The effect of good corporate governance on stock returns in the Netherlands

Transcription

1 The effect of good corporate governance on stock returns in the Netherlands Master Thesis Name: Danja Varekamp Studentnumber: Cours: MSc Research seminar Accountancy en Control (6314M0041) University UvA Version Final Supervisor Dhr J.J. van Raak Date: 24 th of June 2013

2 Abstract This paper analyzes whether good corporate governance leads to higher stock returns, and enhances firm value in the Netherlands. Following the research method of Gompers et al. (2003), two different types of portfolios are build that consist of companies with good corporate governance and of companies with poor corporate governance. The performance differences between those portfolios, based on abnormal returns, are analyzed. Three different proxies for corporate governance are used in this research: the level of compliance to the Dutch Corporate Governance Code, the level of ownership concentration and the Bureau van Dijk Independence Indicator. The results show that there is a weak but positive relation between these three variables and stock returns of Dutch listed companies. An investment strategy that bought shares in one of the three good governance portfolios, would have earned positive abnormal returns. Keywords: Corporate governance, firm value, stock returns, Dutch Corporate Governance Code, ownership concentration, independence indicator, abnormal returns. 2

3 Table of contents Abstract... 2 Table of contents Introduction Literature Review Corporate Governance Theories The principal-agent theory Stewardship Theory Stakeholder Theory Transaction Cost Economics Prior research in corporate governance Corporate Governance and stock returns Positive relations No relation Negative relation Ownership concentration and corporate governance Hypothesis development Research Data and descriptive statistics Level of compliance to the Dutch Corporate Governance Code Ownership concentration The Bureau van Dijk Independence Indicator Spearman Rank Order Correlation Methodology Corporate governance and stock returns Results summary statistics Corporate governance and returns Returns from the Three Factor Model Discussion Conclusion References Appendix

4 1 Introduction Corporations are powerful and dominant institutions in today s society. The governance of these companies has influenced economies. In one of the biggest accounting scandals of all times, Enron, poor financial reporting enabled executives of the company to hide billions of dollars in debt. Enron s shareholders lost a total of $ 45 billion dollars due to this fraud. High-profile accounting scandals like those of Enron, Worldcom, Ahold, to name a few, all highlight the need for increased transparency and control in the financial reporting process. Over the last several years companies are actively reviewing and improving their corporate governance and disclosure practices. Corporate governance is broadly defined as the manner in which companies are controlled and in which those responsible for the direction of companies are accountable to the stakeholders of these companies (Daya et al., 1996). Governments mandated new regulations in response to accounting scandals, in particular the Enron and Worldcom scandals in the US and the Ahold scandal in the Netherlands. In the US the Sarbanes-Oxley act (SOX) was implemented and in the Netherlands the Dutch Corporate Governance Code (Code Tabaksblat) was enforced. Both regulations had the aim of improving corporate governance and thereby restoring investors confidence. Compliance with the code should reduce the risk of inappropriate behavior by managers. Therefore one could expect that firms that have good corporate governance mechanisms should have a higher firm value then firms that have poor corporate governance systems. In 2002 The McKinsey "Global Investor Opinion Survey" showed that 15 percent of European institutional investors consider corporate governance to be more important than the financial issues of a company. Additionally, 22 percent of European institutional investors are willing to pay a premium of 19 percent for well-governed firms. This evidence shows that the interest in corporate governance has heightened amongst investor. Previous research has investigated the relationship between corporate governance and stock returns in the US, and in Europe. It is interesting to see if this relationship also exists in the Netherlands. Previous research has yielded mixed results on the relationship between good CG and firm value. Also there is not that much empirical literature which examines the impact of a complete set of governance standards on firm performance. Most studies instead investigate the impact of a single governance characteristic on firm performance. The central question of this research will be as follows: 4

