner is
  the family M that owns 50 of the shares in
  Company B and Company B owns 30 of the shares in
  Company A, we designate family M as controlling
  30 of the control rights of Company A and owning
  15( 50 x 30) of the cash flow rights.
• 7 In summary, an ultimate owner is defined as
  the shareholder who has the determining voting
  rights of the company and who is not controlled
  by anyone else. If a company does not have an
  ultimate owner, it is classified as widely held.
  To economize on the data collection task, the
  ultimate owners voting right level is set at 50
  and not traced any further once that level
  exceeds 50. Although a company can have more
  than one ultimate owner, we focus on the largest
  ultimate owner. We also identify the cash flow
  rights of the ultimate owners. To facilitate the
  measurement of the separation of cash flow and
  voting rights, the maximum cash flow rights level
  associated with any ultimate owner is also set at
  50. However, there is no minimum cutoff level
  for cash flow rights.

22
II. Data and method

• B. Model Specification
• To test the effect of board structure on
  the association between the separation of control
  rights from cash flow rights of the largest
  shareholder and firm valuation, we employ the
  following model-
• TOBINQi,t ß0 ß1CASHi,t-1 ß2VCi,t-1
  ß3VCOUTDIR i,t-1 ß4VCEQOWN i,t-1
  ß5VCTENUREi,t-1 ß6VCBODSIZEi,t-1
  ß8OUTDIR i,t-1 ß4EQOWN i,t-1 ß5TENUREi,t-1
  ß6BODSIZEi,t-1 ß15SALECHGi,t-1
  ß17CAPEXi,t-1 ß18LNASSETi,t-1 Country
  Dummies Year Dummies Industry dummies (1)
• where-
• TOBINQ market value of equity plus book value
  of total liabilities divided by total assets.
• CASH share of cash flow rights held by the
  largest shareholder.
• VC control rights minus cash flow rights of the
  largest controlling shareholder.
• OUTDIR proportion of outside directors on the
  board. An outside director is defined as a
  director who is neither a current nor former
  employee of the firm.

23
II. Data and method

• EQOWN common stock and stock options held by
  outside directors divided by number of ordinary
  shares outstanding in the firm.
• TENURE Mean tenure of all directors on the
  board.
• BODSIZE Number of directors on the board.
• SALECHG prior year sales growth.
• CAPEX capital expenditure divided by sales.
• LNASSET natural logarithm of total book value
  of assets.
• Country Dummies Dummy variables for countries.
• Year Dummies Dummy variables for years.
• Industry dummies Dummy variables for
  industries.
• Subscripts i and t refer to firm and year
  respectively.

24
II. Data and method

• Prior studies (La Porta et. al (2002),
  Claessens, Djankov, Fan and Lang (2002), Lins
  (2003)) suggest that high cash-flow rights of the
  largest shareholder are associated with higher
  incentive alignment and thus, we expect
  coefficient ß1 to be positive. A negative
  coefficient ß2 indicates investors discount the
  valuation of firms with high separation of
  control rights from cash flow rights of the
  largest controlling shareholder
• Hypothesis H1 predicts that the negative
  association between firm valuation and the
  separation of control rights from cash flow
  rights is less pronounced in firms with high
  proportion of outside directors on the board.
  Thus, we expect coefficient ß3 to be positive.
  Hypothesis H2 maintains that high equity
  ownership by outside directors mitigates the
  negative association between firm valuation and
  the separation of control rights from cash flow
  rights. Thus, we expect coefficient ß4 to be
  positive. According to hypothesis H3, the
  negative association between firm valuation and
  the separation of control rights from cash flow
  rights is more pronounced in firms with longer
  board tenure. Thus, we expect coefficient ß5 to
  be negative. From Hypothesis H4, in firms with
  high separation of control rights from cash flow
  rights, firm valuation should be lower in those
  firms with larger boards. Thus, we expect
  coefficient ß6 to be negative.
• Our control variables are as follows. We
  control for growth opportunities by including
  prior years sales growth (SALECHG) and capital
  expenditure to sales ratio (CAPEX). We control
  for firm size by including the natural logarithm
  of book assets (LNASSET). We also include dummy
  variables for countries, years and industries.

