Family Control and Corporate Governance: Evidence from Taiwan*

Transcription

1 International Review of Finance, 2:1/2, 2001: pp. 21±48 Family Control and Corporate Governance: Evidence from Taiwan* YIN-HUA YEH, TSUN-SIOU LEE y AND TRACIE WOIDTKE z Department of International Trade and Finance, Fu-Jen Catholic University, Taipei, Taiwan; y Department of Finance, National Taiwan University, Taipei, Taiwan; and z Mays College of Business, Texas A&M University, College Station, Texas, USA ABSTRACT A recent stream of literature shows that family control is central in most countries of the world, but little research exists regarding family control and corporate governance. This paper analyses family control and corporate governance using a sample of Taiwanese firms. The results suggest that family control is even more prevalent than previously suggested and that a non-linear relation exists between family control and relative firm performance. Family-controlled firms that have low levels of control have lower relative performance than both family-controlled firms with high levels of control and widely held firms. This is consistent with the conflict of interest between majority and minority shareholders being the greatest when the majority shareholder's level of control is high enough to influence a firm's decision-making process but ownership is low enough that the benefits of expropriation outweigh the costs. Furthermore, a positive valuation effect exists when controlling families hold less than 50% of a firm's board seats. Taken together, the results in this paper suggest that when family control is central, high levels of family ownership and low levels of family board representation are effective ways of mitigating the separation of cash flow rights and control and, thus, decreasing the conflict of interest between majority and minority shareholders. I. INTRODUCTION Much of the literature on corporate governance assumes widely dispersed ownership and focuses on mitigating conflicts of interest between managers and * We are especially grateful to an anonymous referee, K. C. Chan, Sheridan Titman (the editors) and Pei-Gi Shu for their insightful comments and Jun-yee Shy for excellent research assistance. We would also like to thank Joseph P. H. Fan, Ferdinand A. Gul, Judy Tsui and Takeshi Yamada; participants at the Seventh Asia Pacific Finance Association Annual Conference (2000), the 2000 APJAE Symposium, the Seventh Conference on Pacific Basin Finance, Economics, and Accounting (1999) and the NFA/APFA First Joint International Conference (1998); and seminar participants at National Taiwan University and National Central University for helpful comments. Yeh and Lee would like to thank the National Science Council of ROC for financial support under Contract No. NSC H All remaining errors are our own. ß International Review of Finance Ltd Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA.

2 International Review of Finance shareholders resulting from the separation of ownership and control. 1 However, a recent stream of literature brings into question the assumption of widely dispersed ownership and suggests that perhaps the more fundamental conflict of interest is between majority and minority shareholders. For example, Holderness et al. (1999) show that, contrary to the claim that dispersion of ownership is just a matter of time, managerial ownership in the USA actually increased on average from 13% in 1935 to 21% in La Porta et al. (1998) study a sample of large non-financial firms from 49 countries and find that average ownership by the three largest shareholders is 46%. In addition, La Porta et al. (1999) show that control is often concentrated within a family. Similarly, Claessens et al. (2000b) examine nine East Asian countries and find a predominance of family control and family management. In addition, Zingales (1994), Kunz and Angel (1996), Rydqvist (1996), Taylor and Whittred (1998) and Smith and Amoako-Adu (1999) document concentrated ownership by families in Europe, Canada, and Australia. According to La Porta et al. (2000), important implications of this evidence for the study of corporate governance are the relative irrelevance of the Berle and Means corporation ± with dispersed shareholders and professional managers in control ± in most countries in the world and the centrality of family control. Shleifer and Vishny (1997) also argue that the fundamental agency problem in large corporations of most countries is not the Berle and Means conflict between outside investors and managers, but the conflict between outside investors and controlling shareholders that have nearly full control over managers. Even within the USA, Woidtke (2001) finds a negative valuation effect associated with increased ownership by activist public pension funds, suggesting that other shareholders may actually be hurt when large shareholders influencing management have conflicts of interest with other shareholders. However, La Porta et al. (2000) argue that the reputation of a large family shareholder may be needed to raise external capital when protection for outside investors is poor. Furthermore, family control may signify entrepreneurial talent and cohesive management. Therefore, it is not clear whether family control is value increasing or decreasing, especially when legal protection of outside investors is poor. The goal of this paper is to extend our knowledge of corporate governance beyond the Berle and Means framework by examining a sample of firms in a country where family control is prevalent, Taiwan. Specifically, we first provide a more comprehensive measure of control rights than existing studies and examine what level of control is needed for a family to have effective control of a firm. Second, we examine the relative valuation effects associated with different levels of family control to examine the degree of conflict or convergence between the interests of majority and minority shareholders. Finally, we examine the relation between relative performance and board composition to identify better corporate governance structures in the presence of a majority shareholder, or family control. 1 See Berle and Means (1932) and Jensen and Meckling (1976) for a discussion of these issues. 22 ß International Review of Finance Ltd. 2001