5 Does good corporate governance lead to higher stock returns for Dutch Listed companies? To answer the research question, the methodology by Gompers et al. (2003) is followed. Two types of portfolios are constructed for each indicator of corporate governance. One portfolio is made up out of companies with good corporate governance and the other portfolio consists of poorly governed companies. To measure the level of corporate governance three different proxies are used: the level of compliance to the Dutch Corporate Governance Code, level of ownership concentration and the independence indicator by Bureau van Dijk. In total six different portfolios are constructed. For each portfolio the raw returns are calculated using monthly stock price data. Then the excess returns are calculated using the Three Factor model of Fama and French (1983). The results show weak support for a positive relationship between the three proxies for corporate governance and stock returns. The remaining of the paper is structured as followed; First the literature review will be discussed. In this chapter important corporate governance theories are elaborated on to gain a thorough understanding of what corporate governance entails. The literature review also provides an overview of research that has investigated the relationship between corporate governance and stock returns, an overview of the Dutch Corporate Governance Code, and a paragraph on ownership concentration. Section three will discuss the data and methodology used for this research. This section is followed by the results and the final sections consist of the discussion and the concluding remarks. 5

6 2 Literature Review Corporate governance is an important topic in business which received heightened attention after numerous accounting scandals. The academic literature on this subject is limited and most research in this area uses event-study methodology. These event studies look at an announcement of a new defense mechanism and then analyze the firm value following that announcement. In this literature review some important theories that have all contributed and influenced the development of corporate governance are discussed to gain a better understanding of the topic. After that an overview of the empirical evidence of the effect of corporate governance on stock returns is provided. 2.1 Corporate Governance Theories The topic of corporate governance has been influenced by many theories. The most cited corporate governance theory is the principal-agent theory which introduces us to the problems that arises when ownership and control are separated. After the agency theory there was the development of the stewardship theory, stakeholder theory and eventually the transaction cost economics theory. In the next section the principal-agent theory is discussed in more detail The principal-agent theory In the practice of corporate governance the conflicts of interest between stakeholders and management is a central issue. The search for solutions that can solve these problems has been prominent for years. At the base of explaining these conflicts lies the principal-agent theory. The agency theory was preceded by the theory of the firm. Jensen and Meckling say that this theory is in fact the Theory of the Markets (1976). This theory describes the firm as a black box that strives to maximize the present value of the entire firm (1976). However an organization consists of many of participants. Each of these participants have their own personal objectives that may or may not be congruent with the overall objectives of the organization. This self-interest behavior of managers has been pointed out by Adam Smith back in He said that : 6

7 The directors of such [joint-stock] companies, however, being the managers rather of other people s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. The theory of the firm assumes that all the participants in a company want the same thing, which is the best for the company. The theory of the firm does not leave any room for selfinterest behavior by managers. This limitation of the firm incorporated into the agency theory. This theory is developed by Jensen and Meckling (1976). They define the agency relationship as where one person, the agent, acts on behalf of another person, the principal (1976). Jensen and Meckling assume that if the principal and agent are both utility maximizers there is a potential risk that the agent will perform actions in his own best interests, and not in the interests of the principal (1976). Jensen and Meckling further add that the agency problem exists in every organization and in all cooperative effort at every level of management in the firm (1976, p. 309). The importance of controlling the principal agent problem can best be described by exploring the issue of separation of ownership and control by Fama and Jensen. When the managers who are in charge of making important decisions are not the residual claimants to the wealth that arises from those decisions, it is likely that those managers will make decisions that are not always in the best interests of the actual residual claimants (Fama and Jensen, 1983). The principal can take actions to limit the deviations from his interests by establishing appropriate incentives for the agents and incurring monitoring costs to limit the abnormal activities of the agent. In addition in some situations the agent may be required to incur bonding costs. These are costs that are put in place to make sure that the agent doesn t take any actions that could potentially harm the principal, or that when he does the principal will be compensated for his harm (Jensen and Meckling, 1976). Generally it is impossible for the agent or the principal to ensure at zero cost that the agent will make optimal decisions not only for him but also for the principal. In most principal-agent relationships the principal will incur monitoring costs and the agent will incur bonding costs. Additionally there will remain some divergence between the decisions taken by the agent and those decisions that will maximize the welfare of the principal. This divergence will result in a reduction in welfare for the principal which is often referred to as residual loss. The total agency costs are the sum of : (1) the monitoring costs 7

