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What Matters in Corporate Governance in Emerging Markets: Time-Series Evidence from

the BRIKT Countries (Brazil, Russia, India, Korea, Turkey)

Bernard BlackNorthwestern University

(Law School and Kellogg School of Management)

(coauthors: Antonio Gledson de Carvalho; Vikramaditya Khanna; Woochan Kim; Burcin Yurtoglu)

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Some broad research questions

• How does optimal firm-level governance vary across countries?• Across firms within countries?• How do we measure “corporate governance”, anyway?• Can we build a meaningful, firm-level “corporate governance

index”– that predicts share price, profitability, tunneling, or other

performance measures within country– What are the components of such an index?– How will such an index vary across countries?

Different question (LLSV etc.): Effect of country-level governance on firm value; economic development, etc.

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Array of methodological issues• “Construct validity” issues:

– What is “good” governance?– Can we measure it?– How does it vary across countries?– Tobin’s q (as dependent variable) is a construct too

• Several flavors of “endogeneity”:– Omitted variables– Reverse causation (value governance)– Optimal differences between firms

• Differences in local legal rules– What varies across firms is country specific– Local practices vary [often idiosyncratic]

• Data limitations– Data on governance– Data on control variables

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Two Main Approaches• [Massively] Multicountry studies (broad and shallow)

– Indices: S&P disclosure (2002); CLSA (2001); ISS/RiskMetrics (2003-)– Papers: Klapper Love (JCF 2004); Durnev Kim (JF 2005); Aggarwal Erel Stulz

Williamson (RFS 2006); Bruno Claessens (JFI 2009); Doidge Karolyi Stulz (JFE 2007); Dahya Dimitrov McConnell (JFE 2008)

• Country studies (narrow and deep). Representative list in emerging markets:– Brazil (Black, de Carvalho, Gorga, JCF 2012; Leal and Carvalhal-da-Silva, 2007,

Braga-Alves and Shastri, FM 2011)– China (Cheung, Jiang, Limpaphayom and Lu (2009)– Hong Kong (Cheung, Connelly, Limpaphayom and Zhou, 2007, 2009)– India (Black and Khanna, JELS 2007; Balasubramanian, Black and Khanna 2009;

Dharmapala and Khanna, JLEO 2013)– Korea (Black Jang and Kim, JLEO 2006; Black & Kim, JFE 2012; Black Kim Jang

and Park 2012)– Russia (Black, EMR 2001; Black, Love and Rachinsky, EMR 2006)– Turkey (Ararat, Black, Yurtoglu, working paper 2012)

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This project: Blend of the two approaches

• Country studies– in 5 major emerging markets: BRIKT– Not China, less generalizability

• Examine: What is generalizable?– And what isn’t

• Big picture answer: Not much is generalizable– Cast doubt on massively multi-country efforts

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Why Country Studies?Why focus on emerging markets?

• Core corporate governance issues are different in developed vs. emerging markets. Stylized view:– Core US issue: ensure good management– Core emerging markets issue: control self-dealing– Governance more important in emerging markets

• No good multicountry index– ISS/RiskMetrics: US-centric only developed countries– Other multicountry indices are dated, limited:

• S&P (2002): run once; only disclosure• CLSA (2001): run once; some elements subjective

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Why Country Studies - II?• Endogeneity is key issue: we care about

causation, not just association:– Will Δgov cause Δy

y = Tobin’s q; other outcome variable• Simple regression isn’t enough:

– Regress y = a + b*gov + c*controls + ε• Coefficient b on gov tells us about association, not

causation– One example, reverse causation:

Regress gov = a’ + b’*y + c’*controls + ε• b and b’ usually have same sign, similar statistical significance

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To assess causation• minimum: extensive control variables• better: panel data, firm fixed or random effects

– Address unobserved time-invariant firm characteristics

• best: respectable natural experiment/shock– not available in most countries

(No good non-shock instruments exist)• Suppose we require a study to be about (or include)

emerging markets and want even one of these . . .(Or results so strong that alternate explanations are unlikely)

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Emerging markets, plus decent econometrics:

• Multicountry studies– Papers: Klapper and Love (JCF 2004); Durnev and Kim (JF 2005); Doidge, Karolyi

and Stulz (JFE 2007); Dahya Dimitrov McConnell (JFE 2008)

[Nothing left.]• Country indices

– Brazil (Black and de Carvalho, JCF 2012)

– Hong Kong (Cheung, Connelly, Limpaphayom and Zhou, 2009)

– India (Black and Khanna, JELS 2007; Dharmapala and Khanna, JLEO 2013)

– Korea (Black Jang and Kim, JLEO 2006; Black and Kim, JFE 2012; Black, Kim Jang and Park, working paper 2012)

– Russia (Black, EMR 2001; Black, Love and Rachinsky, EMR 2006)

– Turkey (Ararat, Black and Yurtoglu, working paper 2012)

[Apologies for the self-citation, but that’s what exists, to my knowledge.]

