QUALITY OF GOVERNANCE AND FIRM

PERFORMANCE: EVIDENCE FROM SPAIN

Eloisa Pérez de Toledo Universitat Autònoma de Barcelona – Dept. Economia de l’Empresa

Eloisa.Perez@uab.es

Supervisor :

Prof. Carles Gispert Pellicer Universitat Autònoma de Barcelona – Dept. Economia de l’Empresa

Carles.Gispert@uab.es

ABSTRACT

Corporate governance is a set of mechanisms relevant to economic efficiency since it

can minimize agency problems. The question is to determine how governance and firm

performance interact. Recent research shows that firm-level corporate governance

mechanisms are more important in countries with low investor protection, suggesting

that firms can partially compensate for ineffective legal environments. Within this

context, the main objective of this paper is to construct a robust proxy for quality of

governance for the Spanish public companies. A second objective is to verify which are

the determinants of governance in the case of Spain, and to assess whether they

influence the performance of the companies. Thus, after providing an extensive

literature review on the field, I construct a governance index (GOV-I) for a sample of 97

Spanish non-financial public companies and, through simple and multiple OLS

regressions, I assess the interaction between governance and performance. The results

show a significant relationship between governance and performance, future growth

opportunities and size, demonstrating that Spanish firms adopt better standards of

governance to compensate for the low level of investor protection holding in the

country. The results support the prevalent hypothesis of a positive relationship between

corporate governance and performance.

Keywords: corporate governance, governance index (GOV-I), firm performance,

investor protection, Spain.

JEL classification: G32, G34

TABLE OF CONTENTS

1. Introduction 3

2. Problem Statement And Objectives 5

2.1 Determinants of the Quality of Corporate Governance 6

2.2 Quality of Governance and Performance 8

3. Governance And Performance: Theory And Practice 9

3.1 What Does the Literature Say? 11

3.2 The Construction of Indexes as a Proxy for Quality of Governance 15

3.3 Designing the Research: Questions and Hypotheses 16

4. Methodology 17

4.1 Sample Selection and Data Collection 19

4.2 The Corporate Governance Index (GOV-I) – definition and

specifications 19

4.3 Determinants of the Quality of Corporate Governance 20

4.4 Relationship between Governance and Performance 21

5. Empirical Results 25

5.1 Descriptive Statistics 25

5.2 The Governance Index (I-GOV) description 28

5.3 Empirical Results 31

6. Discussion and Conclusions 36

References 38

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1. INTRODUCTION

In a capitalist economy, financing is fundamental to the viability of companies and to

the persistence of the capitalism itself. The availability of funds depends on the efficient

allocation of resources by the economic agents from financial markets to productive

investments, e.g. for the creation of new ventures or to finance the growth process of

established companies. An efficient allocation depends on the investors expected return,

but also, on the investors belief that the firm will be managed in order to maximize the

investment and that the cash flows promised in exchange for the investment will

effectively be returned. The economic viability of investment projects can be assessed

through capital budgeting techniques and risk-return trade-off analysis for asset

allocation decisions. Nevertheless, investors trust depends on a broad set of factors as

the legal, institutional and regulatory environment that guarantees the investor

protection. In this sense, corporate governance surges to mitigate the agency problems

derived from the relationship between principals and agents.

Shleifer and Vishny (1997) define corporate governance as a set of mechanisms relevant

to economic efficiency due to its influence over the decision of investors to provide

finance, debt or equity, to the firm. The purpose of a governance structure is to assure a

significant flow of capital to the financing of firms. The separation between ownership

and control, as described by Berle and Means (1932), aggravated by the problem of

information asymmetry between managers and providers of capital, can lead to the

expropriation of the capital suppliers’ wealth. An efficient governance structure should

be able to guarantee that the agent will undertake the optimal level of investment and

minimize the amount of rent seeking behavior. In the presence of agency problems, it is

necessary a mechanism that is able to govern the way in which decisions will be taken

in the future in face of an event that was not contemplated in the contract established

between agent and principal, as described by Hart (1995, p.679) “(…) governance

structure matters when some actions have to be decided in the future that have not been

specified in an initial contract: governance structure provides a way for deciding these

actions”.

A variety of governance mechanisms can be used in order to design efficient

governance structures, for instance, the organization of a board of directors, the

ownership structure and control, stock options and other incentives programs to

management and employees, the capital structure, the market competition, the product

competition, the presence of an active market for corporate control, among others.

Another reason why corporate governance is relevant to economic growth is related

with its possible impact on the performance of the companies. The basic idea is that in a

population of companies, some can be distinguished as “companies with good

governance”. These firms would become more attractive to investors, ceteris paribus,

increasing their access to capital. As a result of such increment in the availability of

credit, the cost of capital of these companies would be reduced, both the cost of debt

and the cost of equity, which implies that companies with good governance should

experience a reduction in their weighted average cost of capital (WACC). As a

consequence of such reduction in the cost of capital, there would be an increment in the

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market value of these companies1. Besides, the reduction in the required rate of return

allows the firm to accept a greater number of investment projects which could increase

its competitiveness.

In a broad sense, research on corporate governance is justified by its contribution to the

increase in the access to capital and, consequently, to the reduction of the cost of capital

in a given economic system. As stated by Shleifer and Vishny (1997), the suppliers of

finance use corporate governance structures to ensure that they will get a return on their

investment. Moreover, according to Rajan and Zingales (2004, p.51) there are three

obstacles in the way of broadening access to finance: (1) the degree to which risk is

concentrated (in a developed system the risk is widely distributed and allocated to the

players that can best hold it, which reduces the risk premium demanded by investors);

(2) the limited information financiers or investors have about borrowers and their

prospects; and, (3) the possibility that borrowers may not act in the best interest of the

financiers. Research on corporate governance can reduce the third problem by analyzing

and defining the mechanisms that assure that firms (managers) will use the funds in the

best interest of the investors.

There are some firm characteristics that are associated with the governance of the public

companies, the so-called internal and external mechanisms of governance. Ownership

concentration and board structure are pointed to be the primary internal mechanisms,

while an active market for corporate control is the main external mechanism. These

mechanisms are alleged to work together “in a system to affect the governance of the

firms” (Cremers and Nair, 2005). In this paper, I try to provide some empirical evidence

of how these mechanisms interact within the Spanish reality. For reaching this objective

I ask two questions: Which observable factors make companies adopt different levels of

governance under the same contracting environment? Does quality of governance affect

firm performance? In order to proxy quality of governance, and following a new trend

in governance studies, I construct a governance index for the Spanish public companies,

namely GOV-I.

This paper has two major contributions. First, I construct a governance index (GOV-I)

for Spain. And, second, I assess the relationship between governance and performance

through the use of OLS regressions. The results show a positive relationship between

corporate governance and firm performance, for instance, firms with higher standards of

governance receive higher market valuations, measured by Tobin’s q.

Generally, the paper shows that ownership concentration (measured by the presence of a

controlling shareholder and the presence of large blockholdings) and leverage are the

significant governance mechanisms in the case of Spain. On the other hand, other

traditional mechanisms such as board independence, board size or duality CEO-

Chairman did not show a significant impact on the valuation of the firms.

The paper is organized as follows. Part 2 states the problem, defines the objectives and

puts forward the hypotheses. Part 3 presents the theoretical framework and offers a

revision of the extant literature. In Part 4 there is a description of the research

1 The logic of such increment in the value of the firm is based on the fundamentals of capital budgeting.

The value of a company is calculated discounting its expected free cash flows by the weighted average

cost of capital (WACC).

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methodology, data and design. Part 5 presents the empirical results. In Part 6, I discuss

the results and conclude the paper.

2. PROBLEM STATEMENT AND OBJECTIVES

The theoretical discussion about corporate governance is based on two hypotheses,

firstly that governance mechanisms influence the performance of the firms, and, second

that firm performance also influences the governance system adopted by the firms.

Essentially, the basic issue is to detect whether the performance is determined by

internal or external mechanisms of governance. Gillan (2006, p.385) divide the internal

mechanisms into 5 categories: (1) the board of directors; (2) managerial incentives; (3)

capital structure, (4) bylaw and charter provisions (antitakeover measures); and (5)

internal control systems. Similarly, the external mechanisms of governance are also

divided into 5 categories: (1) law and regulation; (2) the markets (capital markets,

market for corporate control, labor markets, and product markets); (3) the providers of

capital market information (credit, equity, and governance analysts); (4) accounting,

financial and legal services from parties external to the firm (auditing, insurance, and

investment banks); and, (5) private sources of external oversight (media and external

lawsuits).

Hitherto, there is still no conclusive empirical evidence in the literature about whether

and how governance mechanisms influence the performance of the firms; and, about

how governance mechanisms interact (in a complementary or substitute way) (Bøhren

and Ødegaard, 2003). According to Chi (2005), there are three possible causal

relationships between quality of governance and firm performance (or market value

proxy by Tobin’s q), as illustrated by Figure 1. The first possibility is that there is a

direct causal relationship with governance enhancing firm performance. In the second

possibility, causality runs in both ways and, finally, the third possibility is that

governance and performance are not directly related, but they are spuriously connected

through other variables (Chi, 2005 p.67).

Most studies analyze exclusively the possible influence of specific governance

mechanisms on specific corporate performance variables. In these studies, governance

mechanisms are treated as independent variables and performance measures as

dependent variables. In this sense, governance mechanisms are considered and treated

as exogenous variables with no relation with other governance mechanisms or other

firm’s characteristics. Himmelberg et al. (1999), however, argue that the ownership

structure of the firm may be endogenously determined by the firm’s contracting

environment, which differs across firms in observable and unobservable ways. For

instance, if the scope for perquisite consumption is low in a firm, then a low level of

management ownership may be the optimal incentive contract.

The endogeneity of management ownership has also been noted by Jensen and Warner

(1988, p.13): “A caveat to the alignment/entrenchment interpretation of the cross-

sectional evidence, however, is that it treats ownership as exogenous, and does not

address the issue of what determines ownership concentration for a given firm or why

concentration would not be chosen to maximize firm value. Managers and shareholders

have incentives to avoid inside ownership stakes in the range where their interests are

not aligned, although managerial wealth constraints and benefits from entrenchment

could make such holdings efficient for managers.”

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FIGURE 1

THREE POSSIBLE CAUSAL RELATIONSHIPS BETWEEN GOVERNANCE AND

PERFORMANCE

Source: Adapted from Chi (2005, p.68).

Finally, the set for exploring these matters is the Spanish governance system which is

characterized, according to Demirgüç-Kunt and Maksimovic (1996), as having an

underdeveloped capital market both in terms of market capitalization and in volume of

traded shares, the banking sector is of greater importance in financing firms, and,

according to La Porta et al. (1998), the degree of investor protection is low since it is

based on the Civil law system.

Within this context, the main objective of this paper is to assess whether the

mechanisms of governance are exogenous and influence the performance of the Spanish

public companies. To reach this objective the study is divided into two parts:

1. Determinants of the quality of corporate governance – to assess the possible

factors that make companies adopt different levels of governance under the same

level of investor protection (legal, institutional and regulatory environment).

2. Relationship between corporate governance and corporate performance – to

assess the influence of the quality of governance on the performance of the Spanish

public companies through the use of OLS simple and multiple regressions.