8 made by the principal, (2) the bonding costs made by the agent, and (3) the residual loss (Jensen and Meckling, 1976). After this overview of the principal-agent problem, we can conclude that every situation that involves the cooperative actions by two or more people there is a probability of agency problems. Over the years there is a growing body of literature which suggests potential solutions to the agency problem. A possible solution is to find the optimal contract between the managers and the outside investors (Healey et al., 2001). A contract is optimal when the interest of the managers are aligned with the interest of the outside investors. An optimal contract will require management to disclose important information to the investors to show them that they have complied with previous agreements made. The Board of directors can also be of great assistance in solving the agency problem. They can mitigate the agency-effect by monitoring management and correcting their decisions when and if necessary. Intermediaries can help by increasing the amount of information that becomes available to the investors. Even with some of these measures in place it still happens that the agents will take decisions based on their own self-interest. Corporate governance codes can be seen as extra enforcement to control the principal-agent relation for organizations. Compliance with corporate governance codes should reduce the risk associated with inappropriate behavior of the agent and it should increase investors confidence Stewardship Theory Another important corporate governance theory is the Stewardship theory. The stewardship theory is an alternative to the agency theory and offers opposite predictions. This theory states that the steward, which is the manager, wants to do a good job. The stewardship theory holds that there is no inherent, general problem of executive motivation (Donaldson and Davis, 1991). According to this theory differences in performance arise due the extent of the capability of managers to take effective action. This in turn depends on the structural situation in which the manager is located. The organization structure helps the manager implement plans for good corporate governance when it provides clear, consistent role expectations and gives senior management enough empowerment. The stewardship theory states that there are several non-financial motives for managerial behavior. These motives are: the need for achievement and recognition, the intrinsic satisfaction 8

9 of a successful performance, respect for authority and the work ethic (Muth & Donaldson, 1998). According to this theory, when managers are confronted with an action which is not seen as personally rewarding, they may comply with it based on a sense of loyalty to the organization (Etzioni, 1975) Stakeholder Theory A stakeholder can be defined as any group or individual who can affect or is affected by the achievement of the organization s objectives (Freeman, 1984). This theory stresses the corporation s dependency on many different groups. Stakeholder analysts argue that all of the individuals with a legitimate interest in the company should be treated equally and that no interest has the priority over another interest. The stakeholder theory has three different aspects; descriptive, normative and instrumental (Donaldson and Preston, 1995). The descriptive aspect of the theory tries to explain and present relationships that are observed in the external world and describes how a firm should be controlled. The instrumental aspect constructs a framework which can be used to examine the connections between the practice of stakeholder management and achieving corporate performance objectives. The fundamental basis of the stakeholder theory is considered to be of a normative nature. Each stakeholder group should receive the same amount of consideration and the interests of all stakeholders are of equal intrinsic value. Thus when a firm is formulating its policies all of the interests and incentives of these stakeholder groups need to be considered Transaction Cost Economics Transaction cost economics views the firm itself as a governance structure. According to Williamson, opportunism is considered to be a central element in the study of transaction cost (1979, p.234). When a company is outsourcing certain production activities, it needs to write and enforce contracts with the trading partner. Transaction costs then arise not only due to the contracting costs, but also because there are risks associated with the potential opportunistic behavior of the trading partner ( Williamson, 1985). There are three elements that increase the risk of outsourcing : (1) infrequency of the transaction, (2) the task uncertainty/complexity of transaction activities, and (3) the degree to which the investments are relation-specific (Williamson, 1985). These elements increase the transaction risk (and cost) associated with 9