3 Family Control and Corporate Governance For a sample of Taiwanese listed firms, we find that average control by the largest family is 26%. Earlier studies reported average ownership concentration in Taiwanese listed firms to be around 19%; however, they use a less comprehensive measure of indirect ownership when measuring control rights and have smaller samples (La Porta et al. 1998; Claessens et al. 2000b). We find that when we calculate the critical level of control for each firm, families need only 15% control, on average, to control a firm effectively. Moreover, the critical level of control is inversely related to firm size, which is consistent with the view that families can gain effective control over larger companies with lower levels of control because ownership by other shareholders is generally more widely dispersed. We find that family control exceeds a firm's critical control level in 76% of Taiwanese firms. This is much higher than the less than 50% documented by La Porta et al. (1998) and Claessens et al. (2000b) when fixing the critical level for all firms to be 20%. To the extent that the same relationship exists in other countries, these results suggest that family control is even more prevalent than previously suggested. We use industry-adjusted Tobin's Q and industry-adjusted return on assets to measure relative performance associated with family control and find no evidence of performance differences between family-controlled firms and widely held firms. However, family-controlled firms that have low levels of control have lower relative performance than both family-controlled firms with high levels of control and widely held firms. This is consistent with the conflict of interest between majority and minority shareholders being the greatest when the majority shareholder's level of control is high enough to influence a firm's decision-making process, but ownership is low enough that the benefits of expropriation outweigh the costs. In widely held firms, it is less likely that a shareholder will be able to influence a firm's decision-making process even if expropriation is desirable. In family-controlled firms with high levels of control, expropriation is less desirable because the family now bears more of the costs. Finally, we examine board composition to provide insight into what structure may be more effective in the presence of a majority shareholder. We find no relation between the presence of a second large group or institution on the board and relative performance. However, a negative (positive) relation exists between relative performance and the percentage of seats held by the controlling family (whether the controlling family holds less than 50% of the board seats). Furthermore, we find that within family-controlled firms, those with high levels of control and low family board representation have the highest relative performance, but those with low levels of control and high family board representation have the lowest relative performance. Taken together, these results suggest that in the presence of family control, higher levels of ownership and lower levels of family board representation are effective ways of mitigating the separation of cash flow rights and control and, thus, decreasing the conflict of interest between majority and minority shareholders. The remainder of the paper is organized as follows. Section II discusses related literature and describes the corporate governance environment of Taiwan. ß International Review of Finance Ltd

4 International Review of Finance Section III describes the sample and provides summary statistics. Section IV presents the empirical analysis, and Section V concludes. II. CORPORATE GOVERNANCE A. Ownership structure and corporate governance In 1932, Berle and Means presented the argument that, when managers hold little equity in the firm and shareholders are too dispersed to enforce value maximization, corporate assets may be deployed to benefit managers rather than shareholders. Since that time, numerous corporate governance studies have focused on mitigating the conflict of interest between managers and shareholders. For example, Morck et al. (1988) examine the relation between Tobin's Q and managerial ownership and find a significant non-monotonic relationship. They suggest that the convergence-of-interest effect is dominant at both low levels and high levels of managerial ownership, but the entrenchment effect is dominant at medium levels of managerial ownership. Pound (1991) and Black (1992) suggest that institutional investors, as large shareholders in the USA, can become monitors of management and increase value. Consistent with this view, McConnell and Servaes (1990) find a positive relation between institutional ownership and Tobin's Q. However, Woidtke (2001) finds a negative relation between relative firm value and ownership by activist public pension funds, suggesting that certain large shareholders having influence with management may actually have interests that conflict with other shareholders. Woidtke's results are consistent with a recent stream of research that argues that outside investors may be hurt by the presence of large shareholders rather than benefit by their presence. Within the classical Berle and Means framework, outside investors are assumed to have similar interests ± maximize shareholder wealth ± so that other shareholders benefit when a large shareholder is present to monitor management. However, Shleifer and Vishny (1997) argue that `as ownership gets beyond a certain point, the large owners gain nearly full control and prefer to use firms to generate private benefits of control that are not shared by minority shareholders'. La Porta et al. (1999) suggest that when large shareholders effectively control corporations, they might try to expropriate wealth by seeking personal benefits at the expense of minority shareholders. For example, families tend to control firms through pyramid structures and cross-holdings. Therefore, a family might use its control to transfer profits to another company it controls. Bennedsen and Wolfenzon (2000) thus argue that when investor protection is poor, dissipating control among several large investors can serve as a commitment to limit expropriation. On the other hand, if family control represents entrepreneurial talent or expertise, then family control will be value increasing. Furthermore, an entrepreneur or his or her family may need to retain control of the firm because the family's reputation is needed to raise external 24 ß International Review of Finance Ltd. 2001