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Country studies have problems too

– Hard to generalize from one study– Endogeneity still a major concern– Indices not fully comparable across studies

• Still, can get time series, firm fixed or random effects, good controls– In Korea and India, decent natural experiments– Maybe Turkey too (shock in late 2011; research underway)

• My ongoing research strategy:– Time series, country studies in BRIKT countries– Similar indices (not identical because laws vary) [mostly lose Russia]– Exploit natural experiments, when they exist– Local coauthors to ensure I understand what matters– Look for similarities and differences across countries

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This project: Combine data across countries

• Brazil corp. gov. surveys: 2004, 2007, 2009• India surveys: 2005, 2007, 2012• Turkey: 2006-2011 (extending through 2011)• Korea: 1998-2004 (extending through 2009)• Russia: 1999-2005 (can partly extend thru 2008)

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Each country: build local index

• Index elements in each country must be:– Measurable– Meaningful (in judgment of local coauthors)– We think they might reflect “good” governance

• Lots of judgment here!– Significant variation across firms

• Not required by law• Not otherwise nearly universal or rare

• Similar subindices, to extent feasible

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Endogeneity: How Big an Issue• Important in developed markets

– E.g., low performance high board independence (Bhagat & Black, 2002)

• Maybe, smaller issue in emerging markets– hard to predict firm-level governance choices (Black, Jang and Kim, JCF

2006a, Korea)– similar in India (adj. R2 < 0)

Large role for apparently idiosyncratic firm choice

• More work needed on what firm-level factors predict governance across emerging markets:– . . . next project

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Similar indices, subindices

• In each country: Build broad corp. governance index

• Rely on our own surveys, to supplement public data– Similar subindices, to extent feasible

• Often only partly feasible, as we’ll see

• Why different subindices?• What elements are required by law? [If so, little/no variation

across firms]• What are typical practices?• Which elements have meaningful variation across firms?• What data exists?

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Brazil Corp Gov Index (BCGI) in 2005

• Use Brazil to illustrate approach and complexities• Subindices (each 0 ~ 1) for:

– Board Structure (7 elements)– Ownership Structure (5 elements)– Board Procedure (6 elements)– Disclosure (12 elements)– Related Party Transactions (5 elements)– Minority Shareholder Rights (7 elements)

• BCGI = [∑(subindices)/7] – Range: [0.32, 0.81)

• BCGInorm = normalized [∑(normalized subindices)]

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What’s in BCGI?

Subindex Element Public data MeanBoard Board includes one or more independent directors 0 0.73Structure Board has at least 30% independent directors 0 0.47

Board has at least 50% independent directors 0 0.20CEO is NOT chairman of the board 1 0.71Audit committee exists 1 0.14Permanent or near-permanent fiscal board exists 0 0.68Audit committee or permanent fiscal board exists and includes minority shareholder representative 0 0.47

Focus on Board Structure Subindex (2004)

Note: Only 2/7 elements rely on public data• Guessing may not work well. For Brazil:

• Dahya Dimitrov McConnell (2008) estimate 57% indep directors• Our data: 2004 mean (median) = 24% (20%)

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Importance of local knowledge

Brazilian institution: fiscal board• Can be permanent (in charter) or near-permanent (demanded

every year or most years by minority shareholders)• Function similar to audit committee

– Might be more effective: must include representative of minority shareholders

– Brazil: substitute for audit committee• Many firms have one or the other; few have both• Audit committees rare (mean = 0.14)• Fiscal board more common (mean = 0.68)

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Compare Brazil to Korea for Board StructureBrazil Element Korea

Board includes one or more independent directors (NP) Required

≥ 30% independent directors (NP) Requires 25% indep. directors≥ 50% independent directors (NP; mean = 0.20) Index element

Board has majority of indep. directorsCEO is NOT board chairman Not availableAudit committee exists (uncommon; mean = 0.14) Index elementPermanent or near-permanent fiscal board exists Not meaningfulAudit committee or permanent fiscal board includes minority shareholder representative Not available; rare

Rare (NP) Compensation committee existsRare (NP) Outside director nom. committee exists

NP = no public data (we use our survey)Only common elements are:

50% outside directors (uncommon in Brazil)audit committee (rare in Brazil; misleading alone)

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Example 2: Board procedure subindexStart with Brazil & India: see if avail in Korea, Turkey