10 opportunistic behavior of the trading partner. Accordingly the governance structure is chosen as a way to minimize these transaction costs. Transaction cost economics assumes that the agents and the owners of the firms are incentive-aligned and that they will opportunistically manage their transactions and therefore these actions need to be controlled. 2.2 Prior research in corporate governance This section outlines and discusses prior literature to create a thorough understanding of those published results. This section discusses the papers that have examined the relation between corporate governance and stock returns. The papers that have found a positive relation will be discussed first, followed by the ones that didn t find a significant relation or that found a negative relation Corporate Governance and stock returns In this section I will provide an overview of the articles that have empirically investigated the relation between corporate governance and stock returns. I will start with the articles that find a positive relation between corporate governance and stock returns. Then I discuss the articles that did not find a relationship. After that I continue with the articles that find a negative relation Positive relations One of the most influential papers on the relationship between corporate governance and stock returns is that of Gompers, Ishi, and Metrick (2003). Gompers et al. (2003) argue that most research on wealth effects of corporate governance provisions is done by event-study methodology, which analyzes a firm s stock return following the announcement of a new defense. The difficulties these studies face is that the new defenses may be driven by contemporaneous conditions that are present at the firm. The authors want to avoid these difficulties by taking a long-horizon approach to study the relation between corporate governance and corporate performance. Gompers et al. (2003) combine a large set of governance provisions into an index which then proxies for the strength of the shareholder rights. They use this index to study the empirical relation between corporate governance and corporate performance. The date in their research is derived from the Investor Responsibility Research Center (IRRC). The IRRC provides 28 corporate governance provisions, of which 24 are unique, for approximately 1500 firms in the U.S. since Gompers et al. (2003) divide these 24 10

11 unique provisions into five different groups; (1) delay, (2) voting, (3) protection, (4) other, and (5) state. Each of the provisions gives management a tool to resist shareholders. The delay group is related to those provisions that slow down a hostile bidder and is considered to be the most crucial. The rights of shareholders in elections or bylaw amendments are covered in the voting group. The protection group is related to protecting the managers and directors against jobrelated liability or has to do with their compensation following a termination. The remaining firm-level provisions will be covered in the other group and the state group deals with the state take-over laws. Gompers et al. (2003) make their own governance index (G). For every provision that increases managerial power en decreases the rights of the shareholders, they add one point so G has a possible range from 1 till 24. To look at good versus bad corporate governance effects on stock returns, they construct two extreme portfolios; the dictatorship portfolio and the democracy portfolio. The Dictatorship portfolio consists of the firms with the greatest managerial power and the weakest shareholder rights (G 14). Firms with the strongest shareholder rights and the lowest managerial power are placed in de Democracy portfolio (G 5). Gompers et al. (2003) show that a $1 investment in the (value weighted) dictatorship portfolio earns an annual return of 14.0 percent while a $1 investment in the democracy portfolio earned a 23.3 percent return which is a difference of more than 9 percent. They conclude that corporate governance is strongly related with stock returns in the 1990s. They find that an investment strategy which purchased shares in the Democracy firms, and sold shares of the Dictatorship firms, earned abnormal returns of 8.5 percent per year (2003, p.144). To estimate firm value the authors use Tobin s Q. Tobin s Q is the market value of the assets divided by the book value of the assets. The authors found that for every one percentage point increase in G, Tobin s Q dropped by 2.2 percentage points. By the end of the 1990s the decrease in Tobin s Q amounted to 11.4 percentage points. Overall, the main results are that firms in the 1990s with stronger shareholder rights earned significant higher returns, were valued higher and had better operating performance. The authors do recognize that there is a possibility that their results, or some parts of the results, can be attributable to unobservable firm characteristics. However, they argue that the long-run benefits of decreasing the number of provisions can still be very large. Another paper that follows the same approach as Gompers et al. (2003) is the one of Drobetz, Schillhofer, and Zimmerman (2003). This paper investigates the relation between 11