5 Family Control and Corporate Governance funds when the legal protection of outside investors is poor (La Porta et al. 2000). Therefore, it is not clear whether family control is value increasing or decreasing, especially when legal protection of outside investors is poor. Prior studies have examined expropriation by large shareholders by focusing on firms with differential voting rights and find evidence that private benefits of control exist for these shares (see, for example, Lease et al. 1983; DeAngelo and DeAngelo 1985; Zingales 1994; Rydqvist 1996). 2 However, La Porta et al. (1999) find that multiple classes of shares do not appear to be a central mechanism of separating ownership and control. Relative to shares with differential voting rights, they find pyramidal ownership to be a more important mechanism used by controlling shareholders to separate their cash flows from their control rights. Wolfenzon (1999) argues that pyramids can be used by controlling shareholders to make existing shareholders pay the costs but not share in all the benefits of new ventures. However, it is also possible that pyramiding or cross-company holdings by family-controlled companies offer value. For example, Slovin and Sushka (1997) find evidence suggesting that a parent±subsidiary organizational structure enhances corporate financing flexibility and mitigates underinvestment problems. They find no evidence of wealth expropriation. To examine whether large shareholders expropriate wealth in a more general setting, we focus our study on Taiwan, a country that is predominantly family-controlled and that does not have strong investor protection. B. The corporate governance environment in Taiwan In the USA, several internal and external governance mechanisms ± such as ownership by institutions, the composition of the board and the market for corporate control ± provide incentives for managers to maximize shareholder wealth. In contrast, the corporate governance structures in Japan and Germany are characterized by strong relationships between firms and banks (Kaplan 1994a, b, c; Kaplan and Minton 1994; Kang and Shivdasani 1995). Yet little is known about corporate governance structures when family control is predominant, even though it is common in many countries. Taiwanese listed companies are typical of family-controlled companies. Families generally oversee the development of a business from its inception, and family control gives the business a potential advantage of having strong leadership and cohesive management teams that are formed by family members. Even after a company goes public, family ownership or control tends to play a dominant role in the decision-making process. Thus, companies are generally owned, controlled and managed through blood and marriage ties. However, Taiwanese listed companies are generally owned, controlled and managed, in marked contrast to their US and Japanese-Germanic counterparts. For example, Taiwan is characterized by the absence of effective audit committees, low 2 Barclay and Holderness (1989) also find that block trades for firms without differential voting rights are typically priced at substantial premiums. ß International Review of Finance Ltd

6 International Review of Finance institutional ownership 3 and an inactive market for corporate control. 4 In addition, neither Corporation Law nor Securities Exchange Law requires outside directors in Taiwanese listed firms. According to Claessens et al. (2000b) and La Porta et al. (1999), the proportion of family-controlled firms in Taiwan is similar to the average proportion of family-controlled firms in nine Asian economies and in medium-sized firms in 27 countries around the world. La Porta et al. (1999) and Claessens et al. (2000b) also show that Taiwanese listed firms do not deviate greatly from one-share-one-vote, but instead controlling owners tend to exercise control through a pyramid. However, the complexity of the ownership structure in Taiwan is not fully recognized in most previous studies. More often than not, other corporations and legal entities owning shares in a firm are either affiliated companies or nominal investment companies associated with the controlling family. 5 In addition to their personal shares, families often increase their dominance within a firm through arrangements where nominal investment companies or holding companies under their control also hold shares in the firm. In many cases, nominee accounts are used to control more shares than are disclosed. Families also use cross-holdings of affiliated companies to strengthen their control. For instance, Fig. 1 illustrates the complexity of tracing control in Taiwan for one business group. Formosa Plastics Group is composed of four Taiwanese listed companies: Formosa Plastics, Nan Ya Plastics, Formosa Chemicals and Fiber, and Formosa Taffeta. The founder, Yung-ching Wang, together with his family members, directly own shares in three of the four companies. However, they indirectly control shares in all four companies through cross-holdings and pyramidal ownership. As families control a substantially larger portion of a firm's shares than the general public, they are able to elect board directors of their choice and appoint management. Claessens et al. (2000b) find that management in approximately 80% of Taiwanese listed firms is from the controlling family. 6 However, Hsu (1997) finds that family control through family members serving as board members and senior managers has been gradually decreasing in Taiwan, while the incidence of professional managers serving as board members and senior managers has been increasing. Semkow (1994) examines excessive nepotism and finds that promotion of descendants within the corporate ranks dilutes the pool of non-family talent and 3 Although the Taiwanese government has set a policy to increase the role of institutional investors, institutional ownership is still limited. For example, ownership by financial institutions was between only 4 and 5% in the 1990s. They have yet to play an effective role in corporate governance 4 According to a survey by Ko et al. (1999), takeovers occur only when there are internal conflicts between family owners or when major stockholders dilute their holdings through the market. 5 Corporations or other legal entities are used to create a cross-holding mechanism in Taiwan. They owned about 25% of all outstanding shares in This is similar to the 69% family representation in management found in La Porta et al.'s (1999) study of 27 countries. 26 ß International Review of Finance Ltd. 2001

7 Family Control and Corporate Governance Figure 1 The Ownership Structure of the Formosa Plastics Group. The investment companies and other entities include Chin's International Investment Co., Wan- Shoon International Investment Co., Chang Gung University, and Chang Gung Hospital. They were jointly founded by Wang's family, Formosa Plastics, Nan Ya Plastics, Formosa Chemicals and Fiber, and Formosa Taffeta. leads to corporate failure when family members are not capable of maintaining and enhancing the business left by the founder. Consequently, family members are not promoted to senior management or board positions unless they have developed extensive personal networks by working in a number of different, lower level positions first. In contrast, non-family individuals with professional training are filling senior management and board positions because of their demonstration of traditional `structural family' characteristics, such as trust, loyalty and predictability. Therefore, even though there is little pressure to appoint outside directors in Taiwan, the presence of non-family professionals may have important implications for corporate governance. 7 III. SAMPLE AND SUMMARY STATISTICS In order to study corporate governance with family control, we collected ownership data, family ties and board composition data for Taiwanese listed companies for the years 1994 and 1995 from company prospectuses and China Credit Information Services. Shareholdings of major equity holders, long-term 7 Rosenstein and Wyatt (1990) and Weisbach (1988) examine the function of outside board members in the USA. ß International Review of Finance Ltd