2.1. Determinants of the Quality of Corporate Governance

First of all, it is preemptive to define quality of corporate governance. Durnev and Kim

(2005, p.1463) define the quality of governance as (1 − d), where d is the proportion of

firm value diverted for private gains. Thus, a high level of d implies poor governance

practices, where d is broadly defined to include a wide range of value-decreasing

activities from what Jensen and Meckling (1976) define as excessive evasion and

corporate benefits to direct stealing of tangible and intangible corporate resources. This

causal Quality of

governance (G)

Firm

performance (P)

causal

Possibility II

Possibility I

Quality of

governance (G)

Firm

performance (P)

causal

Quality of

governance (G) Firm

performance (P)

Spurious

correlation

observed

Possibility III

causal Other factors

(observable and

unobservable)

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definition of the quality of governance captures various governance and managerial

practices in place that may or may not be legally compulsory.

Recent research has been focused in analyzing the quality of corporate governance

among firms operating in different country-level investor protection. It is possible,

however, that, due to some observable characteristics, not all firms operating in the

same country (with the same legal environment) offer the same degree of protection to

their investors. As hypothesized by La Porta et al. (1998), the legal system is

fundamental to corporate governance. In particular, they argue that the extent to which a

country’s laws protect investor rights and the extent to which those laws are enforced

are the most basic determinants of the ways in which corporate finance and corporate

governance evolve in that country.

Within this framework, Klapper and Love (2004) provide a cross-country study of firm-

level corporate governance practices and they conclude that companies operating in the

same level of investor protection show different levels in the quality of corporate

governance. They found firms with a high level of corporate governance provisions in

countries with weak legal environments and vice-versa.

This approach, developed by Himmelberg et al. (1999), Himmelberg et al. (2002) and

Klapper and Love (2004), states that investor protection has an external component

related to the legal environment and an internal component related to the activity

developed by the firm and other characteristics (endogenous protection). According to

Himmelberg et al. (2002, p.2) “(…) ‘investor protection’ refers collectively to those

features of the legal, institutional and regulatory environment – and characteristics of

firms or projects – that facilitate financial contracting between insider owners

(managers) and outside investors.” Thus, it is probable that firms operating in the same

country offer different degrees of investor protection, due to specific operational

characteristics and to particular interests. It is corroborated by the research of La Porta

et al. (2000). They find that firms in common law countries where investor protection is

stronger make higher dividend payouts when the firms’ investment opportunities are

poor than do firms in countries with weak legal protection.

According to Klapper and Love (2004) corporate governance is likely to be

endogenously determined and they point out three sources of endogeneity that in theory

could be associated with firms adopting better governance mechanisms: (1) the

composition of a firm’s assets; (2) unobservable growth opportunities; and, (3) firm

size. The composition of a firm’s assets will affect its contracting environment because

it is easier to control and harder to steal fixed assets (equipments, etc.) than “soft”

capital (intangibles, R&D, etc.). In that sense, a firm with a high level of intangibles

may find optimal to adopt a higher level of corporate governance (and avoid possible

misuse of these assets). The variable ‘unobservable growth opportunities’ is related with

the fact that firms with good growth opportunities will need capital to finance the

expansion process and they can find optimal to improve their level of governance in

order to reduce the cost of capital. And finally, firm size has ambiguous effects because

large firms may have greater agency problems due to destination of their free cash flows

and small firms may have better growth opportunities and greater need for external

finance, thus, both have incentives to adopt better governance mechanisms.

Besides these three variables, other variables will be introduced, for instance, ownership

structure, corporate performance, and issuance of stocks in an American or European

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(non-Spanish) stock market2. As a proxy for quality of governance, it will be built a

governance index (GOV-I). For the construction of the index, the approach to be used is

the one developed by Gompers, Ishii and Metrick (2003) and strengthened by Brown

and Caylor (2004), but departing from the determinants of governance detected by

Klapper and Love (2004).

The use of indexes in the field of corporate governance is relatively new, and the

authors that have built and/or used governance indexes for analyzing the reality of

different countries are Black (2001) for Russia, Gompers et al. (2003) for the US,

Klapper and Love (2004) for emerging markets, Brown and Caylor (2004) also for the

US (they strengthen the index developed by Gompers Ishii and Metrick 2003), Leal and

Carvalhal-da-Silva (2004) and Silveira (2004) for Brazil, Black et al. (2005) for Korea,

Durnev and Kim (2005) for emerging markets, Cremers and Nair (2005) for the US,

and, Beiner et al. (2006) for Switzerland.

2.2. Quality of Governance and Firm Performance

Ownership structure is one of the most important mechanisms of governance. The vast

majority of the initial studies in the field tried to capture the influence of this

mechanism in the performance of the firms, for instance Demsetz and Lehn (1985),

Mørck et al. (1988), McConnell and Servaes (1990) and Hermalin and Weisbach

(1991). In sum, the results of these studies pointed to a positive and significant

relationship between ownership concentration and corporate performance. Recently, a

research line initially developed by La Porta et al. (1998) try to assess how ownership

structure vary across countries, hypothesizing that the decisive factor to explain

differences among countries is the degree of investor protection.

From this perspective, firms’ ownership structure is an equilibrium response to the legal

environment in which they operate. The research of La Porta et al. (2000), La Porta et

al. (1999), Claessens et al. (2002) and Beck et al. (2001) suggest that country-level

differences in law systems and law applicability cause differences in ownership

structure, dividend policies, availability of external finance and in the valuation of

corporate bonds. In this sense, most of the literature on ownership structure try to assess

whether differences in the level of investor protection within distinct contractual

environments (different countries) promotes a greater ownership concentration.

Demsetz (1983, p.377) was the first to propose an approach in which ownership

structure is an endogenous result of a corporate efficiency maximization process. To test

this hypothesis, Demsetz and Lehn (1985) developed an empirical model in which

specific firm or industry characteristics, such as size, riskiness and regulation could be

assessed as the determinants of ownership concentration. The authors argue that the

causal relationship between ownership structure and performance is spurious, since

ownership concentration can be considered an endogenous variable.

Himmelberg et al. (1999), in the same line of research as Demsetz and Lehn (1985),

broaden their results through the introduction of other independent variables for

explaining ownership concentration and the use of panel data. The authors propose that

investor protection, besides having an external component related to the legal

2 The idea is that companies that issue stocks in an American or European stock exchange (besides listing

in the Madrid Stock Exchange) are likely to present higher standards of governance.

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environment (legal protection), also has an internal component related to the nature of

the firms operation and to other firm characteristics (endogenous protection). In this

sense, ownership concentration is a function of legal protection, but also of firms’

intrinsic protection, that is different for firms operating in distinct contracting

environments.

Among the endogenous aspects mentioned by Himmelberg et al. (1999) as the

determinants of ownership concentration, three can be pointed as the most important:

size, managers’ discretion, and idiosyncratic risk. According to the authors, size has a

priori a dubious effect on ownership concentration. On the one hand, agency costs and

monitoring could be more severe in big companies increasing the need for ownership

concentration. On the other hand, big companies can make use of economies of scale in

monitoring management, for instance, using rating agencies. In relation with

management discretion, they argue that as fixed assets are observable and easier to

monitor, firms with high level of tangible assets should present a lower optimal level of

ownership concentration. In companies with a high level of intangibles, instead, high

ownership concentration can improve monitoring. Finally, with relation to the

idiosyncratic risk, the authors point out that, ceteris paribus, high ownership

concentration implies to the investor a less diversified portfolio. Thus, as higher a firm

systematic risk the lower its optimal level of ownership concentration.

De Miguel et al. (2003) analyze ownership concentration in Spain, in order to test the

monitoring and expropriation hypotheses, and to analyze insider ownership seeking

evidence of the convergence-of-interest and entrenchment hypotheses. Their results

confirm not only the monitoring but also the expropriation effect for the very high

levels of ownership concentration of Spanish firms. The authors conclude that due to

the fact that Spanish majority shareholders manage to expropriate the wealth of

minority shareholders, unlike UK, US, Germany or Japan, differences in corporate

governance systems lead to different value-ownership relations.

3. GOVERNANCE AND PERFORMANCE: THEORY AND

PRACTICE

The conceptual framework for the present study is given by a combination of

approaches to the theory of the firm: the neoclassical theory of the firm, the principal-

agent theory, the transaction cost economics, the property rights approach and the

institutional theory. The theory of the firm is the classical theoretical framework for the

studies in the field of corporate governance. The neoclassical theory is the one that

provides the first notions of the firm. Nevertheless, despite its formalism and rigor in

the construction of economic models, the neoclassical theory portrays the firm in a

rudimentary way. In the words of Hart (1996 p.200), “(n)eoclassical theory describes in

rudimentary terms how firms function, but contributes little to any meaningful picture

of their structure”. Trying to fulfill the gap, important theories were developed in the

twentieth-century by academics like Knight (1921), Coase (1937), Alchian and Demsetz

(1972), Williamson (1975), Jensen and Meckling (1976), among others, that aimed to

incorporate characteristics of the real world in a new theory of the firm.

The agency theory surges to explain the agency problem and the costs associated with

it. The discussion about the need for improving the governance of the firms is a

response to many cases of expropriation of shareholders’ wealth by the top executives,

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but also by the majority shareholders at the expense of the minority shareholders. This

phenomenon describes quite well the agency problem, when the agents take decisions in

order to maximize their own best interests rather than those of the shareholders (the

same apply to the appropriation by the majority shareholders of the private benefits of

control).

The agency problem is an essential element within the contractual view of the firm,

developed by Coase (1937), Alchian and Demsetz (1972) and Fama and Jensen (1983).

The theme of corporate governance is inserted within this context and the development

of governance mechanisms aims to mitigate this problem. According to Jensen (2001)

the contractual view is based on the idea that the firm is a nexus of contracting

relationships among clients, workers, executives and suppliers of goods and capital. In

line with this view, executives and shareholders sign a contract specifying how firm

resources must be managed. In theory, a complete contract should be designed,

specifying all actions the agent must undertake in face of any possible situation or

contingency. The problem is that, since many contingencies are hard to predict,

complete contracts are unviable. Due to this problem, investors have to allocate their

residual control rights or their right to decide in circumstances not predicted in the

original contract.

The institutional theory provides the conceptual basis for the discussion about the

degree of investor protection holding in each country. The property rights are the

explicative variables of the level of economic development in a given institutional

environment, and of the governance model adopted by the companies, since it has an

impact on their ownership structure. Moreover, the new institutional economics

visualize the firm as a nexus of contracts and, for North (1990) the institutions are the

“rules of the game” in a society. The institutions determine not only the economic

performance, but also the governance structure and the governance model adopted by

the firms. It is necessary to understand the evolution of the institutions in a given

environment (e.g. country) to understand its patterns of corporate governance.

Nevertheless, all these approaches to the theory of firm that try to develop a more

realistic picture of the famous ‘black box’ have weaknesses as pointed by Hart (1996):

the “(p)rincipal-agent theory enriches neoclassical theory significantly, but still fails to

answer the vital questions of what defines a firm and where the boundaries of its

structure are located”. The transaction cost economics provides the basis for introducing

the idea of planning and contracting costs that was neglected by the neoclassical theory,

but despite the contribution of Williamson (1975, 1985), “the precise nature of these

costs are unclear” (Hart, 1996 p.204). The same reasoning can be applied to the

property rights approach to the firm, even though being more complete than the

previous approaches (property rights contains common features of all described

approaches)3, it does not consider the separation between ownership and control that is

actually present in the large public corporations. As a consequence, Hart (1996)

concludes that a formal model of the firm that incorporates all these features, including

an explanation of firm’s financial structure is an important (but not impossible) task for

future research.