12 corporate governance and expected stock returns for listed companies in Germany. Drobetz et al (2003) choose not to focus on the legal environment, which affects all firms equally within a single jurisdiction, but they focus on the relation between a broad corporate governance rating and the expected rate of return of individual firms. The German Corporate Governance Code has a comply or explain report. This means that listed firms can indicate in their annual report if they comply or explain with the provisions of the code and explain why they deviate from the provisions. This legal set-up views corporate governance as chance and not as an obligation. Their central hypothesis is that better corporate governance will allow investors to spend less time and resources on monitoring management and hence will reduce the required rate of return for investors. Like Gompers et al. (2003) they also construct their own corporate governance rating (CGR) as a proxy for firm-specific governance quality which has a range of 1 to 30. They use 30 relevant governance proxies and divide them into five categories: (1) Corporate governance commitment, (2) shareholder s rights, (3) transparency, (4) management and supervisory board, and (5) auditing. They believe that this firm-specific CGR can act as a proxy for the estimated auditing and monitoring costs incurred by outside investors. They construct two portfolios; the principal portfolio and the agent portfolio. The principal portfolio has the highest governance quality (CGR>21) and the agent portfolio the weakest governance quality (CGR<18). Their results show that there is a strong relation between the CGR and firm value for listed German firms. An investment strategy that bought firms with high-cgr and shorted firms with low-cgr, would have earned abnormal returns of 12 percent on an annual basis. They conclude that better governance will reduce the required rate of return on equity. Bauer, Günster, and Otten (2003) find similar results as Gompers et al. (2003). They investigate whether good governance leads to higher common stock returns and enhances firm value in Europe. To analyze this they construct a portfolio of well governed firms and one of poorly governed firms and make a comparison between the two. Their research design is somewhat different from that of Gompers et al (2003). Bauer et al. (2003) use a dataset that consist of two currency areas, the U.K. and the European Monetary Union (EMU), and then analyze them separately. They use the corporate governance ratings of Deminor, which covers most companies included in the FTSE Eurotop These ratings are based on 300 different criteria, which can be divided into four broad categories: (1) Rights and duties of shareholders, (2) Range of takeover defenses, (3) disclosure on corporate governance, and (4) board 12

13 structuring and functioning. The firms were ranked based on their corporate governance rating for the EMU and the U.K. Bauer et al. (2003) deviate from Gompers et al. (2003) in their portfolio construction. They construct their portfolios based on relative score of a firm versus the entire sample, instead of using an absolute score. Bauer et al (2003) want to ensure that the portfolios are about equal with respect to total market capitalization. Like Gompers et al (2003) they found that corporate governance has a positive effect on stock returns and firm value. However, the relationship between good corporate governance and higher stock returns weakens significantly after adjusting for country differences. After correcting for country differences, they found a substantial difference in results between the EMU and the UK. The excess returns of a corporate governance strategy in the EMU were much smaller than in the UK. This was partly the case after adjusting for country effects. They also found a stronger relation between good corporate governance and firm value in the UK than in the EMU. A possible explanation for these results could be that in the Eurozone corporate governance standards have already been incorporated in the stock prices. This could be because in the EMU countries traditionally tend to have weaker governance standards due to civil law. In the Eurozone most countries are civil law countries and under those laws shareholder protection is weak. Therefore EMU companies might adopt more measures to create higher managerial power No relation The research described above all found a positive relation between good corporate governance and stock returns. In this paragraph I will discuss some articles that have replicated the research of Gompers et al. (2003) but however failed to find a significant positive relation between governance and stock returns. Core, Guay, and Rusticus (2006) replicated the research of Gompers et al. (2003). They followed the same research method. and measured governance by using the constructed governance index (G-index). Core et al. (2006) find that the G-index had a negative association with future operating performance. To determine if this negative association is caused by the fact that investors are surprised about the poor operating performance of weak governance firms, they conduct two complementary tests: (1) an analysis of the relation between forecasting errors of analysts and governance, and (2) an analysis between governance and earnings announcement returns. These tests are both based on the idea that investors will be surprised when they do not understand the association between governance and stock returns. 13