25
III. Results

• A. Descriptive statistics
• B. Firm valuation
• C. Robustness tests
• C.1. Results by economy
• C.2. Alternative measures of country-
  level investor protection
• C.3. Results by time period
• C.4. Operating profitability

26
III. Results

• A. Descriptive statistics
• Table I presents the descriptive statistics.
  In terms of financial data, the average firm in
  the sample has a market-to-book asset ratio of
  1.418, a one-year sales growth rate of 0.145, a
  capital expenditure to sales ratio of 0.089, a
  firm size (measured by the natural logarithm of
  assets) of 11.33 and a return on assets of 0.039.
  Turning to board characteristics, the mean board
  size is about 8.194, the mean proportion of
  outside directors on the board is 41, mean
  equity ownership of outside directors is 3 and
  mean board tenure is 8 years. The mean cash-flow
  rights of the largest controlling shareholder is
  25.78 and the mean voting rights of the largest
  controlling shareholder is 33.10. The mean
  difference between control rights and cash-flow
  rights is 7.39.

27
III. Results

• B. Firm valuation
• Table II presents the results of
  regression of firm valuation on corporate
  ownership and board structure. In column (1), we
  present our baseline model to benchmark our
  results against the findings in Claessens,
  Djankov, Fan and Lang (2002). We find that the
  higher the cash-flow rights of the largest
  shareholder, the higher the firm valuation. We
  find that firm valuation is negatively
  association with the separation of voting rights
  from cash flow rights. Thus, our results are
  consistent with the findings of Claessens,
  Djankov, Fan and Lang (2002).
• In column (2), we examine the effect of
  board structure on the negative association
  between firm valuation and the separation of
  voting rights from cash flow rights. The
  interaction term between the separation of voting
  rights from cash flow rights and the proportion
  of outside directors on the board (VCOUTDIR) is
  positive and significant at the 5 level. This
  result indicates that in firms with high
  separation of voting rights from cash flow
  rights, those with higher proportion of outside
  directors on the board have higher valuation. We
  posit that the greater monitoring associated with
  higher board independence reduces the controlling
  shareholders propensity to divert corporate
  resources for rent-seeking purposes, and thus,
  results in lower valuation discount in firms with
  high expected agency costs arising from their
  concentrated ownership structures. In terms of
  economic significance, a one standard deviation
  increase in the concentration of control rights
  over the cash flow rights in the hands of the
  largest shareholder (8.153) reduces
  market-to-book ratio by 0.1606. Based on the
  coefficient of the interaction term (VCOUTDIR),
  an increase in the proportion of outside
  directors from the 25th percentile (30) to the
  75th percentile (52) is associated with a 0.216
  increase in the market-to-book ratio8. With a
  mean sample market-to-book ratio of 1.418, this
  corresponds to an increase in relative market
  valuation by 15. Thus, the effect of an increase
  in board independence on the association between
  firm valuation and the separation of voting
  rights from cash flow rights is large and
  economically significant.
• 8 Based on the specification in column (2), a
  one standard deviation increase in control rights
  over cash flow rights in the hands of the largest
  shareholder (8.153) lowers relative market
  valuation by -0.1606 ( -0.0197 x 8.153). The
  coefficient on the interaction term (VCOUTDIR)
  is 0.0021. Assuming a one standard deviation
  increase in control rights over cash flow rights
  in the hands of the largest shareholder of
  8.153, an increase in the proportion of outside
  directors from the 25th percentile (30) to the
  75th percentile (52) increases firm valuation
  by 0.3766 (0.0021 x 8.153 x (52-30) ). Summing
  up, the net effect is an increase in firm
  valuation by 0.2160 ( - 0.1606 0.3766).