3 “It is based on maximizing behavior (like neoclassical approach); it emphasizes incentives issues (like

the principal-agent approach); it emphasizes contracting costs (like transaction costs approach); it treats

the firm as a ‘standard form’ contract (like the nexus of contracts approach); and it relies on the idea that

a firm’s owner has the right to alter membership of the firm (…)” (Hart, 1996 p.210).

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The theoretical framework could be improved by the inclusion of an approach

developed by Jensen (2001), the ‘corporate objective function’. Actually there are two

corporate objective functions discussed by the literature: “the value (or shareholders)

maximization proposition” and the “stakeholder theory”. The stakeholder theory has

been gaining great acceptance among professionals and governments but also among

academics whose argument is that managerial decisions impact investors but also a

number of stakeholders who have an intrinsic relationship with the firm: employees,

clients, suppliers, the community were the firm is located, etc, the so-called externalities

by the economists. In the words of Tirole (2001, p.4), “Why should institution design

ignore the natural stakeholders, and favor the investors, who are ‘stakeholders by

design’, by giving them full control rights and by aligning managerial compensation

with their interests?”, and goes further, defining corporate governance as “the design of

institutions that induce or force management to internalize the welfare of stakeholders.”

Nevertheless, neither the theory of the firm with the value (shareholder) maximization

paradigm nor the stakeholder theory with its multiple objectives offers a clear picture of

the exact direction of the causality between governance and firm value. Governance

theories suggest that strong shareholder rights can mitigate agency problems and, as a

consequence, increase firm value. However, shareholders rights can be restricted by the

managers. Therefore, no causal inferences can be drawn from the theory since it is not

clear that there is a causal relationship and its direction. Due to this lacuna in the

theoretical framework, many researchers have been showing empirically that

governance drives performance. However, they point out the limitations of their results

warning that they may not be robust to some unobservable firms’ characteristics (Chi,

2005).

In the sequence, a literature review on the field of corporate governance is provided,

giving special attention to the relationship between governance and performance.

3.1. What Does the Literature Say?

3.1.1. Ownership Structure and Performance

The relationship between ownership structure and performance was firstly approached

by Berle and Means (1932). They suggest that, due to the separation between ownership

and control in the American big corporations, there is an inverse relation between

disperse ownership and performance. Four decades after, Jensen and Meckling (1976)

and Stulz (1988) developed theoretical models trying to formalize the relationship

between ownership and performance, arguing that ownership influences performance.

The model of Stulz (1988) predicts a concave relationship between managerial

ownership and firm value. In the model, as managerial ownership and control increase,

the negative effect on firm value associated with the entrenchment of manager-owners

starts to exceed the incentive benefits of managerial ownership.

The first empirical studies in the field aimed to test this hypothesis assessing the impact

of ownership structure on performance through the use of linear regressions with

ownership structures as the independent variables. Among the first empirical studies,

the most important are Mørck et al. (1988), McConnell and Servaes (1990) and

Hermalin and Weisbach (1991). In all these studies, the authors find a significant

relationship between ownership structure and firm value that can be interpreted as

consistent with the theoretical hypothesis formulated by Jensen and Meckling (1976)

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and Stulz (1988). Mørck et al. (1988) find an inverse U-shaped relationship between

managerial equity ownership and firm valuation for a sample of US firms. One

interpretation is that firms' performance improves with higher managerial ownership,

but after a point, managers become entrenched and pursue private benefits at the

expense of outside investors. McConnell and Servaes (1990) also provide empirical

support for this relationship for US firms.

Demsetz and Lehn (1985) formulate an alternative hypothesis assuming that ownership

structure is endogenously determined under the assumption of equilibrium. To test this

hypothesis, more recent studies make use of sophisticated econometric techniques and

consider the ownership structure variables as endogenous rather than exogenous. These

studies have not been corroborating the hypothesis that ownership structure is an

exogenous variable and that it influences performance (Cho, 1998; Himmelberg et al.

1999; Demsetz and Villalonga, 2001).

Cho (1998) examines the relationship between ownership structure, investment and

corporate value in the United States. According to the author, common sense says that

ownership structure must influence corporate investment decisions, and that the last

must influence corporate value. In the first part of the study, the author uses the method

of ordinary least squares (OLS) to test the hypothesis. The initial results suggest that

ownership concentration (considered as the independent variable) has a significant

impact on corporate investment (proxy by capital investments and investments in

R&D). Thus, these results corroborate the assumption that ownership structure

influences firm value. In the sequence, the author changes the method to simultaneous

equations systems and considers ownership structure as an endogenous variable. Cho

(1998) concludes that causation is reversed, running from performance to ownership

structure rather than in the opposite way, with investments influencing corporate value

and corporate value, in its turn, influencing the ownership structure. The author presents

empirical evidence showing that probably ownership structure is not an exogenous

variable, and questions previous research that tried to demonstrate the causal

relationship between ownership structure and performance.

Himmelberg et al. (1999) analyze the determinants of insider ownership and the

relationship between ownership structure and performance in the US. The study follows

the methodology proposed by Demsetz and Lehn (1985) and tries to find evidence that

insider ownership is endogenously determined by other corporate variables like size and

industry. After introducing other possible variables as capital intensity, R&D expenses,

free cash flow (FCF) and investment rate, the authors, through the use of panel data

analysis, try to isolate unobservable firm characteristics that did not vary across the time

period under analysis. They conclude that insider ownership and performance are

endogenously determined by some characteristics of the legal environment and that they

are only partially observable.

Demsetz and Villalonga (2001) analyze the relationship between ownership and

performance primarily using the traditional approach of isolated regressions (OLS)

considering ownership structure as the independent variable. Their results indicated that

ownership structure has a significant influence on performance so as the results obtained

by Mørck et al. (1998) and McConnel ans Servaes (1990). Then, the authors run some

tests using a two simultaneous equation system through the procedure of 2SLS (two

stages least square). The results produced by this approach showed that ownership

structure has no statistically significant influence on performance.

13

De Miguel et al. (2003) investigate the relationship between ownership structure and

value in the Spanish firms. They provide new evidence on this relation, since the

Spanish corporate governance system differs from the ones considered in previous

theoretical and empirical research (e.g. US, UK, Germany). The authors use panel data

methodology and control for potential endogeneity using instruments. Their results

confirm the monitoring and the expropriation effect for the very highest concentration

values in Spanish firms. The fact that Spanish majority shareholders manage to

expropriate the wealth of minority shareholders confirms the idea that differences in

corporate governance systems are related to the legal environment as described by

Klapper and Love (2004) and Himmelberg et al. (2002).

More recently, De Miguel et al. (2005) examine how different control mechanisms

relate to one another in the Spanish corporate governance system. The authors propose a

new empirical approach that consists in analysing control mechanisms according to the

non-linearity of the value-ownership relation. They conclude that the Spanish corporate

governance system is very different from the US one. Moreover, their results show that

control mechanisms (especially insider ownership, debt and dividends) are used in a

complementary way by Spanish firms.

3.1.2. Board Composition and Firm Performance

The Board of Directors has a fundamental role in a corporate governance system,

considered a major internal mechanism along with ownership concentration, is used to

reduce agency costs between shareholders and executives, and between controlling and

minority shareholders.

The work of Hermalin and Weisbach (1991) offers a summary of the United States

evidence on the board mechanism: (a) higher proportions of outside directors are not

associated with superior firm performance, but are associated with better decisions

concerning issues such as acquisitions, executive compensation, and CEO turnover; (b)

board size is negatively related to both general firm performance and the quality of

decision-making; and, (c) poor firm performance, CEO turnover, and changes in

ownership structure are often associated with changes in the membership of the board.

Evidence from other countries is offered by Wymeersch (1998) for Europe, Rodriguez

and Anson (2001) for Spain, Mak and Yuanto (2002) for Malaysia and Singapore,

Eisenberg, Sundgren, and Wells (1998) for Finland, and Dahya, McConnell, and

Travlos (2002) for the UK.

Rodriguez and Anson (2001) examine the market reaction to announcements of

compliance to the Olivencia Code by Spanish firms. They observe that the stock prices

react positively to announcements of compliance when such announcements imply a

major restructuring of the board. Besides, this reaction is stronger for firms that have

been performing poorly.

Wymeersch (1998) provides a wide narrative of the composition of European boards of

directors. The author reports that, in most European countries, the role of the board of

directors is not defined by law. So, the shareholder wealth maximization has not been

the primary goal for European boards. This varies across countries, with the British,

Swiss, and Belgian systems being closer to the American model. European Boards are

most often unitary, as in the United States. However, in some European countries the

two-tiered system is the rule. A two-tiered structure is compulsory in some countries,

14

e.g. Germany and Austria, and optional in others, e.g. France and Finland. Two-tier

boards generally consist of a managing board, composed by executives of the firm, and

a supervisory board. In the case of Germany, employees are represented in the

supervisory board, a system called co-determination, and it is mandatory for firm with

more than 500 employees.

Dahya, McConnell, and Travlos (2002) address the effect of the Cadbury Committee

(UK Code of Best Practice) on board effectiveness. Among other things, the Code

recommends that boards of UK corporations include at least three outside directors and

that the positions of chairperson and CEO is held by different individuals. The

compliance to the Code is voluntary. Nevertheless, the London Stock Exchange requires

that all listed companies explicitly indicate whether they are in compliance with the

Code, and if not, an explanation is required.

As consistent with US evidence, there is some evidence of a negative relation between

board size and firm performance in several non-US countries. Mak and Yuanto (2002)

find evidence of an inverse relationship between board size and Tobin’s Q in Singapore

and Malaysia, while Eisenberg, Sundgren, and Wells (1998) document an inverse

relation between board size and profitability for SME’s in Finland. Carline, Linn, and

Yadav (2002) find that board size is negatively related to operating performance

improvements after UK mergers.

3.1.3. Large Shareholdings and Firm Performance

The presence of large shareholders can have positive or negative effects on firm

performance. Many researches have been conducted in order to assess the positive

effects of large shareholdings in the maximization of firms’ value. However, less

attention has been given to the costs associated with the presence of large investors, as

pointed out by Claessens, Djankov, Fan and Lang (2002). The authors conducted an

analysis with 1,301 publicly traded corporations from eight East Asian economies4.

They find that relative firm value (measured by the market-to-book ratio of assets)

increases with the share of cash-flow rights in the hands of the largest shareholder. This

result is consistent with previous studies on the positive incentive effects associated

with increased cash-flow rights in the hands of one or a few shareholders. But, on the

other hand, they find that the entrenchment effect5 of control rights has a negative effect

on firm value.

The findings of Claessens et al. (2002) complement the findings of Mørck, Stangeland,

and Yeung (2000) for Canada. The authors show that large shareholdings control

impedes the growth of Canadian public companies, because entrenched controlling

shareholders take many advantages in maintaining the current value of the firm.

Dick and Zingales (2004), estimate the private benefits of control for 39 countries in an

international comparison. They conclude that higher private benefits are associated with

less developed capital markets, more concentrated ownership and more private

negotiated privatizations. The authors point out the lack of empirical evidence on this

topic despite the importance of this concept. It is related, according to the authors, to the

4 Hong Kong, Indonesia, South Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand.

5 The entrenchment effect occurs when large controlling shareholders pursue the private benefits of

control at the expense of other groups (minority shareholders and other stakeholders). This effect was

originally formulated by Stulz (1988).