8 International Review of Finance investment and shareholdings of directors are collected from a company's prospectus. We gather information on the cross-shareholdings of listed firms and members of controlling families from `Business Groups in Taiwan', which is published by China Credit Information Services, to identify when more than one company is under the control of a single family. We define family shareholdings to include shares owned by all family members (of blood and marriage ties), 8 shares owned by nominal investment companies and other legal entities that are effectively controlled by the family and shares cross-owned by affiliated companies. The Taiwan Stock Exchange requires that a company discloses relationships between its directors and managers and among its directors. Thus, we obtain the names of a company's directors from its prospectus and identify whether the director has ties to the largest family shareholder, to the second largest family shareholder or to an institutional investor to calculate what percentage of a board's seats are held by the largest family shareholder. Directors without any ties to the largest family shareholder are classified as non-family directors. The company prospectus does not include detailed ownership data for each shareholder. Thus, we must use the number of shareholders and the total shareholdings of various predetermined groups in order to calculate a Herfindahl index of ownership concentration. Finally, financial data are provided by the Taiwan Economic Journal. We exclude companies with a change of control rights during the sample period, companies in the financial industry and companies not listed before the end of Our final sample consists of 208 companies, which represents 73% of the 285 companies listed on the Taiwan Stock Exchange in A. Measures of family control and board composition Because we are interested in a family's control of a firm, our definition of ownership relies on control rights, and not on cash flow rights. Thus, we include the indirect control of a family through the shareholdings of nominal investment companies, non-profit organizations and other institutions by collecting the shareholdings of these nominal agents and tracing the chain of ownership before calculating the ultimate control of a family. Specifically, family control is the sum of the following three types of direct and indirect ownership: 10 (a) the shares directly owned by family members; (b) the cross-shareholdings of listed companies in the same conglomerate group and the indirect shareholdings through pyramid structures; and (c) the shareholdings of the nominal agents 8 Family ties include a person's spouse, parents, children, siblings, mother-in-law, father-in-law, brothers-in-law, sisters-in-law, daughters-in-law and sons-in-law. 9 The financial industry is heavily regulated and uses a different accounting system from other industries. 10 We define indirect control as the shareholding that is not directly owned but is still controlled by the family members. 28 ß International Review of Finance Ltd. 2001

9 Family Control and Corporate Governance controlled by the family. For example, refer to Nan Ya Plastics in Fig. 1. The Wang family directly owns 12.97% of Nan Ya Plastics. Other Taiwanese listed companies controlled by the Wang family, namely Formosa Plastics and Formosa Chemicals and Fiber, own 4.93 and 4.75% of Nan Ya's shares, respectively. Two nominal investment companies, Chin's International Investment Co. and Wan- Shoon International Investment Co., own 3.63 and 4.56% of Nan Ya, respectively. Through non-profit organizations such as Chang Gung University and Chang Gung Hospital, Mr Wang also controls another 4.16 and 0.77% of Nan Ya, respectively. Thus the shares of Nan Ya that are ultimately controlled by the Wang family sum up to 35.77%. Mok et al. (1992), La Porta et al. (1999) and Claessens et al. (2000b) analyse the control patterns of firms by defining ultimate control based on 10 and 20% ownership cut-offs. However, fixing the ultimate control level fails to consider the distribution of ownership within a firm. For example, the requirement of 10% ownership may be too low for firms with highly concentrated ownership. In contrast, the requirement of 20% ownership may be too high for companies with widely dispersed ownership. In order to address this issue, we adopt a model proposed by Cubbin and Leech (1983) and Leech (1987a, b) to determine the critical control level (i.e. the level of control necessary to gain effective control) for each firm. A firm's critical control level is calculated as follows: s P H ˆ Z 1 Z 2 1 where P* is the critical control level; Z is the z-value such that P(z Z) ˆ for a Normal distribution; is the probability of winning the vote at a shareholder meeting; is the probability of shareholders exercising their vote; and H is the Herfindahl index of ownership concentration. Because we are interested in the control level necessary to gain effective control of a firm, we set ˆ and ˆ 1 to be conservative. By setting to 0.999, we require a shareholder to be able to win a shareholder vote with near certainty in order to have effective control. By setting to 1, we assume that shareholders always exercise their votes, making it more difficult for one particular shareholder to win. 11 Because ownership data are not available for individual shareholders, we calculate the Herfindahl index using shareholder bracket data as in Yeh and Chiu (1996). H ˆ Xk s 2 i n i 2 iˆ1 where H is the Herfindahl index of ownership concentration; s i is the total percentage shareholdings of all shareholders in the ith shareholder bracket; n i is n i 11 We also use other values for but find that the critical control level is not sensitive to changes in this variable. For example, if ˆ 0:999 and H ˆ 243, the critical control level is when ˆ 1.00 and when ˆ ß International Review of Finance Ltd