28
III. Results

• The interaction term between the separation
  of voting rights from cash flow rights and the
  equity ownership of outside directors (VCEQOWN)
  is positive and significant at the 1 level. This
  result indicates that the negative association
  between firm valuation and the separation of
  voting rights from cash flow rights is mitigated
  by the equity ownership of outside directors.
  Thus, in firms with high separation of voting
  rights from cash flow rights, investors assign a
  higher valuation to the sub-sample of firms with
  higher equity ownership by outside directors. We
  interpret our finding as suggesting that higher
  equity ownership of outside directors improves
  monitoring incentives of the outside directors,
  which in turn curbs the agency conflicts between
  controlling shareholder and external
  shareholders. In terms of economic significance,
  based on the coefficient of the interaction term
  (VCEQOWN) and assuming a one standard deviation
  increase in the separation of voting rights from
  cash flow rights in the hands of the largest
  shareholder, an increase in the equity ownership
  of outside directors from the 25th percentile
  (0.382) to the 75th percentile (4.176) lowers
  the valuation discount from 11 to 89. Thus,
  the effect of an increase in equity ownership of
  outside directors on the association between firm
  valuation and the separation of voting rights
  from cash flow rights is large and economically
  significant.
• 9 Based on the specification in column (2), a
  one standard deviation increase in control rights
  over cash flow rights in the hands of the largest
  shareholder (8.153) lowers relative market
  valuation by -0.1606 ( -0.0197 x 8.153) or an
  11.3 reduction in relative market valuation
  based on a mean sample market-to-book ratio of
  1.418. Based on the coefficient on the
  interaction term (VCEQOWN) of 0.0013 and an
  increase in control rights over cash flow rights
  in the hands of the largest shareholder of
  8.153, an increase in the equity ownership of
  outside directors from the 25th percentile
  (0.382) to the 75th percentile (4.176)
  increases firm valuation by 0.0402 (0.0013 x
  8.153 x (4.176 0.382) ). Summing up, the net
  effect is an decrease in firm valuation by 0.1204
  ( - 0.1606 0.0402) or an 8 reduction in
  relative market valuation based on a mean sample
  market-to-book ratio of 1.418.

29
III. Results

• The interaction term between the separation
  of voting rights from cash flow rights and the
  average board tenure (VCTENURE) is negative and
  significant at the 1 level. This result
  indicates that the negative association between
  firm valuation and the separation of voting
  rights from cash flow rights is more pronounced
  in firms with longer board tenure. In other
  words, the combination of longer board tenure and
  the separation of voting rights from cash flow
  rights exacerbate agency costs in the firms,
  resulting in outside investors additionally
  discounting the valuation of these firms. Our
  result is consistent with Vafeas (2003) finding
  that extended board tenure is associated with
  lower board skepticism and weaker monitoring of
  management, resulting in more managerial
  entrenchment. In terms of economic
  significance, an increase in average board tenure
  from the 25th percentile (5.907 years) to the
  75th percentile (9.013 years) is associated with
  a 0.2011 decrease in the market-to-book
  ratio10. With a mean sample market-to-book
  ratio of 1.418, this corresponds to a decrease in
  relative market valuation by 14. Thus, average
  board tenure has a substantial and economically
  significant effect on the association between
  firm valuation and the separation of voting
  rights from cash flow rights of the largest
  shareholder.
• 10 Based on the specification in column (2), a
  one standard deviation increase in control rights
  over cash flow rights in the hands of the largest
  shareholder (8.153) lowers relative market
  valuation by -0.1606 ( -0.0197 x 8.153). The
  coefficient on the interaction term (VCTENURE)
  is -0.0016. Holding constant the increase in
  increase in control rights over cash flow rights
  in the hands of the largest shareholder at
  8.153, an increase in the average board tenure
  from the 25th percentile (5.907 years) to the
  75th percentile (9.013 years) reduces firm
  valuation by 0.0405 ( - 0.0016 x 8.153 x (9.013
  -5.907) ). Summing up, the net effect is a
  decrease in firm valuation by 0.2011 ( - 0.1606
  - 0.0405).