15

nature of the phenomenon and its difficult observation. In general, the international

evidence indicates that the accumulation of control rights in excess of cash flow rights

reduces the observed market value of firms.

As summarized by Denis and McConnell (2003, p.26), “a number of conclusions can be

drawn from the international literature on the ownership of publicly-traded firms. First,

ownership is, on average, significantly more concentrated in non-US countries than it is

in the US. Second, ownership structure appears to matter more in non-US countries than

it does in the US – i.e. it has a greater impact on firm performance. Overall, private

ownership concentration appears to have a positive effect on firm value. Third, there are

significant private benefits of control around the world, and they are more significant

for most non-US countries than they are for the US. Structures that allow for control

rights in excess of cash flow rights are common, and generally value-reducing”.

3.2. The Construction of Indexes as a Proxy for Quality of Governance

The main objective of an empirical study in the field of corporate governance is to

assess whether governance drives performance. To reach this objective, recent studies

have constructed corporate governance indexes that put together in only one measure all

relevant information about a series of governance mechanisms.

Black (2001) analyzes the hypothesis that good governance practices affect firms’

market value in Russia. As a proxy to quality of corporate governance, the author uses a

corporate governance ranking created by the Brunswick Warburg Investment Bank.

Gompers Ishii and Metrick (2003) use the incidence of 24 different provisions to build a

governance index for about 1,500 firms per year, and then they study the relationship

between the index and several performance measures during the 1990s. The authors find

a strong relationship between corporate governance and stock returns. They also find

that weaker shareholder rights are associated with lower profits, lower sales growth,

higher capital expenditures, and a higher amount of corporate acquisitions.

Klapper and Love (2004) evaluate the differences in the governance practices of

fourteen companies in emerging markets through the use of a corporate governance

index developed by the Credit Lyonnais Securities Asia (CLSA), an investment bank.

The authors verified a huge variation in the quality of corporate governance among

companies, and the average quality of corporate governance was superior in countries

with more efficient legal systems.

Bøhren and Ødegaard (2003) analyze the relationship between corporate governance

and performance in Norway. The authors find that corporate governance matters for

economic performance, insider ownership is the most important, outside ownership

destroys market value, and direct ownership is superior to indirect. Their results persist

across a wide range of single-equation models, suggesting that governance mechanisms

are independent and may be analyzed one by one. The authors conclude that the lack of

significant relationships in the tests allowing for endogeneity may not reflect optimal

governance, but rather an underdeveloped theory of how governance and performance

interact.

Leal and Carvalhal-da-Silva (2004) analyze the relationship between quality of

corporate governance and the performance of the Brazilian public companies. The

16

authors also construct an overall governance index composed by fifteen questions

divided into four categories: disclosure, board composition, ownership structure and

shareholder rights. They found evidence that companies with best governance practices

have a higher market value (proxy by Tobin’s Q).

Brown and Caylor (2004) develop an index called Corporate Governance Quotient

(CGQ). They found that firms with weaker corporate governance are less profitable,

since they have lower return on assets, lower return on average equity, lower return on

equity, and lower return on investment than do firms with stronger governance

(measured by the CGQ). Besides, the authors also find evidence that firms with weaker

corporate governance are riskier, have lower dividend payouts and lower dividend

yields than firms with stronger corporate governance. They examine four factors: board

composition, managerial compensation, takeover defenses, and audit. Board

composition is the most important factor while takeover defenses is the least important

for the firm’s quality of corporate governance.

Black et al. (2005) report evidence that corporate governance is an important factor for

predicting the market value of South Korean firms. The authors construct a corporate

governance index for 515 Korean companies listed in the Korea Stock Exchange. The

study offers evidence consistent with a causal relationship between an overall

governance index and higher share prices in emerging markets. Finally, the authors

allege that they report the first evidence consistent with greater board independence

causally predicting higher share prices in emerging markets.

In the case of Spain, the literature on corporate governance is concentrated on the

analysis of ownership structure and the effects of ownership concentration on the

performance of the companies, which is justified given that ownership concentration is

the main control mechanism in the Spanish corporate governance system. Nevertheless,

the construction of an index that considers other dimensions of governance can offer a

more complete picture of the Spanish reality.

3.3. Designing the Research: Questions and Hypotheses

In the first part of the empirical research the objective is to assess the possible factors

that make companies adopt different levels of governance under the same level of

investor protection (legal, institutional and regulatory environment), what takes us to the

following research question and hypothesis:

Part 1: Determinants of the quality of governance

Research question: Which observable factors make companies adopt different levels of

governance under the same contracting environment?

H1 (Hypothesis 1)

There is a significant relationship between the variables selected as possible

determinant factors and the level of corporate governance adopted by the companies of

the sample. Moreover, the direction of the relationship is the one proposed by the

literature.

17

In the second part, the objective is to assess the influence of the quality of governance

on the performance of the Spanish public companies, thus the question to be answered

and the correspondent hypothesis are:

Part 2: Relationship between corporate governance and performance

Research question: Does corporate governance influence corporate performance?

H2 (Hypothesis 2)

There is a significant relationship between the quality of governance and the

performance of the companies. Besides, companies with higher quality of governance

present better performance, ceteris paribus.

4. METHODOLOGY

Empirical research in the effectiveness of corporate governance mechanisms are subject

to the problem of endogeneity and reverse causality. Nevertheless, endogeneity and

reverse causality are under-explored theoretically and empirically (Bøhren and

Ødegaard, 2003). According to the authors, “endogeneity occurs when mechanisms are

internally related, (…) and reverse causation is when performance drives governance”

(Bøhren and Ødegaard, 2003, p.2). And, according to Gompers Ishii and Metrick (2003,

p.4) “the governance structures of a firm are not exogenous, so it is difficult in most

cases to draw causal inferences. For this reason, we make no claims about the direction

of causality between governance and performance”.

Similarly, Bhagat and Jefferis (2002, p.3) analyze the efficiency of antitakeover

mechanisms and state: “(w)e argue that takeover defenses, takeovers, management

turnover, corporate performance, capital structure, and corporate ownership structure

are interrelated. Hence, from an econometric viewpoint, the proper way to study the

relationship between any two of these variables would be to set up a system of

simultaneous equations that specifies the relationships between these six variables.

However, specification and estimations of such a system of simultaneous equations are

nontrivial”.

Empirical research on the evidence about the relationship between governance

mechanisms and performance can be classified according to the methodology used.

Bøhren and Ødegaard (2003, p.8) propose the following classification presented in

Table 1:

TABLE 1

MECHANISM INTERACTION AND MECHANISM-PERFORMANCE CAUSALITY

Causation

Mechanisms One-way Two-way

Exogenous 1 3

Endogenous 2 4

Source: Bøhren and Ødegaard (2003, p.8)

18

According to the authors, almost all studies can be classified in cell 1, where the

econometric approach considers governance mechanisms as externally given, causation

is supposed to run from insider ownership to performance, and where the single-

equation regression typically contains one or two mechanisms. Among the most tested

mechanisms of governance are the internal mechanisms: ownership structure, Board

composition and managers’ compensation; and, the external mechanisms: active market

for corporate control, capital structure and the presence of institutional investors.

Himmelberg et al. (1999) are closed to cell 2. They analyze one-way causation from

insider ownership to performance, similarly to the studies classified in cell 1. However,

they point out that ownership structure is determined by the country-level investor

protection, and in that sense, they treat ownership structure as an endogenous variable.

According to Bøhren and Ødegaard (2003), research in cell 3 is not viable since two-

way causation cannot be modeled without considering at least one governance

mechanism as endogenous related to performance. Finally, in cell 4 are the empirical

researches that estimate the coefficient of the governance mechanisms and performance

measures through the use of simultaneous equations. Cell 4 methodology has been used

in a series of studies: Agrawal and Knoeber, 1996; Barnhart and Rosenstein, 1998; Cho,

1998; Demsetz and Villalonga, 2001; Bhagat and Jefferis, 2002; Claessens et al. 2002;

Klapper and Love, 2004; Bøhren and Ødegaard, 2003; Silveira, 2004, and Beiner

(2006). In all these studies, most of the significant results disappear.

Due to the occurrence of endogeneity and reverse causality, research in corporate

governance should be developed in cell 4 methodology, more specifically with

simultaneous equations systems. Nevertheless, Bøhren and Ødegaard (2003) argue that

successful implementation of this method depends on whether corporate governance

theory can offer well-founded restrictions on the equation system. In other words, we

cannot find in the theoretical framework of corporate governance reference about

whether and how governance mechanisms interact, which are the exogenous variables

(not related to governance) driving two-way causation or the nature of the equilibrium

in terms of an optimal combination of governance mechanisms for a given set of

exogenous variables. The opened question is to know whether the results obtained using

cell 4 methodology is reliable.

Recent research and the extant literature in the field consider the use of different

econometric approaches as very important for capturing the reverse causality between

governance and performance and the potential endogeneity among the mechanisms of

governance, as corroborated by all quoted studies. Nevertheless, still in line with the

research on the field, the objective of this paper is to answer the research questions

proposed through the use of statistics, concretely, through the use of OLS simple and

multiple regressions (cross-sectional analysis). The use of more a sophisticated

methodology, for instance simultaneous equations aims a database with a longer

horizon of time for the development of a panel data, for example, in order to be robust

and to avoid misspecifications. Thus, since our governance data were collect only for

the year 2005, the use of this methodology is a suggestion for a future study. For this,

our study belongs to cell 1 methodology. The vast majority of studies in corporate

governance are classified in cell 1 methodology, and since my study is a first

approximation to the dynamics of the Spanish non financial firms’ governance system,

the methodology adopted is justified.

19

4.1. Sample Selection and Data Collection

The sample is composed by all Spanish non-financial listed companies in the Madrid

Stock Exchange (Mercado Continuo). The main data source is the web pages of the

companies, but also the Spanish Securities Exchange Commission (Comisión Nacional

del Mercado de Valores – CNMV) and the Madrid Stock Exchange (Bolsa de Madrid)

databases for all governance related information (board composition, ownership

structure and control, etc.). All financial and accounting information (balance sheets,

income statements, capital structure, industry/sector, book values, stock prices, etc.)

were obtained from COMPUSTAT. The data refers to the year 2005 for all governance

related information (GOV-I and board composition) and for the years 2004 and 2005 for

all financial information (sales, assets, ROA, Tobin’s q, etc.) except for sales growth

that captures the growth in sales in the last three years, covering the period from 2002 to

2005.

The final sample is composed by 97 firms and the selection criteria are (1) to be a

Spanish firm and (2) to not belong to the financial and real estate sectors. During the

collection of the data, one firm has presented insufficient information to construct the

index, so it was excluded from the sample. The rational for such selection criteria is that

the foreign companies listed in the Madrid Stock Exchange are not located and

operating in Spain, thus they are not exposed to the legal, institutional and regulatory

environment holding in Spain. The financial and real estate sectors are regulated by

specific rules which influence their governance model directly, for this reason they were

excluded from the sample.