10 International Review of Finance the number of shareholders in the ith bracket; and k is the number of shareholder brackets. Thus, the higher the desire to win a shareholder vote, the higher the probability of shareholders voting their shares (), and the higher the ownership concentration in a firm (H), the higher the level of control necessary to gain effective control of the firm. In order to identify whether firms have a controlling family, we consider family control resulting from both ownership and managerial participation. Specifically, we classify a firm as a family-controlled firm if: (a) the sum of direct and indirect ownership by the largest family shareholder exceeds the firm's critical control level as calculated in eqn (1); and (b) either a family member serves as the chief executive officer or chairman of the board or family members hold more than 50% of the board seats. The information in Table 1 describes control in the sample of Taiwanese listed firms. Panel A presents a comparison of the predominance of family control in our sample with that found in Claessens et al. (2000b) according to various fixed cut-off points. For example, 81.4% of the firms in our sample are classified as family-controlled when the control level is set at 10%, but only 65.6% of Claessens et al.'s sample are classified as family-controlled at the same level. However, our results are not directly comparable. We collect additional data that allow us to increase our sample size and to use a more comprehensive definition of ownership based on control rights. Panel B describes the predominance of family control when we estimate the critical control level separately for each firm based on ownership concentration. We find that approximately 76% of the sample is family-controlled, 17% is widely held and the remaining 7% is controlled by the state, a widely held corporation or a foreign investor. Because we are interested in family control and control by other types of shareholders is so rare in Taiwan, we focus the remainder of the paper on family-controlled and widely held firms. Even though no shareholder effectively controls widely held firms based on ownership, the largest shareholders in these firms are families. In order to examine separately the ownership and board composition components of control, we first define excess control as the difference between family control (the sum of direct and indirect ownership) in a firm and the firm's critical control level. We then classify family-controlled firms as having high (low) excess control if the controlling family's excess control is above (below) the median value of excess control for the subsample of family-controlled firms. Second, we identify different characteristics of the board. We define family board representation as the number of board seats held by a family's members divided by the total number of board seats. To measure whether a company has a professional manager or second large shareholder to monitor the controlling family and the firm, we classify a company as having a second large group sitting on its board if another family or independent institution owns more than 3% of the company's shares and holds at least one seat on the board. 12 As an alternative, 12 Although the 3% ownership requirement is somewhat arbitrary, too few companies meet the requirement if higher levels of ownership are required to make meaningful comparisons. 30 ß International Review of Finance Ltd. 2001

11 Family Control and Corporate Governance Table 1 Control of Companies in Taiwan A: The predominance of family control in Taiwan with fixed cut-off points Cut-off points (%) Sample size 10% 20% 30% 40% This study Claessens et al (2000b) B: Control of publicly traded companies in Taiwan with critical control cut-offs Widely held Family State Widely Widely Foreign held held corporation financial Number (percentage) (16.83) (75.96) (2.88) (1.92) (0.00) (2.40) of companies controlled by shareholder class The sample consists of 208 publicly traded companies in Taiwan. Control, or ownership based on control rights, is defined as the sum of direct ownership and indirect ownership holdings that are not directly owned but are still controlled by a shareholder. Panel A compares the predominance of family control (i.e. proportion of firms in which family control exceeds a fixed cut-off point) between our sample of Taiwanese firms and Claessens et al.'s (2000b) sample. Panel B illustrates the pattern of control in our sample of Taiwanese listed firms when a critical control level is calculated separately for each firm based on its ownership concentration. Ownership data are from China Credit Information Services and company prospectuses. All values are averaged over the years 1994 and we also identify whether a company simply has an institutional investor sitting on the board. Panel A of Table 2 describes governance characteristics of the 193 firms that are either family-controlled or widely held. On average, 15% control is required to control these firms effectively compared with the levels of 10 and 20% used in previous studies. The largest family shareholder controls 26% of the shares and holds 53% of the board seats, on average. Thus, families control both shareholder and board meetings on average. Claessens et al. (2000b) find that family control is more concentrated among small firms. Therefore we compare governance characteristics between the largest and smallest asset-based quartiles of the family-controlled and widely held firms in Table 3. Interestingly, we find no significant differences in ownership by the largest family shareholder, ownership by the board and proportion of board seats Independent institutions include governmental agencies, unrelated companies, unrelated mutual funds, unrelated financial institutions and foreign investors. ß International Review of Finance Ltd

12 32 ß International Review of Finance Ltd Table 2 Descriptive Statistics for a Sample of Taiwanese Firms in which the Largest Shareholder Is a Family Definition Mean Median Standard deviation A: Governance characteristics s H Ownership required for Z critical control (%) 1 Z 2, in which Z is the z-value such that P z Z ˆ for a Normal distribution; a is the probability of winning the vote at a shareholder meeting; is the probability of shareholders exercising their vote; and H is the Herfindahl index of ownership concentration Ownership by largest family shareholder (%) Ownership by board members (%) Percentage of board seats held by largest family shareholder (%) (Number of shares held by members of the family with the largest shareholdings + number of shares held by other listed companies and entities controlled by the family + number of shares held by nominal agents controlled by the family)/total number of shares Number of shares held by board members/total number of shares Number of directors belonging to largest family/board size International Review of Finance