14 More specifically, they argue that the market should be negatively surprised by the poor operating performance of weak governance firms if the relation between poor operating performance and bad stock returns is causal. Overall, they found no evidence that governance causes unexpected cash flows that in turn can cause abnormal stock returns. They found that firms that had a weak governance which substantially underperformed compared to the market, did not surprise investors since they continue to forecast this difference. Also, their results show that the takeover rate of bad governance firms was about the same as the takeover rate of good governance firms. Their findings indicate that good corporate governance does not cause higher stock returns. Johnson and Moorman (2009) also reexamine Gompers et al. (2003) and focus on whether industry clustering in the Dictatorship and Democracy portfolios matters when it comes to measuring the long-term abnormal returns. They find that firms in Dictatorship and Democracy portfolios are distributed differently across industries when compared to each other or to the general population of firms. The authors found that firms that had strong shareholder rights and firms that had weak shareholder rights differ from each other, and the population of firms, in how they are clustered across industries. Fama (1998) stated that model misspecification that is driven by industry clustering can lead to false long-term abnormal results. They conduct specification tests in industry-clustered samples to test long-term abnormal returns. The authors found that holding a long position in the Democracy portfolio and shorting a position in the Dictatorship portfolio statistically earned zero long-term abnormal returns. Johnson et al. (2009) show that particular industries experienced unexpectedly high or low realized returns and this point to the fact that industry, instead of governance, causes the variation in returns across the Dictatorship and Democracy portfolio. Overall, Johnson et al. (2009) find no evidence that good corporate governance lead to higher stock returns which contradicts the findings of Gompers et al. (2003) Negative relation Cremers and Ferrell (2010) recently investigated the relation between corporate governance and firm value and their results are opposite of those previously found by Gompers et al. (2003). Cremers and Ferrell (2010) found a robust negative association between poor corporate 14

15 governance ( proxied by higher G- and E- indexes) and firm value measured by Tobin s Q. The authors hand-collected a shareholder database that started in 1978 and ended in They tracked approximately 1,000 unique firms. For each firm in their database they calculated the firms G-index and E-index. Their results indicate that firms with a high number of anti-takeover provisions have a lower firm value as measured by Tobin s Q. They however found limited evidence to support a reverse causation, that firms with low value would adopt more governance provisions. 2.3 Ownership concentration and corporate governance The concentration of ownership is often used as an indicator for the level of corporate governance. This rational finds his origin back in 1932, and is referred to as the Berle-Means problem. Berle and Means (1932) said that in diffuse ownership structures there is a lot of information and incentive asymmetries which will cause a disruption of the relationship between managers and investors a. La Porta, Lopez-De-Silanes, Shleifer, and Visny (2002) showed that companies with higher cash flow ownership have higher firm valuations measured by Tobin s Q. There are two types ownership structures, diffused or concentrated. A company that has a diffused ownership structure has a lot of small shareholders and no large block shareholders. The opposite is the case for a company that has a concentrated ownership structure. There are advantages and disadvantages for both structures. Demsetz and Lehn (1985) argue that the most obvious disadvantage of greater diffuseness in ownership is the fact that there is a greater incentive for owners to shirk. Demsetz and Lehn (1985) go on to state that the incentive to shirk is much larger in very diffusely owned firms. When there is diffused ownership, the benefits derived by a shirking owner accrue entirely to him. The cost of this shirking, likely to be poorer firm performance, is shared by all shareholders in proportion to the numbers of shares or stock they own. The deviation between the benefits and the costs will be very large for the owner in this case which can make him respond by not carrying out some of the task related to his ownership. This incentive risk is much smaller for a company which concentrated ownership. When the ownership structure of a company is concentrated the benefits 15