30
III. Results

• The interaction term between the separation
  of voting rights from cash flow rights and the
  board size (VCBOARDSIZE) is negative but it is
  not significant at the conventional levels.
  Thus, there is no evidence that board size
  affecting the association between firm valuation
  and the separation of voting rights from cash
  flow rights11.
• The control variables are generally in their
  predicted directions. Firm valuation is
  positively associated with sales growth,
  suggesting that higher growth reflects better
  future growth opportunities. Firm valuation is
  negatively associated with firm size suggesting
  that smaller firms have better growth prospects.
• 11 Coles, Daniel and Naveen (2008) find that
  firm value is positively associated with board
  size in complex firms such as those that are
  diversified, those that are large, and those with
  high debt. In contrast, they find that firm value
  is negatively associated with board size in
  simple firms. As a robustness test, we partition
  our sample based on firms complexity such as
  number of segments, firm size and debt. Results
  (not tabulated) indicate the interaction term
  between the separation of voting rights from cash
  flow rights and the board size (VCBOARDSIZE) is
  not statistically significant in all
  specifications. Thus, our results are
  qualitatively similar across different dimensions
  of firms complexity.

31
III. Results

• C. Robustness tests
• C.1. Results by economy
• As a sensitivity analysis, we also repeat
  all our tests at the economy level. In Table III,
  we find that higher separation of cash flow
  rights from control rights in the hands of the
  largest shareholder is associated with lower firm
  valuations in all four economies. We continue to
  document that the mitigating effects of board
  independence on the negative association between
  separation of cash flow rights from control
  rights and firm value in all economies and this
  relationship is statistically significant in
  Malaysia, Singapore and Thailand. Similarly, we
  also find that the mitigating effects of outside
  directors equity ownership on the negative
  association between separation of cash flow
  rights from control rights and firm valuation in
  all four economies. Similarly, in Malaysia,
  Philippines and Singapore, our results indicate
  that in firms with high separation of cash flow
  rights from control rights, those with longer
  board tenure have even lower valuation.
  Collectively, our results are qualitatively
  similar and they are not concentrated in any
  given economy.

32
III. Results

• C.2. Alternative measures of country-level
  investor protection
• We also employ several country-level control
  variables as alternatives to country dummy
  variables. Controlling shareholders receive
  fewer private benefits in countries with stronger
  investor protection. Thus, we include a proxy for
  investor protection in a firms home country. We
  estimate the models with different proxies of
  investor protection such as shareholder rights,
  the index of judicial efficiency and legal origin
  from LaPorta et. al (1998). We also repeat our
  tests with various securities law measures from
  LaPorta, Lopez and Shleifer (2006) such as their
  disclosure index (which measures the quality of
  disclosure requirements), burden of proof index
  (which measures liability standards) and their
  investor protection index (which is principal
  component of disclosure, liability standards and
  anti-director rights).

33
III. Results

• In summary, our inferences are robust across
  alternative measures of country-level investor
  protection proxies. Results (not tabulated)
  indicate that board structure, namely outside
  directors equity ownership, board independence
  and board tenure - still matter in constraining
  expropriation of corporate resources, especially
  in firms with high expected agency costs arising
  from the divergence between control rights and
  cash flow rights. Thus, our results suggest that
  there is an incremental role for firm-specific
  internal governance mechanisms, beyond
  country-level institutions, in improving firm
  valuation by mitigating insiders entrenchment.
  To the extent that changes in country-level legal
  institutions are relatively more costly and
  time-consuming than changes in firm-level
  governance mechanisms, our result suggests that
  improvement in firm-specific governance
  mechanisms can be effective to reduce private
  benefits of control.