13 ß International Review of Finance Ltd B. Firm characteristics Tobin's Q (Market value of equity + book value of debt)/total assets Industry-adjusted Q Tobin's Q average Tobin's Q for firms in the same industry Return on assets (ROA) (Net income + depreciation)/ Total assets (%) Industry-adjusted ROA ROA average ROA for firms in the same industry (%) Return on equity (ROE) (Net income + depreciation)/ Book value of equity (%) Industry-adjusted ROE ROE average ROE for firms in the same industry (%) Total assets (million NT$) Book value of total assets Debt/assets (%) Book value of debt/total assets R&D/assets (%) R&D expenses/total assets Advertising/assets (%) Advertising expenses/total assets Variable definitions and descriptive statistics are presented for a sample containing 158 family-controlled and 35 widely held firms. Panel A describes corporate governance characteristics of the sample, and Panel B describes firm characteristics. Ownership and board data are from China Credit Information Services and company prospectuses. Financial data are from the Taiwan Economic Journal. All values are averaged over the years 1994 and Family Control and Corporate Governance

14 International Review of Finance Table 3 Firm Size and Corporate Governance Characteristics Largest Smallest Difference t-test z-test quartile quartile in means difference difference mean mean (medians) in means in medians (median) (median) Total assets *** 9.747*** (million NT$) ( ) ( ) ( ) Market value of *** 8.528*** equity ( ) ( ) ( ) (million NT$) Ownership by largest family (22.175) (26.950) ( 4.775) (%) Ownership by board members (14.276) (15.958) ( 1.682) (%) Percentage of board seats held (57.778) (47.222) (10.556) by largest family shareholder *** 2.031** Ownership (10.889) (15.561) (4.672) required for critical control (%) Herfindahl index *** 2.031** of ownership ( ) ( ) ( ) concentration Corporate governance characteristics are compared between the largest and smallest quartiles in which the quartiles are formed according to total assets. Each quartile contains 48 firms. Ownership and board data are from China Credit Information Services and company prospectuses. All values are averaged over the years 1994 and ***, **, and * indicate significance at the 1, 5 and 10% levels, respectively. held by the largest family shareholder across quartiles. However, we do find significant differences in the Herfindahl index for ownership concentration and the critical control level. Large firms have significantly less ownership concentration and lower critical control levels, on average, than small firms. Taken together, these results are in contrast with the findings in Claessens et al. (2000b) that family control is concentrated in smaller firms. Our results instead suggest that large firms have more family control in Taiwan when ownership concentration is taken into account. B. Measures of relative firm performance and firm characteristics Tobin's Q is widely accepted as a measure of firm value, or market-related performance (e.g. Morck et al. 1988; McConnell and Servaes 1990; Cho 1998; Woidtke 2001). Several studies also use return on assets (ROA) and return on equity (ROE), or profit rates, as alternative measures of performance (e.g. Holderness and Sheehan 1988; Morck et al. 1988; Kang and Shivdasani 1995; Qi 34 ß International Review of Finance Ltd. 2001

15 Family Control and Corporate Governance et al. 1998). Therefore, we use industry-adjusted Tobin's Q, industry-adjusted ROA and industry-adjusted ROE to measure relative firm performance. The results for industry-adjusted ROA and industry-adjusted ROE are similar, so we only report the industry-adjusted ROA results for the sake of brevity. A firm's Tobin's Q is defined as the firm's market value of equity plus its book value of debt, all divided by the firm's book value of assets. A firm's ROA is defined as the firm's net income plus depreciation, all divided by its book value of total assets. Industry-adjusted Q (ROA) is then defined as a firm's Tobin's Q (ROA) less the average Q (ROA) for firms in the same industry according to the Taiwan Stock Exchange's industry classification. We take the average 1994 and 1995 values for all financial variables. Panel B of Table 2 presents values for firm performance variables and for variables which are commonly used as control variables for firm performance: total assets, the ratio of debt to assets, the ratio of research and development expenditures to assets and the ratio of advertising expenses to assets (e.g. Morck et al. 1988). The average firm has a Tobin's Q of 1.95, a ROA of 7.88% and a ROE of 12.48%. IV. EMPIRICAL ANALYSIS This section explores the relation between family control and firm performance and examines whether board composition is an effective governance mechanism in the presence of family control. A. The relation between family control and firm performance Table 4 presents the results of a multivariate analysis investigating whether family-controlled firms have better performance than widely held firms after controlling for other variables believed to be related to the performance variables. Three different specifications are used for each model. In the first specification, a dummy variable, which is equal to one when a firm is family-controlled, is included to see whether a controlling family benefits or hurts a firm in general. The coefficient is not significantly different from zero, indicating that familycontrolled firms, as a whole, perform no differently from widely held firms. One explanation for the lack of significance is that one subset of familycontrolled firms has better performance than widely held firms, but another subset has worse performance. For example, families in firms with high levels of family control are less likely to expropriate from minority shareholders because their costs of doing so are high. However, they may benefit minority shareholders through their expertise and reputation. In contrast, families in firms with low levels of family control are more likely to expropriate from minority shareholders because their costs of doing so are low. 13 Therefore, 13 Not only are cash flow rights lower at this level of ownership, Yeh et al. (1997) also argue that the penalty for exploitation is less severe in Taiwan than in the USA. ß International Review of Finance Ltd