4.2. The Corporate Governance Index (GOV-I) and the quality of governance

The governance index is created for proxy quality of governance. It is constructed based

on a questionnaire with binary objective questions and the answers must be obtained

exclusively from secondary data. Since the ultimate objective is to measure the degree

of transparency of the companies, the use of secondary data is justified (annual reports,

companies’ webpage, and the securities exchange commission webpage – CNMV).

The questions of the governance index (GOV-I) were developed based on the Credit

Lyonnais Securities Asia (CLSA) questionnaire used by Klapper and Love (2004) and

in the questions developed by Brown and Caylor (2004) when building their Gov-Score.

For a detailed description of provisions and antitakeover measures, the reference was

the work of Gompers et al. (2003). The construction of the index is straightforward, I

first code the 25 variables as 1 or 0 depending on whether the firm has satisfactory

corporate governance standards or not. Each positive answer adds one point to the

index, and the companies present a corporate governance level that ranges, in theory,

from 0 to 25. The main source of information is the Annual Report on Corporate

Governance prepared by the companies for the year 2005.

The index is composed by four dimensions in order to assess good governance

practices: (1) access and content of the information; (2) structure of the board; (3)

ownership structure and control; and, (4) progressive practices. Table 9 provides the

questions compounding the index.

The governance index (GOV-I) is one proxy for quality of governance. Other proxies

used in the study are: board independence (BIN), board size (BSZ), and duality CEO-

20

Chairman. These mechanisms are also contemplated and measured by the GOV-I. Table

2 provides a description of each dimension and the question that assess each of them.

These dimensions could also be called subindices.

TABLE 2

I-GOV DIMENSIONS

DIMENSION QUESTIONS

GOV-I 1 Access and content of the information 1-7

GOV-I 2 Structure of the board 8-16

GOV-I 3 Ownership structure and control 17-20

GOV-I 4 Progressive practices 21-25

4.3. Determinants of the Quality of Governance

Based on the work of Himmelberg et al. (1999), Himmelberg et al. (2002) and Klapper

and Love (2004), the governance determinants to be tested are: future growth

opportunities, firm size, composition of firm’s assets, ownership structure, corporate

performance, and listing in an American or European (non-Spanish) stock market,

besides the control variable industry.

Future growth opportunities are measured following Klapper and Love (2004) through

the average annual sales growth over the past three years (2002-2005). There are three

measures of performance, Tobin’s q, return on assets (ROA) and EBITDA. Tobin’s q

reflects firm performance and also firm profitability, the other two accounting variables

are used to proxy operating profitability (EBITDA) and net profitability (ROA). Firm

size is proxy by the logarithm of the total assets. Finally, composition of firm’s assets is

proxy by the ratio of fixed assets to net sales.

Table 3 describes the variables, the rational for introducing each variable in the analysis

explaining its possible influence in the governance of the companies and the code

attributed to each of them.

The governance index (GOV-I) is constructed for proxy quality of governance, as

described in the previous section, and a cross-sectional OLS model is used to directly

examine the relation between governance and the selected operational characteristics

measured by the above mentioned variables. The general model to be tested is the

following:

GOV-Ii = α+ β1 GROWTHi +β2 SIZEi +β3 TANGi +β4 INTSMi +β5 IBEX-35i +

+β6 OWNCONi +β7 PERFi +Σδj INDji + εi

EQUATION 1

21

The coefficients are expected to be statistically significant and to present the following

signals:

� β1, β4, β5, β7 > 0;

� β3 < 0;

� since the effect of firm size and ownership structure on governance are

ambiguous, in theory, no signal is expected for β2 and β6;

� δj is the coefficient for the binary variable of industry, no signal is

expected for it.

4.4. Relationship between Governance and Performance

This part of the study aims to contribute to the body of knowledge in the field of

corporate governance by answering the following question: Does corporate governance

influence corporate performance of the Spanish public companies? As described earlier,

the direction of the causality is not clearly defined by the theory, nevertheless, it is

conceived that causality may run both ways. Nevertheless, assuming that all relations

are linear, in this second part of the study, I first run a series of regressions as an initial

approach to assess the relationship between governance mechanisms and performance

measured by Tobin’s q (Q) (equation 2). The regressions are run considering

performance as an endogenous variable and the governance variables as exogenous but

including other variables to control for observable firm heterogeneity.

In order to assess the impact of quality of governance on the valuation of the firms,

another equation is estimated with Tobin’s q (Q) as the dependent variable. Since

Tobin’s q must also reflect firm’s profitability, ROA is included in equations (2) and (3)

in order to capture a possible interrelation between operating profitability and firm-

specific governance. Besides, the introduction of ROA is based on simple valuation

models: Q may depend on ROA and Beta (Chi, 2005; Beiner et al., 2006). In this sense,

ROA is introduced in equation 2 to capture a possible influence of operational

profitability on firm valuation. Finally, as the calculation of the traditional Tobin’s q is

“costly both in terms of its data requirements and computational efforts” (p.70), I

propose the use of the approximation of Tobin’s q proposed by Chung and Pruitt

(1994)6.

PERFi = α+ β1 GOVi +β2 GROWTHi +β3 SIZEi + β4 TANGi + β5 ROAi +

+Σδj INDji + εi

EQUATION 2

6 Defined as: Tobin’s q ≅ (MVE + PS + DEBT)/TA.

Where: MVE is the product of a firm’s share price and the number of common stock shares

outstanding (or the market value); PS is the liquidating value of the preferred stocks; DEBT is the value

of the firm’s short-term liabilities net of its short-term assets, plus the book value of the firm’s long term

debt; and, TA is the book value of the total assets of the firm.

22

Where:

PERFi – is represented by Tobins’s q (Q) and is measuring performance and firm

profitability.

GOVi – represents the governance mechanisms: GOV-I (the Governance Index),

BSZ (Board Size), BIN (Board Independence) and CEO-CHAIR (duality between CEO

and Chairman of the board), ownership structure (OWNCON and OWNmain), and

LEVER (Leverage).

And finally, a final equation is estimated considering all governance mechanisms

simultaneously. This regression allows for the adoption of different governance

mechanisms at the same time, which is conceivable with the practice where companies

adopt a series of mechanisms together.

PERFi = α+ Σβj GOVji +β7 GROWTHi +β8 SIZEi + β9 TANGi + β10 ROAi +

+ β11 LEVERi +Σδj INDji + εi

EQUATION 3

Where:

GOVji – represents the governance variables: GOV-I (the Governance Index),

BSZ (Board Size), BIN (Board Independence) and CEO-CHAIR (duality between CEO

and Chairman of the board).

Table 4 provides a description of each research variable used in the study as well as the

descriptive statistics.

23

TABLE 3

POSSIBLE DETERMINANTS OF GOVERNANCE

GOVERNANCE

DETERMINANT

REASONING CODE

Future Growth

Opportunities

A growing firm with large needs for outside financing has

more incentive to adopt better governance practices in order

to lower its cost of capital (Klapper and Love, 2003).

GROWTH

Firm Size

The effect of size is ambiguous as large firms may have

greater agency problems (because it is harder to monitor

them, so they need to adopt better standards of governance

to compensate. On the other hand, small firms may have

better growth opportunities and greater need for external

finance, so they may present better governance mechanisms

(Klapper and Love, 2003).

SIZE

Ownership Structure

(OWN)

Managers and shareholders have incentives to avoid inside

ownership stakes in the range where their interests are not

aligned, although managerial wealth constraints and benefits

from entrenchment could make such holdings efficient for

managers (Jensen and Warner, 1988). Besides, several

studies describe a positive and significant relationship

between ownership concentration and corporate

performance.

OWNCON

OWNmain

Performance

(PERF)

The best is the performance of the company, the higher the

governance standards we could expect, due to the lower

external shareholders expropriation. Besides, the

performance variables are used to assess the possible

occurrence of reverse causality with corporate governance.

Q

ROA

EBITDA

Composition of Firm’s

Assets

The composition of a firm's assets will affect its contracting

environment because it is easier to monitor and harder to

steal fixed assets than intangibles. Hence, the firm operating

environment will affect its governance system. (Himmelberg

et al., 1999).

TANG

IBEX-35

Companies that are included in the Spanish Market Index

(IBEX-35) are expected to adopt higher standards of

governance. IBEX-35

Listing in another stock

market

Companies that are listed in an American or European stock

market (non-Spanish) must adopt higher standards of

governance.

INTSM

Industry

Industry is expected to influence governance. Mostly

because there are more regulated economic sectors than

others, but also due to the competition holding in certain

sectors.

IND

TABLE 4

SUMMARY OF THE RESEARCH VARIABLES

CODE VARIABLE DEFINITION N Mean Median Std Dev Min Max

GROWTH Future Growth Opportunities Average sales growth in the last 3 years 95 0,09 0,07 0,16 -0,49 0,71

SIZE Firm Size Log of net sales 96 5,76 5,74 0,85 3,78 7,68

GOV-I Corporate Governance Index Index composed by 25 binary questions 97 13,38 14,00 2,77 4,00 21,00

BSZ Board Size Total number of board members 97 10,67 10,00 3,78 3,00 20,00

BIN Board Independence % of independent and external directors 97 0,36 0,33 0,19 0,00 0,87

CEO-CHAIR

CEO and Chairman are not the same

person

1 if the CEO and the Chairman are not represented by the same

person; 0 otherwise 97 0,41 0 0,49 0 1

OWNCON Ownership Concentration Σ % of shares owned by the controlling shareholders

(shareholders with more than 5% stake in the firm) 97 0,62 0,66 0,22 0,03 0,97

OWNmain Ownership of the main shareholder % of shares owned by the main shareholder 97 0,32 0,25 0,23 0,01 0,94

Q Tobin’s q Ratio of the market value of equity plus the book value of debt

to book value of total assets 93 1,45 1,12 1,02 0,18 5,61

ROA Return on Assets Net income / Total assets 96 0,04 0,04 0,09 -0,54 0,33

EBITDA Earnings Before Interests Taxes

Depreciation and Amortization EBITDA / Total assets

96 0,10 0,09 0,11 -0,46 0,47

TANG Composition of firm’s assets Fixed assets / Net Sales 95 0,85 0,56 1,03 0,04 7,24

LEVER Capital Structure Total debt / Total assets 96 0,23 0,25 0,18 0 0,75

IBEX-35 Belong to the IBEX-35 1 if the company belongs to the IBEX-35; 0 otherwise 97 0,26 0 0,44 0 1

INTSM Listing in an International Stock Market 1 if the company is listed in an American or European (non-

Spanish) stock market; 0 otherwise 97 0,33 0 0,47 0 1

This table provides descriptive statistics for all variables included in the empirical analysis. The initial sample consists of 97 companies and the total number of observations

for each variable is included in the table (N). The data is for the year 2005.

5. RESULTS

5.1. Descriptive Statistics

The descriptive statistics for the governance index (GOV-I) are presented in Table 5 and the

histogram and the normal curve of the distribution are drawn in Figure 2. The mean for the

GOV-I is 13,38 and the median is 14, indicating a relatively symmetric distribution. Appendix

1 provides histograms for the total sample and for the firms that belong to the Spanish stock

market index (IBEX-35). As one could expect, the companies that compose the IBEX-35

present a significantly higher mean for the GOV-I than the other firms compounding the

sample. Besides, the histogram can reveal that there is a wide distribution for the GOV-I

between the firms compounding the sample, the minimum value is 4 and the maximum is 21

(16% and 84%, respectively) which mitigates possible sample selection bias (Beiner et al.,

2006).