Overall Procedure subindex Brazil India Korea Turkey≥ 4 regular board meetings per year NP NP X availableAverage board meeting attendance rate ≥ 80% NP X Outside directors attend minimum % of meetings NP X

Firm has system to evaluate CEO NP X

Firm has system to evaluate other executives NP X

Firm evaluates nonexecutive directors NP X

Firm has succession plan for CEO NP X

Firm has nonexecutive director retirement age X

Directors receive regular board training X

Nonexecutives-only or outside directors only annual board meeting exists NP, rare X X

Board receives materials in advance NP X

Nonexecutives can hire own counsel & advisors X

Directors’ positions on board meeting agenda items are recorded in board minutes NP NP X

Firm has code of ethics NP X XSpecific bylaw/policy to govern board NP NP NP XFirm has ≥ 1 foreign outside directors NP NP X availableShareholders approve outside directors’ aggregate pay NP, rare X

With only public data, can’t build Brazil index at allEven with surveys, can’t build consistent subindex across countries

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Example 3: Ownership Structure Brazil vs. India, Korea

Brazil Elements India (no ownership index) KoreaFraction of common shares held by largest shareholder Data available Data available

1.5*[(common shares/(total shares)-1/3]

Not meaningful: One share, one vote rule

Not meaningful: One share, one vote rule

Ownership parity (for largest shareholder) Not meaningful, no pyramids Ownership parity (for control

group)[((members of control group, winsorized at 11) -1)/10]. No data No data

firm has an outside 5% institutional investor Data available Data available

Only potential common elements are:ownership by largest shareholderExistence of outside 5% shareholder.

How meaningful are these?• India: Choose not to build ownership structure subindex

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Disclosure subindex: Compare Brazil to ISS• ISS disclosure index:

– consulting fees to auditors < audit fees– audit committee has solely independent directors– shareholders approve auditor

Nothing about what firms actually discloses!?• Compare Brazil:

– Address auditor independence through audit firm rotation (every 5 years)– 80% of firms pay 0 consulting fees to auditor (only 6% pay > 10% of audit fees)– audit committee at only 14% of firms, solely independent at 1 firm in 2004– Control group shareholder approval of auditor not meaningful

• Brazil firm scores: almost always 1, minimal variation – 1 point for low consulting fees– 0 for solely indep audit committee– 0 for shareholders approve auditor

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Lesson: index must be country-specific

• If we require the same elements in each country:– Can measure little– What we can measure may not be very relevant

• Problem gets worse if add more countries

• Even if measure same thing, meaning will differ• Consider proportion of outside directors

– US: minimum 51%; median 70%– India: minimum 1/3 (+ CEO ≠ board chair); otherwise min 50%– Korea: minimum 25%; median 33% [> 50% required for large firms]– Turkey: minimum 0 (75% of firms), mean 25%

• With country fixed effects, estimate impact of typical within-country variation• Not really measuring the same thing across countries?

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Severe construct validity questions

• We’re not sure how to measure “governance”– We’re not sure what counts as “good”

governance, for which firms, in which countries– We have. . .

• Different overall index in each country• Different subindices in each country• Very different subindex elements in each country

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Tobin’s q is a construct too

• Common approach: q as dependent var.• One possible definition:

– BVE = book value of equity– MVE = market value of equity

• Problem: q captures many things:– Growth opportunities– Intangible assets (not included in book assets)– Real and quasi rents (not captured in book assets)– Other book-to-market differences in assets– Value of share liquidity– And value of governance (higher market value for same assets)

• Empirical strategy:– control for other factors– hope that Δq captures value of Δgov

( )book assets MVE BVEqbook assets

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So what do we do?

• We give subindices similar names• We thenhope (pretend?) they measure a

common construct• OK, what do we see?

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Simple cross-section results across countriesCountry Russia Brazil India Korea TurkeyOverall Governance Index 0.198*** 0.145*** 0.101*** 0.097*** 0.112***

(5.45) (2.83) (2.91) (6.39) (2.77)

Subindices alone  togetherBoard Structure   -0.091 0.066* 0.042*** 0.026   (-1.55) (1.80) (2.79) (0.69)Ownership Structure   0.076*   0.045***     (2.00)   (3.61)  Board Procedure   0.136*** 0.045 0.018 0.040   (2.66) (1.25) (1.25) (1.20)Disclosure 0.355*** -0.008 0.069* 0.023*** 0.089** (7.98) (-0.11) (1.80) (2.68) (1.99)Related Party Transactions   -0.067 0.022       (-1.31) (0.63)    Minority Shareholder Rights   0.142*** 0.064** 0.022** 0.011   (2.90) (1.99) (2.03) (0.40)Control Variables Vary by countryObservations (Firms if different) 228 (99) 66 252 495 135Time Period 2001 2005 2006 2001 2006