16 36 ß International Review of Finance Ltd Table 4 Regression Analysis of Relative Firm Performance with Different Classifications of Family Control According to a Firm's Critical Control Level Industry-adjusted Q Dependent variable Industry-adjusted ROA Independent variable Intercept (4.197)*** (3.659)*** (2.958)*** ( 4.464)*** ( 3.724)*** ( 4.589)*** Family control v. widely held dummy (0.724) ( 0.332) High family control v. low family control dummy ( 0.438) (2.037)** Widely held v. low family control dummy ( 0.646) (1.787)* Debt/assets ( 0.454) ( 0.312) (1.111) ( 8.244)*** ( 7.903)*** ( 6.401)*** R&D/assets (1.242) (1.307) (0.248) (2.153)** (1.492) (0.386) Advertising/assets ( 0.152) ( 0.386) (0.027) (0.672) (1.183) (0.148) Natural log of assets ( 4.034)*** ( 3.376)*** ( 2.942)*** (5.699)*** (4.658)*** (5.290)*** Number of observations R Adjusted R Three specifications are used to measure the relation between firm performance and different aspects of family control. The first specification is for the sample of firms in which the largest shareholder is a family and includes the family control versus widely held dummy, which equals one when family control exceeds the firm's critical control level, and zero otherwise. The second specification is for the subsample of firms in which family control exceeds the firm's critical control level and includes the high family control versus low family control dummy, which equals one when excess family control (i.e. family control less the firm's critical control level) exceeds the median value for the subsample, and zero otherwise. The third specification is for the subsample of firms that are either widely held or have low family control and includes the widely held versus low family control dummy, which equals one when family control is less than the firm's critical control level, and zero otherwise. The remaining variables are defined in Table 2. t-statistics are given in parentheses. ***, ** and * indicate significance at the 1, 5 and 10% levels, respectively. International Review of Finance

17 Family Control and Corporate Governance their reputation is less credible, and the wealth they expropriate may be greater than any value their expertise may create. To investigate this possibility, we rerun the regression for the subset of firms that are familycontrolled in specification 2 and include a dummy variable that is equal to one when the level of family control is higher than the median value for all family-controlled firms. The coefficient is positive and significant in the industry-adjusted ROA model, which is consistent with the convergence-ofinterest effect dominating when family control is high. 14 The results of specification 2 suggest that family-controlled firms with low levels of control have worse performance than those with high levels of control. We are also interested in seeing whether family-controlled firms with low levels of control have worse performance than widely held firms. Specification 3 is for the subsample of firms that are either widely held or family-controlled with low levels of control and includes a dummy variable that is equal to one when a firm is widely held. The coefficient is positive and significant for the industry-adjusted ROA model, indicating that familycontrolled firms with low control also perform more poorly than widely held firms. 15 Taken together, these results suggest that the expropriation effect is dominant in family-controlled firms when family control is above the critical control level, but ownership is not high enough to make expropriation too costly. 16 In contrast, the convergence-of-interest effect appears to dominate at high levels of family control when the costs of expropriation are much higher. 17 Because previous literature fixes the critical control level at 20% for all firms, we reran the regressions using 20% as a fixed cutoff point in determining whether a firm is family-controlled. The results are presented in Table 5. Note that all the family control coefficients become insignificant using this classification. This is important with respect to classifying control. Recall that the average critical control level is 15% when we control for differences in ownership structure. Thus, increasing the cutoff to 20% shifts firms in which families have little excess control (i.e. control not much greater than 15%) and are thus more likely to 14 The results are similar when we use industry-adjusted ROE in place of industry-adjusted ROA. 15 We should note that the environment that makes the study of Taiwanese firms interesting also introduces the possibility of correlation among the residuals. For example, if the predominance of family control and business groups is associated with similar characteristics across several firms, we may be overstating the number of independent observations and, thus, the t-statistics. 16 Claessens et al. (2000b) show that cash flow rights are approximately 83% of control rights in Taiwan. This proportion is higher than the median value for nine East Asian countries. 17 An argument can be made that family control is endogenous or correlated with unobservable firm characteristics that would also affect Tobin's Q and ROA, in which case the coefficients and t-statistics would be biased. For example, Demsetz and Lehn (1985) argue that firms transacting in less predictable environments (an example might be firms having more intangibles) will have more concentrated ownership, because of the greater need for monitoring for such firms. In this case, the direction of causality between measures of corporate performance may be the reverse of what is assumed in this paper. ß International Review of Finance Ltd

18 38 ß International Review of Finance Ltd Table 5 Regression Analysis of Relative Firm Performance with Different Classifications of Family Control According to Classifications of Control in Previous Research Proxy Q Dependent variable Independent variable Intercept (4.320)*** (3.334)*** (2.884)*** ( 4.580)*** ( 2.764)*** ( 3.880)*** Family control v. widely held dummy (0.467) (0.597) High family control v. low family control dummy ( 0.800) (0.683) Widely held v. low family control dummy ( 0.991) ( 0.030) Debt/assets ( 0.363) ( 1.205) (0.166) ( 8.162)*** ( 6.373)*** ( 6.748)*** R&D/assets (1.243) (1.594) (0.328) (2.153)** (2.241)** (0.997) Advertising/assets ( 0.190) ( 0.653) (0.220) (0.778) (0.880) (0.578) Natural log of assets ( 4.082)*** ( 2.907)*** ( 2.694)*** (5.681)*** (3.693)*** (4.765)*** Number of observations R Adjusted R Three specifications are used to measure the relation between firm performance and different aspects of family control. The first specification is for the sample of firms in which the largest shareholder is a family and includes the Family control versus widely held dummy, which equals one when family control exceeds the 20% cut-off point used in previous research, and zero otherwise. The second specification is for the subsample of firms in which family control exceeds the 20% cut-off point and includes the high family control versus low family control dummy, which equals one when excess family control (i.e. family control less the firm's critical control level) exceeds the median value for the subsample, and zero otherwise. The third specification is for the subsample of firms that are either widely held or have low family control and includes the widely held versus low family control dummy, which equals one when family control is less than the 20% cut-off point, and zero otherwise. The remaining variables are defined in Table 2. t-statistics are given in parentheses. ***, ** and * indicate significance at the 1, 5 and 10% levels, respectively. ROA International Review of Finance