TABLE 5

THE GOVERNANCE INDEX (GOV-I)

2005

Governance Index (GOV-I) absolute % Minimum 4,0 16,00

Mean 13,381 53,53

Median 14,0 56,00

Mode 14,0 56,00

Maximum 21,0 84,00

Standard Deviation 2,770 11,08

Number of Firms

GOV-I ≤≤≤≤ 10 14

GOV-I = 11 3

GOV-I = 12 15

GOV-I = 13 13

GOV-I = 14 20

GOV-I = 15 10

GOV-I = 16 13

GOV-I = 17 6

GOV-I ≥≥≥≥ 18 3

TOTAL 97

Means by Dimension absolute % Access to information (GOV-I 1) 4,948 79,69

Board structure (GOV-I 2) 4,186 46,51

Ownership and control (GOV-I 3) 1,268 31,70

Progressive practices (GOV-I 4) 2,979 59,59

This table provides summary statistics on the distribution of GOV-I, the Governance Index for the Spanish

public companies, and the dimensions (Access to information, Board structure, Ownership and control, and

Progressive practices) for the year 2005. GOV-I was constructed from the questionnaire presented in Table 9 as

described in Part 4.

Table 6 presents the GOV-I per industry with aerospace and defense being the sector with the

higher score, 16, followed by transport/airlines with 15,5. Then, we have the vast majority of

companies in the range between 14 and 12 and, finally, the sector presenting the lowest

average is textile/apparel.

26

TABLE 6

THE GOVERNANCE INDEX (GOV-I) PER INDUSTRY

INDUSTRY N mean std dev

Food 10 12,6 2,836

Textil & Apparel 5 10,6 4,393

Paper Products 6 11,7 4,033

Pharmaceuticals 6 12,7 3,327

Leisure 3 13,7 1,528

Media Entertainment 5 14,2 2,049

Transports/Airlines 2 15,5 2,121

Logistics 3 12,7 2,517

IT & Telecom 7 14,3 1,890

Other Services 6 14,5 2,588

Gas & Utilities 9 14,6 2,128

Steel & Metals 8 13,8 3,412

Industrial Machinery 9 12,9 3,060

Construction 10 14,3 1,059

Chemicals 2 13,0 1,414

Engineering 5 12,6 2,510

Aerospace & Defense 1 16,0 0

This table provides summary statistics on the distribution of the Governance Index GOV-I by industry.

Table 7 shows the correlation coefficients between Tobin’s q (Q) and the governance

mechanisms used in the study. Despite not being significantly correlated with any variable,

what is frequent in governance studies, we can analyze the nature of the relationship, if it is

positive, negative or nonexistent.Thus, we find a positive correlation between Q and GOV-I

as was expected, so as with the other governance mechanisms (BIN, BSZ, CEO-Chair and

OWNmain), except for ownership concentration (OWNCON) with what we find a negative

correlation. On the other hand, the GOV-I is significantly positive correlated with the other

three mechanisms of governance (BIN, BSZ and CEO-Chair) and negatively correlated with

the variables of ownership (OWNCON and OWNmain). It is also expected since the GOV-I

is constructed based on the recommendations of the Spanish code of best practices (Aldama

and Olivencia Codes) and is composed by the aforementioned four dimensions of governance

that are also reflected in the other variables. The two ownership variables (OWNCON and

OWNmain) present a significant and positive correlation between them and a negative

correlation with board size and board independence. Nevetheless, the ownership variables

present a positive correlation with CEO-Chair. Board independence is negatively correlated

with board size and with CEO-Chair. And, finally board size and CEO-Chair are positively

correlated.

Table 8 provides descriptive statistics for the board structure variables. In relation with the

size of the boards (BSZ) the average number of directors in the Spanish Boards is 10,67. This

is an acceptable average size since the consensus is in something between 5 and 15.

Nevertheless, it is clear that the size of the board depends largely on the number of influent

shareholders that can nominate “external” directors as their representatives7. The more

influent the shareholder the large the number of directors he/she indicates.

7 In the case of Spain, the external directors indicated by large shareholders are called “dominicales”.

27

TABLE 7

CORRELATION MATRIX BETWEEN GOVERNANCE MECHANISMS AND TOBIN’S Q

I-GOV Tobin's Q OWN CON OWNmain BIN BSZ

Tobin's Q 0,0271 1

(0,7962)

OWN CON -0,1109 -0,0059 1

(0,2796) (0,9555)

OWNmain -0,0617 0,1294 0,6443*** 1

(0,5486) (0,2163) (0,0000)

BIN 0,2516** 0,0207 -0,2082** -0,1098 1

(0,0129) (0,8440) (0,0407) (0,2843)

BSZ 0,3036*** 0,0089 -0,0793 -0,0876 -0,0649 1

(0,0025) (0,9326) (0,4402) (0,3933) (0,5277)

CEO-CHAIR 0,2716*** 0,0748 0,0363 0,1407 -0,0588 0,0958

(0,0071) (0,4758) (0,7239) (0,1693) (0,5671) (0,3507)

This table reports Pearson correlation coefficients between Tobin’s q and the governance mechanisms for the

year 2005. The variables are described in Table 4. Significance at the 10, 5 and 1 percent levels is indicated by *,

** and *** respectively.

Board independence (BIN) is related to the number of independent directors in the board and

the percentage is obtained considering all independent and external directors over the total

number of directors. The best practices in corporate governance recommend that at least 50%

of the directors compounding the board be independent. And, independent means with no

relation with any shareholder or executive of the firm. In the case of Spain, the companies

must inform if the director is executive, external indicated by a shareholder, or external and

independent. This separation is extremely important, because investors are able to understand

the dynamics of ownership and control within the target company just by reading the

Corporate Governance Annual Report issued by the firms.

From Table 8, we can appraise the independence of the Spanish boards with an average

independence of 36,28%. It means that, on average, 4 out of 10 directors are independent in

sample firms. It can and should be improved by the companies, mainly because there are

firms with no independent directors and because the Aldama code strongly recommends the

increase in the number of independent directors in the boards of the public companies.

Finally, in 41,24% of the companies compounding the sample the CEO and the Chairman are

not the same person, which means that in 58,76% of the inquired companies they are

represented by the same person.

TABLE 8

DESCRIPTIVE STATISTICS FOR THE BOARD STRUCTURE VARIABLES

BOARD STRUCTURE

BSZ BIN CEO-

Chairman

N

(Companies)

Mean 10,67 36,28% 41,24%

Std Dev 3,78 19,32% -

Median 10,00 33,33% -

Min 3,00 0,00% -

Max 20,00 86,67% -

97

28

5.2. The Governance Index (I-GOV) description

As described in Table 5, the mean for the GOV-I is 13,38 with a standard deviation of 2,77.

A mean of 13,38 out of 25 (53,53%) can be interpreted as “low” if we consider that many

questions compounding the index were related to basic concepts of corporate governance,

such as access to information and transparency. Besides, one can observe that the questions

with higher percentage of firms with a “yes” are those recommended by the Spanish codes of

best practices on corporate governance (Aldama and Olivencia Codes). The company with the

higher score is Arcelor which is actually a company that operates within the regulation of

Netherlands8, in this sense it is expected that Arcelor shows a higher standard of governance.

Table 9 describes in detail the percentage of “yes” obtained in each question.

The results showed in Table 9 show that virtually all companies are concerned about

governance issues, since 94,85% provide information in the corporate website about its

governance system. On the other hand, only 64,95% provide the same information in English,

many times we can see the icon “English” in the home page of the company, but after

accessing the link what appears is a message such as “information not available” or “page

under construction”. Question 4 is related to the disclosure of information about the

company’s future strategies and the projection of the results, it also shows a low rate

(59,79%) of positive answers, mainly if taken into account that the sample is composed by the

biggest publicly traded corporations in the country that are supposed to disclosure this kind of

information.

FIGURE 2

HISTOGRAM AND NORMAL CURVE OF THE I-GOV

This table shows the distribution of the GOV-I for the 97 listed companies in the “mercado continuo” of the

MSE. The index was constructed based on a questionnaire with 25 binary questions that were designed to proxy

four categories of governance: (1) Access to information,(2) Board structure, (3) Ownership and control, and (4)

Progressive practices. Better-governed firms have higher index scores.

8 The headquarters of Arcelor are located in the Netherlands and the company is subject to the legislation of this

country.

21 18 15 12 9 6 3

I-GOV

30

25

20

15

10

5

0

Mean = 13,381 Std. Dev. = 2,770 N = 97

29

The publication of the Corporate Governance Annual Report (question 22) is a question with

a high percentage of positive answers, but one important point to mention is that many

companies produce a very low quality report; it seems that they are just complying with an

obligation, not to be “out of the market”. Moreover, question 5 “Does the company disclosure

information about its next or tree-year ROA or ROE targets?” presents a disappointing 0%.

This is the type of information that should be disclosed if the companies were interested in

attract new capital, or even to renew the outstanding debt or equity. Since the main function

of the managers is precisely to create value for the company, they were expected to disclose

information about the creation or destruction of value.

In question 9, “Is the Chairman an independent, non executive director?” only 9% of the

companies have an independent director as the Chairman of the board, which is actually a

progressive practice in Western Europe and highly recommended as a good governance

practice. As a contrast, in question 17, “The Chairman and the CEO are not represented by the

same person”, 41,24% of the companies have nominated the CEO as also the Chairman of the

board. Considering the traditional ownership structure of the Spanish companies, as to say

“familiar ownership structures”, the CEO as Chairman can clearly create favorable conditions

to the appropriation of the benefits of control by the majority shareholders. The same is valid

for question 8, “Are the audit committee and the nominating committee exclusively composed

by independent outside directors? “, for which only a quarter of the companies said yes.

Question 10, “Does the CEO serve on no more than one additional board of other public

company?”, shows an interesting phenomenon: the cross participation of the same individuals

in many boards. Analyzing the composition of the boards, one can figure out that the same

names appear many times in different boards. There are Chairmen appearing in more than

twenty five boards, and a question that naturally rises from this fact is if they have time to

manage their own company if they are so busy participating in so many board meetings

during the year. Another point is that, in question 10, I only consider the participation in

boards other than those of the companies’ same group, which aggravates the problem.

Questions 13 (Golden Parachutes) and 20 (Casting Vote) also show the power of the

Chairman/CEO with 45,36% and 39,18% of the companies presenting these provisions,

respectively.

In relation to the board composition and functioning, question 11 “Is the board composed by

no less than 5 and more than 15 members?” shows a 85,57% of the companies compounding

the sample with an acceptable board size. This question is complemented by question 12 “Is

shareholder approval required for changing the board size?”, which is actually dictated by the

bylaws of the firms and, as a consequence, presents a 100% of positive answers. Question 14

shows a 80,41% of the companies not having representatives of banks in the board. This is an

important question because having representatives of banks in the board is very negative and

20% of the companies present such problem. Nevertheless, in the Spanish case, banks play an

important role as shareholders and, in order to adapt the research to this reality, the companies

that have a “no” in question 14 are only those who inform that besides the equity relationship

they also maintain commercial relations with the bank. In any case, this situation should be

avoided by the firms, since there is a clear conflict of interests between the companies and the

banks. Finally, question 15 shows that the Spanish public companies are far from having an

independent board, since in only 31,96% of the firms compounding the sample the

independent directors account for more than 50% of the board. In the item “are board

members elected annually?” (question 16) another disappointing 1,03%.