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This is only association. How about firm FE

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Firm fixed effects across countriesCountry Russia Brazil India Korea TurkeyOverall Governance Index 0.067*** To come To come 0.0396*** -0.021 (2.75) (4.60) (-0.70)Subindices alone  togetherBoard Structure 0.0102*** -0.032 (6.65) (-1.60)Ownership Structure 0.0044 (0.45) Board Procedure 0.0025 -0.015 (0.33) (-0.85)Disclosure 0.071** 0.0136* -0.019 (2.21) (1.93) (-0.58)Minority Shareholder Rights -0.0065 0.034 (-1.09) (1.41)Observations (Firms if different)

964(99) 3,693 (656)

586 (178)

Time Period 99-05 98-04 06-09

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Firm FE summary

• Turkey results are fragile– vanish completely with firm FE or RE– vanish without control variables

• Russia results weaken, but survive• Korea:

– Results remain strong for board structure index• Good causal inference (1999 legal reforms)

– Shareholder rights vanishes• Brazil, India: results to come

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Pretend all indices & subindices created equalPooled OLS (Brazil, India, Korea, Russia)

Overall Governance Index 0.099***(5.36)

Subindices (excl. Russia) All in One Regression

Board Structure 0.036**(2.08)

Ownership Structure (Brazil and Korea Only)

0.034**(2.34)

Board Procedure 0.027(1.58)

Disclosure 0.036**(2.40)

Related Party Transactions (Brazil and India Only)

-0.014(-0.30)

Shareholder Rights 0.031**(2.02)

Decent control variables, but lose some from country regressions

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Compare OLS to Fixed Effects (Korea, Russia, Turkey)Fixed Effects Pooled OLS

Overall Governance Index 0.031*** 0.099***(4.39) (5.36)

SubindicesBoard Structure 0.021*** 0.036**

(4.89) (2.08)Ownership Structure (Brazil and Korea Only)

-0.004 0.034**(-0.51) (2.34)

Board Procedure 0.003 0.027(0.53) (1.58)

Disclosure 0.024*** 0.036**(4.02) (2.40)

RPTs (Brazil, India) -0.014(-0.30)

Shareholder Rights -0.002 0.031**(-0.36) (2.02)

Caveat: Board structure results driven by Korea; opposite in BrazilLittle time variation in ownership, so FE is weak

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Next steps to see what survives

• Firm FE, RE in all countries• Effects for interesting subsamples:

– Large versus small– Manufacturing vs. other– High vs. low growth rate– High vs. low profitability– Business group or not– Old vs. young firms

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Next steps II

• Use common index elements– As in multicountry indices– Construct validity issue changes, doesn’t go away

• Use only the limited control variables available in multi-country studies

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Is Everything Endogenous (or Irrelevant)? Russia (1999 data)

Regress: Ln(Value Ratio) on Governance Score ln

(val

ue r

atio

)

governance ranking7 18 29 40 51

-1

-3

-5

-7

-9

Source: Black (EMR, 2001)(high ranking implies worse governance)Worst-to-best = factor of 700 increase in value ratio!

n = 21 firms r = -0.90 R2 = 0.81 t = -8.97

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Is Everything Endogenous or Irrelevant II:Bulgaria (2002) response to anti-tunneling reform

-0.2

0.0

0.2

0.4

0.6

0.8

Rel

ativ

e P

erce

ntag

e C

hang

e of

Tob

in's

q

2001-Q1 2001-Q2 2001-Q3 2001-Q4 2002-Q1 2002-Q2 2002-Q3 2002-Q4Quarter

Tunneling Risk Defined Using Tunneling Propensities Tunneling Risk Defined Using Ownership

High vs. low tunneling propensity firmsSource: Atanasov, Black, Ciccotell, Gyoshev (JFE 2010)

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Korea: RPTs and Expropriation Risk

Event study: Large firm reform in June-August 1999)Large-plus (1-4T won) vs. mid-sized index (0.5-1T won)

Source: Black, Kim, Jang and Park (working paper 2012)

1999

0520

1999

0525

1999

0528

1999

0602

1999

0607

1999

0610

1999

0615

1999

0618

1999

0623

1999

0628

1999

0701

1999

0706

1999

0709

1999

0714

1999

0719

1999

0722

1999

0727

1999

0730

1999

0804

1999

0809

1999

0812

1999

0817

1999

0820

1999

0825

1999

0830

1999

0903

1999

0908

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

Large-plus Positive ERI

Large-plus Negative ERI

Large-plus Missing ERI

CM

AR

(%)