19 Family Control and Corporate Governance expropriate from minority shareholders into the widely held category, thereby decreasing performance. 18 The differences between the results in Tables 4 and 5 suggest that the level of excess control (i.e. family control less the firm's critical control level) is more relevant than the level of family control when studying the relation between family control and firm performance. We therefore utilize a piecewise linear regression framework for the sample of widely dispersed and family-controlled firms using excess family control variables in Table 6. Excess control is defined as ownership by the largest family (based on control rights) less a firm's critical control level. The excess control variables for the piecewise linear regression are defined as follows: excess (under 0.0) equals excess control when excess control is less than 0.0 (i.e. the firm is widely held) and equals 0.0 otherwise; excess (0.0 to 0.10) equals 0.0 if excess control is less than 0.0, equals excess control less 0.0 if excess control is between 0.0 and 0.10 and equals 0.10 otherwise; excess (over 0.10) equals 0.0 if excess control is less than 0.10 and equals excess control less 0.10 otherwise. 19 The results suggest that firm performance, measured by industry-adjusted Q, increases with family ownership when it is below a firm's critical control level, but then decreases with family ownership when it crosses the critical control level until excess control becomes high. This is consistent with the view that other shareholders benefit from the increased presence of a large family shareholder until they gain effective control. However, families appear to expropriate wealth from minority shareholders during the range where excess control is low. 20 B. The role of board composition In Section IV.A we examined the shareholder control rights of families. However, families also have a strong managerial and/or board presence in Taiwan, which can cause an even greater separation between cash flow rights and control. In contrast, the presence of another large shareholder or professional manager on the board can mitigate the conflict of interest arising from a separation of cash flow rights and control. The regressions in Table 7 include proxies for both the ownership and board composition components of control. The first specification includes a dummy variable to capture when a firm has a second large group sitting on the board. It is equal to one if another family or 18 The regressions in Table 5 are also estimated using fixed cutoffs of 10 and 30% and yield insignificant family control coefficients. 19 The regressions in Table 6 are estimated using breakpoints of 0.05, 0.10, 0.15 and 0.20 for excess control. The results are similar for all regressions. We therefore report the 0.10 breakpoint regressions because they have the highest explanatory power. 20 Claessens et al. (2000a) study the relation between firm value and the wedge between cash flow rights and control rights for eight East Asian countries and find differences across countries. For example, they find no significant relation between firm value and either the level of direct family ownership or the level of indirect ownership in Taiwan; however, they do not allow the relation between firm value and family ownership to be non-linear. ß International Review of Finance Ltd

20 International Review of Finance Table 6 Piecewise Linear Regression Analysis of Firm Performance with Excess Family Control Dependent variable Independent variable Industry-adjusted Q Industry-adjusted ROA Intercept (4.561)*** ( 3.751)*** Excess (under 0.0) (3.399)*** (0.583) Excess (0.0 to 0.10) ( 2.302)** ( 0.524) Excess (over 0.10) (1.529) (1.456) Debt/assets (0.079) ( 6.857)*** R&D/assets (1.230) (2.088)** Advertising/assets ( 0.538) (0.569) Log of assets (4.023)*** (4.717)*** Number of observations R Adjusted R A piecewise linear framework is used to analyse the relation between firm performance and excess family control within different ranges for a sample of Taiwanese listed firms in which the largest shareholder is a family. Excess family control is defined as family control less the firm's critical control point. Excess (under 0.0) equals excess control when excess control is less than 0.0 (i.e. the firm is widely held), and equals 0.0 otherwise. Excess (0.0 to 0.10) equals 0.0 if excess control is less than 0.0, equals excess control less 0.0 if excess control is between 0.0 and 0.10 and equals 0.10 otherwise. Excess (over 0.10) equals 0.0 if excess control is less than 0.10 and equals excess control less 0.10 otherwise. The remaining variables are defined in Table 2. t-statistics are given in parentheses. ***, ** and * indicate significance at 1, 5 and 10% levels, respectively. independent institution owns more than 3% of the firm's shares and holds at least one seat on the board, and zero otherwise. The second specification includes a dummy variable that is equal to one if a firm simply has an institutional investor sitting on the board, and zero otherwise. Specification 3 includes a dummy variable that is equal to one when the controlling family holds less than 50% of the board seats, and zero otherwise. In the final specification, we include the proportion of board seats held by the controlling family. No significant relation is found between performance and the presence of either a second large group or an institutional investor on the board. However, a positive (negative) relation is found between performance and whether the controlling family has minority representation on the board (proportion of seats held by the controlling family). The results in Table 7 suggest that board 40 ß International Review of Finance Ltd. 2001