34
III. Results

• C.3. Results by time period
• In Table IV, we examine whether our results
  are time-period sensitive. As predicted, the
  coefficient on the interaction term between the
  separation of control rights and cash flow rights
  and the board independence (VCOUTDIR) is
  positive and significant in four out of five
  years. In addition, the coefficient on the
  interaction term between the separation of
  control rights and cash flow rights and equity
  ownership by outside directors (VCEQOWN) is
  positive and significant across all years in the
  sample period. Consistent with our hypothesis,
  the coefficient on the interaction term between
  the separation of control rights and cash flow
  rights and the average board tenure (VCTENURE)
  is in the predicted direction in every year and
  it is statistically significant in four out of
  five years. In summary, the year-by-year
  regressions yield qualitatively similar results,
  suggesting our inferences are not time-period
  specific.

35
III. Results

• C.4. Operating profitability
• As an alternative proxy for firm
  performance, we employ operating profitability.
  In Table V, we examine the effect of board
  structure on the association between corporate
  ownership structure and subsequent operating
  profitability. The dependent variable is
  subsequent return on assets, measured as net
  income before tax divided by total assets12.
  Specifically, we examine how the interaction
  between board structure in year t-1 and the
  separation of cash flow rights from control
  rights in year t-1 affect the subsequent return
  on assets in year t. In column (1), we find a
  negative association between the separation of
  cash flow rights from control rights and
  subsequent return on assets. In column (2), we
  examine the interaction between board structure
  and the the separation of cash flow rights from
  control rights in affecting subsequent return on
  assets. More importantly, the negative
  association between return on assets and the
  separation of cash flow rights from control
  rights is reduced by the proportion of outside
  directors on the board. We also document that
  higher equity ownership of outside directors
  mitigates the negative association between return
  on assets and the separation of cash flow rights
  from control rights. Finally, there is some
  evidence that in firms with high separation of
  cash flow rights from control rights, longer
  board tenure is associated with lower subsequent
  profitability. Taken together, the results on
  subsequent profitability reinforces the findings
  using firm valuation stronger board structure
  mitigates the negative association between the
  separation of cash flow rights from control
  rights of the largest shareholder and firm
  performance.
• 12 We acknowledge that different financial
  accounting standards in different countries may
  introduce measurement errors in our operating
  profitability measure. However, ex ante, it is
  not clear that these measurement errors will
  systematically affect our results. Thus, the
  measurement errors in our dependent variable are
  likely to be noise, which weaken the power of our
  statistical tests.

36
IV. Conclusions
We examine the interaction between board
structure and the separation of control rights
from cash flow rights of controlling shareholder
in affecting firm value. Consistent with prior
studies, we find that firm value is negatively
associated with separation of control rights from
cash flow rights of controlling shareholders. The
negative association between separation of
control rights from cash flow rights and firm
value is mitigated by the proportion of outside
directors on the board. Thus, greater monitoring
by independent directors curtails the potential
expropriation of corporate resources by
controlling shareholders, which translates to
lower agency costs and hence higher firm value.
We also find that the negative association
between separation of control rights from cash
flow rights and firm value is mitigated by the
equity ownership of outside directors. Our result
is consistent with the hypothesis that greater
equity ownership increases outside directors
incentives to exert greater monitoring effort to
reduce entrenchment arising from concentrated
corporate ownership. Furthermore, we find that
the negative association between separation of
control rights from cash flow rights and firm
value is magnified by the average tenure of the
board. In other words, the combination of longer
board tenure and the separation of voting rights
from cash flow rights exacerbate agency costs in
the firms, resulting in additional valuation
discount by outside investors. This finding is
consistent with prior studies documenting that
extended board tenure is associated with higher
agency problems due to lower oversight and
skepticism by directors with long tenure.
Overall, our results suggest that higher equity
ownership by outside directors, higher board
independence, and lower board tenure, are
associated with higher firm value, especially in
firms with high expected agency costs arising
from misalignment of control rights and cash flow
rights.
37
III. Results

• Table I Descriptive statistics
• The sample consists of 913 firms for 4,287
  firm-year observations during the period 2001 to
  2005 in four Asian countries (Malaysia,
  Philippines, Singapore and Thailand).