30

TABLE 9

I-GOV QUESTIONS

Dimension of

Governance # QUESTION OF THE GOVERNANCE INDEX (GOV-I)

Percentage of firms

with a "YES" in the

Question

1 Does the company website provide information about its governance

system? 94,85%

2

Does the company have an English version of its website where

results and corporate governance related information are promptly

updated (no later than one business day)? 64,95%

3 Does the company have an Investors Relation Department? 87,63%

4

Does the company disclosure enough information or analysts’

presentations with what any investor can make projections for the

company? 59,79%

5 Does the company disclosure information about its next or tree-year

ROA or ROE targets? 0,00%

6 Does the company publish/announce quarterly reports within two

months of the end of the quarter? 90,72%

Access to

Information

7 Has the public announcement of results promptly published in the

web page of the company? 96,91%

8 Are the audit committee and the nominating committee exclusively

composed by independent outside directors? 27,84%

9 Is the Chairman an independent, non executive director? 9,28%

10 Does the CEO serve on no more than one additional board of other

public company? 40,21%

11 Is the board composed by no less than 5 and more than 15 members?

85,57%

12 Is shareholder approval required for changing the board size? 100,00%

13 Have the Board approved any Golden Parachute Provision for the

senior executives? 45,36%

14

Does the board include no direct representative of banks and other

large creditors of the company? (having any representatives is

negative) 80,41%

15 Do independent, non-executive directors account for more than 50%

of the board? 31,96%

Board

Structure

16 Are board members elected annually (they have a unified mandate of

one year and the reelection is not automatic?) 1,03%

17 The Chairman and the CEO are not represented by the same person. 41,24%

18 Do directors receive part of their remuneration in stocks/stock

options? 16,49%

19 Is directors’ stock ownership at least 1% but not over 30% of total

outstanding shares? 29,90%

Ownership

Structure and

Control

20 Does the Chairman have Casting Vote? 39,18%

21 Does the company offer tag along to the minority shareholders? 3,09%

22 Does the company publish the “Corporate Governance Annual

Report” (as stated by the Aldama Code)? 90,72%

23 Does the board have outside advisors? 84,54%

24 Do directors term limits exist? 71,13%

Progressive

Practices

25 Does mandatory retirement age for directors exist? 48,45%

31

In terms of the directors’ remuneration, question 18 points that only 16,49% of the firms

believe in the stock options as a mechanism of governance capable of aligning the interests of

managers and shareholders. Question 19 deserves deeper research on the causes of such

problem, since only 29,90% of the boards have a percentage ranging between 1% and 30% of

the total outstanding shares in their hands.

Progressive practices in corporate governance were assessed through questions 21 to 25.

Three questions reached a high rate of positive answers (questions 22, 23 and 24) showing

that the companies are progressively incorporating the Aldama Code suggestions and are now

publishing the Corporate Governance Annual Report (90,72%), establishing directors term

limits (71,13%), and hiring outside advisors to assist the directors when necessary (84,54%).

On the other hand, only half of the companies have mandatory retirement age for the directors

(48,45%), for the rest it is still a problem, mainly in the case of family companies.

Nevertheless, the critical point within this dimension is definitely the fact that practically no

company (3,09%) offers tag along to the minority shareholders.

5.3. Empirical results

The empirical analysis proceeds as follows: First, I estimate equation (1) using ordinary least

squares (OLS) regressions in order to assess whether there is a relationship between the

variables selected as possible determinant factors and the level of governance adopted by the

sample firms. Second, I estimate equations (2) and (3) using OLS regressions to verify

whether there is a significant relationship between quality of governance and performance.

The equations include a series of control variables as described in section 4.3 and 4.4.

5.3.1. Determinants of governance

Table 10 presents the results from OLS regressions of GOV-I on the selected variables as its

determinants. The results of the regressions show that future growth opportunities and

composition of firm’s assets have a statistically significant positive effect on the quality of

governance. Size also presents a positive effect on governance for the sample firms. However,

it is not statistically significant. Moreover, performance also has a positive effect on the

quality of governance showing that firms with higher performance adopt higher standards of

governance9. These findings support Hypothesis 1, since these are the factors described in the

literature as the possible determinants of governance.

The effect of ownership concentration is ambiguous, so no signal was expected for this

variable. For instance, a firm with a more concentrated ownership structure could present

poorer quality of governance due to the high level of ownership concentration of the main

shareholder; nevertheless, this fact could also take the company to adopt better governance

practices to compensate for the higher likelihood of expropriation of the minority

shareholders. I found a negative effect of both proxies of ownership concentration (OWN

concentration and OWN main shareholder) on the quality of governance, this result is

maintained for the three proxies of performance: Q, ROA and EBITDA. These results suggest

that the quality of governance could be a function of the probability of expropriation of the

minority shareholders due to the company’s ownership structure and control. Besides, the

coefficients indicate that the negative effect on governance is more accentuated for the

9 This result could indicate a problem of reverse causality since performance can improve governance but

governance can also enhance performance.

32

ownership concentration in the hands of the main shareholder than for the ownership

concentration of blockholdings.

In summary, Table 10 presents six columns. Column (1) shows the results for the regressions

of GOV-I on the selected variables along with Q and OWNCON. Column (2) shows the

results for the regressions of GOV-I on the selected variables along with Q and OWNmain.

Columns (3) and (4) show the results for the EBITDA and OWNCON and OWNmain

respectively. Finally, Columns (5) and (6) show the results for the ROA as a proxy of

performance and OWNCON and OWNmain respectively.

TABLE 10

RESULT FROM OLS REGRESSIONS

POSSIBLE DETERMINANTS OF THE QUALITY OF GOVERNANCE (GOV-I)

Dependent variable = GOV-I

Independent

variable

(1) (2) (3) (4) (5) (6)

Constant 11,876***

(0,003)

11,818***

(0,002)

13,552***

(0,001)

13,530***

(0,000)

14,093***

(0,000)

13,871***

(0,000)

GROWTH 3,901***

(0,003)

4,016*

(0,056)

3,719*

(0,089)

3,721*

(0,082)

3,788*

(0,077)

3,768*

(0,074)

SIZE 0,677

(0,251)

0,695

(0,230)

0,511

(0,383)

0,500

(0,389)

0,462

(0,428)

0,468

(0,418)

TANG 0,547*

(0,010)

0,630*

(0,059)

0475

(0,157)

0,536

(0,111)

0,465

(0,160)

0,525

(0,114)

IBEX-35 0,387

(0,736)

0,224

(0,844)

0,383

(0,739)

0,231

(0,841)

0,498

(0,664)

0,324

(0,779)

INTSM -0,374

(0,765)

-0,518

(0,676)

0,132

(0,910)

0,147

(0,899)

-0,042

(0,971)

0,006

(0,996)

Q 1,284**

(0,030)

1,444**

0,015

EBITDA 2,055

(0,368)

2,372

(0,296)

ROA 3,835

(0,187)

3,911

(0,176)

OWNCON -0,721

(0,613)

-0,853

(0,557)

-1,137

(0,430)

OWNmain -2,028

(0,155)

-1,590

(0,296)

-1,633

(0,251)

Industry Included Included Included Included Included Included

Adjusted R2 0,198 0,220 0,151 0,162 0,162 0,171

Probability F 0,018 0,011 0,048 0,038 0,037 0,031

Companies (N) 90 90 92 92 92 92

This table reports the results from OLS regressions of GOV-I on its determinants. The definition of the variables

is provided in Table 4. Control variables for 17 industries (IND) were included in the regressions but do not

appear here due to the limitation of space. The data is relative to the year 2004 and the GOV-I was constructed

based on information relative to the year 2005. The numbers in parentheses are probability values for two-sided

F test. ***, **, * denotes statistical significance at the 1%, 5% and 10% level respectively.

33

5.3.2. Governance and performance

Table 11 reports the correlation matrix between the I-GOV and the performance variables, as

well as the control variables TANG, LEVER, GROWTH and SIZE. I-GOV has a positive

significant correlation with EBITDA and ROA, and a positive correlation with Q. It is also

positive and significantly correlated with GROWTH and SIZE, which could indicate that

bigger firms present higher future growth opportunities and adopt higher standards of

governance. In the same sense, LEVER is positively correlated with TANG and SIZE but

negatively correlated with ROA as well as TANG is negatively correlated with ROA. These

signals are expected since, otherwise being equal, firms with higher levels of leverage and

tangibles should present lower ROA than if the same firm was all equity financed, due to the

interest and depreciation expenses. Nevertheless, the EBITDA should be equal for both firms,

all equity financed and the leveraged firm, and this is not the case for the companies

compounding the sample. There is a negative correlation also between EBITDA, TANG and

LEVER. This result should be better explored before concluding anything.

Table 12 presents the results from the OLS regressions of performance (Q, EBITDA and

ROA) on individual governance mechanisms along with the exogenous variables included in

equations (2) and (3). Column (1) shows that the governance index (GOV-I) has a positive

impact on firms’ performance measured by EBITDA and ROA and on firms’ valuation

measured by Tobin’s q, nevertheless the effect is not statistically significant. This result

partially support the hypothesis that firms adopting higher standards of governance are better

valued by the market, ceteris paribus.

The only governance mechanism that shows a significant coefficient is LEVER in all

specifications; nevertheless, the results show a negative effect of leverage on firm’s

performance10

which notably contradicts the mainstream hypothesis that leverage can

improve governance due to the debt discipline. This is a typical result from a cross-sectional

study that aims a deeper scrutiny through the use of a panel data and a simultaneous equation

system to capture the reverse causality of leverage and performance, but also the endogeneity

of leverage since the legal and institutional environment has a clear influence in the capital

structure decisions.

An important result from the regressions is that ownership structure, more specifically the

ownership concentration of blockholdings (OWNCON) has a negative statistically significant

impact on Tobin’s Q which means that more concentration of ownership is associated with

lower firm valuation. This observation is consistent with the results obtained by De Miguel et

al. (2005) for Spain that reports a negative impact of high levels of ownership concentration11

on the valuation of the firms since a concentrated ownership structure allows the

expropriation of minority shareholders. Another important finding is that a higher

shareholding of the largest shareholder (OWNmain) is associated with higher firm valuation

which could be a consequence of the more efficient monitoring provided by concentrated

shareholding.

10 Regressions of ROA and EBITDA on LEVER not shown here also exhibit a negative statistically significant

relationship between the variables. 11 They report a quadratic relationship between firm value and ownership concentration and that beyond the

breakpoint firm value is negatively affected by ownership concentration.

34

In columns (9), (10) and (11), all variables are considered together disregarding the

interdependence of different governance mechanisms. The results remain unchanged, with

LEVER appearing as the most significant mechanism of governance for the Spanish public

companies. In that sense the degree of leverage of the firms is negative related with their

valuation, but also with their performance. Ownership concentration of blockholdings is also

statistically significant and has a negative impact on the valuation of the firms, while the

concentration of ownership in the hands of the main shareholder has a positive impact on the

value of the firms. Nevertheless, ownership structure has no significant impact on corporate

performance.

Finally, the coefficients of the exogenous variables (ROA, SIZE, GROWTH and TANG)

show, generally, the expected signs. The adjusted R2 is ranging from 0,631 to 0,674 for the

regressions on Q and are significantly lower for the performance variables EBIT and ROA

(0,276 and 0,232 respectively).