38
III. Results

• Table I (continued)
• Variable definitions-
• TOBINQ market value of equity plus book value
  of total liabilities divided by total assets.
• SALECHG prior year sales growth.
• CAPEX capital expenditure divided by sales
• LNASSET natural logarithm of total book value
  of assets.

39
III. Results

• Table I (continued)
• ROA net profit before tax divided by total
  assets.
• BOARDSIZE Number of directors on the board.
• OUTDIR proportion of outside directors on the
  board. An outside director is defined as a
  director who is neither a current nor former
  employee of the firm.
• EQOWN common stock and stock options held by
  outside directors divided by number of ordinary
  shares outstanding in the firm.
• TENURE Mean tenure of the board.
• CASH share of cash flow rights held by the
  largest shareholder.
• VOTE share of voting rights held by the largest
  shareholder.
• VC voting rights minus cash flow rights of the
  largest controlling shareholder.

40
III. Results

• Table II Regressions of firm value
• The sample consists of 913 firms for 4,287
  firm-year observations during the period 2001 to
  2005 in four Asian countries (Malaysia,
  Philippines, Singapore and Thailand). The
  dependent variable is firm value (TOBINQ),
  computed as market value of equity plus book
  value of total liabilities divided by total
  assets. All variables are defined in Table 1.
  All models include country, year and industry
  indicators and an intercept term (not tabulated).
  T-statistics based on clustered standard errors
  at the firm level are reported in parentheses
  below the coefficient. , and indicate
  significance at the 10, 5 and 1 respectively
  (2-tailed).

41
III. Results

• Table II (Cont.)

42
III. Results

• Table II (Cont.)

43
III. Results

• Table III Regressions of firm valuation by
  economy
• The sample consists of 913 firms for 4,287
  firm-year observations during the period 2001 to
  2005 in four Asian countries (Malaysia,
  Philippines, Singapore and Thailand). The
  dependent variable is firm value (TOBINQ),
  computed as market value of equity plus book
  value of total liabilities divided by total
  assets. All variables are defined in Table 1.
  All models include year and industry indicators
  and an intercept term (not tabulated).
  T-statistics based on clustered standard errors
  at the firm level are reported in parentheses
  below the coefficient. , and indicate
  significance at the 10, 5 and 1 respectively
  (2-tailed).

44
III. Results

• Table III (Cont.)

45
III. Results

• Table III (Cont.)

46
III. Results

• Table IV Regressions of firm valuation by year
• The sample consists of 913 firms for 4,287
  firm-year observations during the period 2001 to
  2005 in four Asian countries (Malaysia,
  Philippines, Singapore and Thailand). The
  dependent variable is firm value (TOBINQ),
  computed as market value of equity plus book
  value of total liabilities divided by total
  assets. All variables are defined in Table 1.
  All models include country and industry
  indicators and an intercept term (not tabulated).
  T-statistics based on clustered standard errors
  at the firm level are reported in parentheses
  below the coefficient. , and indicate
  significance at the 10, 5 and 1 respectively
  (2-tailed).

47
III. Results

• Table IV (Cont.)

48
III. Results

• Table IV (Cont.)

49
III. Results

• Table V Regressions of operating profitability
• The sample consists of 913 firms for 4,287
  firm-year observations during the period 2001 to
  2005 in four Asian countries (Malaysia,
  Philippines, Singapore and Thailand). The
  dependent variable is net income before tax
  divided by total assets. All independent
  variables lagged by one year and are defined in
  Table 1. All models include country and industry
  indicators and an intercept term (not tabulated).
  T-statistics based on clustered standard errors
  at the firm level are reported in parentheses
  below the coefficient. , and indicate
  significance at the 10, 5 and 1 respectively
  (2-tailed).

50
III. Results

• Table V (Cont.)

51
III. Results

• Table V (Cont.)