TABLE 11

CORRELATION MATRIX BETWEEN I-GOV AND THE PERFORMANCE VARIABLES

I-GOV LEVER TANG GROWTH SIZE Tobin's Q EBITDA

LEVERAGE 0,003 1

(0,975)

TANGIBLES -0,038 0,366*** 1

(0,712) (0,000)

GROWTH 0,240** 0,131 -0,231** 1

(0,019) (0,204) (0,025)

SIZE 0,344** 0,317*** -0,047 0,268*** 1

(0,001) (0,002) (0,652) (0,009)

Tobin's Q 0,027 -0,169 0,001 0,249** -0,176* 1

(0,796) (0,105) (0,995) (0,016) (0,091)

EBITDA 0,181* -0,141 -0,146 0,282*** 0,335*** 0,396*** 1

(0,077) (0,170) (0,158) (0,006) (0,001) (0,000)

ROA 0,175* -0,191* -0,206** 0,354*** 0,299*** 0,349*** 0,906***

(0,089) (0,063) (0,045) (0,000) (0,003) (0,001) (0,000)

This table reports Pearson correlation coefficients between I-GOV and performance variables (Tobin’s q,

EBITDA and ROA) besides the control variables TANG, SIZE, GROWTH and LEVER for the year 2005. The

variables are described in Table 4. Significance at the 10, 5 and 1 percent levels is indicated by *, ** and ***

respectively.

TABLE 12

RESULT FROM OLS REGRESSIONS OF PERFORMANCE ON GOVERNANCE MECHANISMS

Dependent variable Q EBITDA ROA

Independent variable (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)

Constant 1,203

(0,271)

1,235

(0,259)

1,326

(0,211)

1,247

(0,254)

1,716

(0,123)

0,923

(0,386)

-0,034

(0,975)

0,704

(0,562)

0,676

(0,581)

-0,419**

(0,026)

-0,268*

(0,092)

GOV-I 0,010

(0,729)

0,008

(0,801)

0,003

(0,536)

0,004

(0,370)

Ln(BSZ)

0,050

(0,816)

0,060

(0,773)

0,046

(0,833)

0,011

(0,754)

0,003

(0,926)

BIN

-0,123

(0,744)

-0,200

(0,581)

-0,226

(0,551)

-0,028

(0,630)

-0,055

(0,265)

CEO-CHAIR

0,029

(0,849)

-0,053

(0,716)

-0,063

(0,677)

0,001

(0,962)

-0,009

(0,643)

OWNCON

-0,394

(0,260)

-0,892**

(0,040)

-0,891**

(0,042)

-0,028

(0,671)

0,011

(0,845)

OWNCON-Main

0,526

(0,125)

0,864*

(0,053)

0,871*

(0,054)

0,028

(0,666)

-0,007

(0,901)

LEVER

-1,589***

(0,004)

-1,157**

(0,049)

-1,145*

(0,054)

-0,192**

(0,017)

-0,173**

(0,011)

ROA 3,179**

(0,017)

3,239**

(0,014)

3,227**

(0,014)

3,267**

(0,012)

3,276**

(0,011)

3,487**

(0,007)

1,328

(0,333)

2,054

(0,157)

1,997

(0,177)

SIZE -0,088

(0,432)

-0,089

(0,440)

-0,081

(0,467)

-0,078

(0,487)

-0,106

(0,344)

-0,054

(0,627)

0,108

(0,377)

0,033

(0,798)

0,028

(0,833)

0,058***

(0,005)

0,034**

(0,045)

GROWTH 1,302**

(0,014)

1,320**

(0,012)

1,338**

(0,011)

1,320**

(0,013)

1,412**

(0,008)

1,322**

(0,011)

1,411***

(0,005)

1,580***

(0,002)

1,566***

(0,003)

0,096

(0,199)

0,144**

(0,026)

TANG 0,151

(0,162)

0,152

(0,157)

0,156

(0,145)

0,155

(0,148)

0,147

(0,167)

0,165

(0,118)

0,268**

(0,014)

0,232**

(0,036)

0,229**

(0,041)

-0,009

(0,615)

-0,010

(0,478)

Industry Included Included Included Included Included Included Included Included Included Included Included

Adjusted R2 0,631 0,631 0,631 0,631 0,637 0,643 0,672 0,674 0,669 0,276 0,232

Probability F 0,000 0,000 0,000 0,000 0,000 0,000 0,000 0,000 0,000 0,003 0,009

Companies (N) 92 92 92 92 92 92 92 92 92 94 94

This table reports the results from OLS regressions of Q on each governance mechanism along with the exogenous control variables. The definition of the variables is

provided in Table 4. Control variables for 17 industries (IND) were included in the regressions but do not appear here due to the limitation of space. The data is relative to the

year 2005. The numbers in parentheses are probability values for two-sided F test. ***, **, * denotes statistical significance at the 1%, 5% and 10% level respectively.

6. DISCUSSION AND CONCLUSIONS

This paper addresses two questions: (1) whether the quality of governance is determined by

some firm specific and observable characteristics, and (2) whether quality of governance

influences firm performance. In order to create a measure for the quality of governance, I

construct a governance index (GOV-I) composed by twenty-five questions covering four

dimensions, (1) access and content of the information; (2) structure of the board; (3)

ownership structure and control; and, (4) progressive practices. The population under scrutiny

is the Spanish non financial publicly traded companies, which resulted in a final sample of 97

firms.

The GOV-I first dimension, access and content of the information, intends to capture the

relevance firms put on transparency and the results show that the Spanish public companies

are paying great attention to this issue. Over 85% of the companies in the sample comply with

at least 4 questions out of 6 (approximately 70% of the total). The only exception is for

question 5, “Does the company disclosure information about its next or tree-year ROA or

ROE targets?”, with 0% as the rate of positive answers. It indicates that the firms do not

disclosure information about their projections of future creation or destruction of value, but

also about their strategic plans.

The second and third dimensions can be grouped into a broader dimension, the decision

making process of the top executives through the use of the Board and the control and

ownership of shares. And, in this scenario, the Spanish companies show a divergent behavior

from the one previously described. Compared with the first dimension, only 16,5% of the

companies in the sample comply with at least 6 questions out of 9 (approximately 70% of the

total) for the second dimension (board structure) and 10,3% of the companies comply with at

least 3 questions out of 4 (75% of the total) for the third dimension (ownership and control).

In contrast with those “transparent” companies offering a lot of information in their websites

and showing themselves as really concerned about governance matters, after reading the

procedures, bylaws and annual reports, one finds out the other face of these companies: a very

tied structure of ownership, a high level of cross-participation on the boards, and the control

centralized in the person of the CEO-Chairman. Furthermore, after a quick scrutiny, it is clear

that the questions with higher percentages of “yes” in the I-GOV are those recommended by

the Spanish codes of best practices (Aldama and Olivencia Codes). It could indicate that the

companies are just following the normative to be “adjusted” to the market, and raises concern

about whether they are really committed to governance matters.

In the second part of the paper, I empirically assess (1) the determinants of the quality of

governance and (2) the relationship between quality of governance and firm performance in

Spain. The vast majority of studies in the field of corporate governance are focused in the US

and emerging markets sets. Only recently, we are witnessing the appearance of this type of

study for the European countries. The main contribution of this paper is to provide a picture

of the Spanish corporate governance system. Spain is a very interesting set for exploring

governance matters due to its particularities: (1) high levels of ownership concentration; (2)

the boards are inefficient; (3) the capital markets are underdeveloped; (4) the market for

corporate control is practically nonexistent; and, (5) there is a low degree of investor legal

protection.

My most important result for the first part supports the hypothesis that there is a significant

relationship between the selected factors and the level of governance adopted by the

37

companies. This result is also in consonance with the literature. Specifically, Tobin’s q has a

statistically significant positive impact in governance, what can indicate that performance

drives governance. Another conclusion is that companies with higher future growth

opportunities present better governance standards; this result is also in accordance with the

literature. Firm size has a positive effect in the quality of governance, which means that

bigger firms adopt higher standards of governance. Nevertheless, composition of firm’s assets

showed a divergent relationship than the hypothesized one. The results indicate that, in the

case of Spain, firms with a more “hard” assets structure tend to present better governance

structures. This result can indicate two things: (1) a sample selection bias, since the

companies compounding the sample are the biggest companies in the country with a high

participation of fixed assets in its assets structure; or, (2) intangible assets can also be proxy

by R&D investments, which means that there is a close relationship between intangibility and

the extent to which firms invest in research and development, and Spain is known by the low

rate of investments in R&D. Due to this fact, it is conceived that the results show a inverse

relationship between tangibility of assets and quality of governance.

In the second part of the empirical study, I assess the relationship between performance and

the governance structure of the firms. The most important result in the second part of the

study is the positive relationship between quality of governance and firm performance which

supports the hypothesis that companies with higher quality of governance present better

performance. Besides, I found evidence that high levels of ownership concentration of

blockholdings have a significantly negative impact on the valuation of the firms (Q), but not

in the corporate performance measured by ROA and EBITDA. For providing a more

complete picture, I use the governance index (GOV-I) and six other governance mechanisms:

board independence, board size, duality CEO-Chairman, blockholdings ownership, ownership

of the main shareholder, and leverage, in order to assess the impact of governance on

performance.

The empirical results have important limitations. The most important limitation is the problem

of time, since in the second part of the empirical research I am using only data for the year

2005. This is the only year for which I have governance related information, and the

performance variables (Tobin’s q, EBITDA and ROA) are calculated based on the financial

reports also for the year 2005. The solution for this problem of time is to collect data for the

year 2006 and reassess the relationship, what is my intention for a future study.

Another important limitation is the well described problem of endogeneity and reverse

causality inherent to the research in corporate governance and that cannot be captured by OLS

regressions. But could be also a problem of substitution, since I am using all mechanisms of

governance together, as a consequence the results could be spurious. Nevertheless, the index

is not directly related to the other governance mechanisms and the overlaps that cannot be

controlled must not be causing major problems. Even so, the solution to all these problems

either the reverse causality or the misspecifications is the use of simultaneous equations and

panel data, what is my suggestion for a (near!) future study.

Overall, the results confirm the positive relationship between governance and the determinant

factors: performance, future growth opportunities and size what can be interpreted as evidence

that the Spanish firms adopt better standards of governance to compensate for the low level of

investor protection holding in the Spanish institutional environment. On the other hand, as

was expected, our result show a negative relationship between quality of governance and the

extremely high levels of ownership concentration holding in Spain. With regard to

performance, the major result is the positive relationship between quality of governance and

38

firm performance (both in terms of valuation and profitability), but also the negative

relationship between value and blockholdings ownership concentration and the positive

relationship between shareholdings of the main shareholder and firm’s valuation. The study

has also important implications for the practitioners that want to improve the governance of

its companies and to investors and analysts that now have a more complete picture of the

Spanish corporate governance system.

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41

APPENDIX 1

HISTOGRAM AND NORMAL CURVE OF THE I-GOV - COMPARATIVE

¡

IBEX-35 N Mean Std. Deviation Std. Error Mean

0 72 12,889 2,934 0,346 I-GOV

1 25 14,800 1,555 0,311

21 18 15 12 9 6 3 I-GOV

30

25

20

15

10

5

0

30

25

20

15

10

5

0

IBEX-35 firms

All sample firms