16 and costs will most likely be borne by the same owner. In this case the owner will have the incentive to maximize value responsibly without neglecting some of his task because in the end he will also bear the costs of this shirking. Demsetz and Lehn (1985) state that in a rational world diffuse ownership structures wouldn t exist due to the inefficiencies associated with shirking behavior. According to Jensen and Mecklig (1976) the costs of deviating from value-maximization declines as management ownership rises. It is argued that diffuse ownership allows managers to serve their own needs instead of the needs of the company, which refers to the principal-agent problem. More concentrated ownership will establish a stronger link between the behavior of managers and the accounting the interest of the owners which in turn will yield higher profit rates, this if often referred to as the convergence-of-interest hypothesis. Demsetz and Lehn (1985) investigated the relationship between ownership concentration and the accounting profit rate for a sample of 511 U.S. firms. They did not find any support for the convergence-of-interest hypothesis because their results didn t yield a significant relationship between accounting profit rate and ownership concentration. Morck, Shleifer, and Vishny (1988) investigated the relationship between management ownership and market valuation of the firm as measured by Tobin s Q. The authors didn t find a significant relation but a cross section of Fortune 500 firms did show a relation between board ownership and Tobin s Q. Morck et al. (1988) found that when board ownership increases from one till five percent, Tobin s Q will increase, the same goes for an increase beyond 25 percent. However, an increase from five till 25 percent will cause Tobin s Q to decrease. Wruck (1989) believes that private and public sales of equity will reveal information to the market about firm value. In a private sell of equity the firm sells a large block of shares to a single or small group of investors. Wruck (1989) states that a private equity sale provides an opportunity to examine the effect of changes in equity ownership concentration on firm value. Wruck wants to examine the change in firm value after the announcement of a new equity issue. Her results show that a private equity sale, which increases ownership concentration, will on average be positively associated with a change in firm value. The announcement of a private equity sale was accompanied by an 4.5 percent abnormal return. Wruck (1989) performed a cross-sectional regression analysis which indicated that this positive relation exists when the 16

17 level of ownership concentration is high or low. In the middle range changes in firm value are negatively associated with change in ownership concentration. Xu and Wang (1999) investigated whether ownership structure significantly affects the performance of publicly listed companies in china within the framework of corporate governance. They find a positive correlation between ownership concentration and a firm s performance. Specifically, they find that a firm s profitability is positively and significantly correlated with the fraction of legal-person shares. This suggests that large shareholders have played a significant part in corporate governance. Demsetz and Villalonga (2001) found completely opposite results. The authors performed a study for 223 U.S. firms and their results yielded no statistically significant relation between firm performance and ownership structure. This finding represents the view that diffuse ownership, even though it may cause some agency problems, can also create competitive advantages. Demsetz and Villalonga (2001) argue that the market is very successful in creating different ownerships structures. This can be diffuse or concentrated but it will always be the structure that is most appropriate for the firms that they serve. Therefore ownership structures differ across firms because each of these firms faces different circumstances under which they have to operate. In the Netherlands, Chirinko, van Ees, Garretsen, and Sterken (2001) investigated the role of investor protections and concentrated ownership. Their research showed that concentrated ownership doesn t really have an impact on the firm performance. They attribute this finding to the fact that these large shareholders will increase the agency costs of expropriation, but on the other hand will lower the cost of managerial agency problems. The above discussion shows that the literature provides arguments in favor of and against concentrated ownership. The argument in favor of concentrated ownership, is related to the agency problem, and says that high ownership concentration aligns the interests of managers and shareholders and therefore less control mechanisms need to be in place. Diffuse ownership raises the costs of expropriation by managers since they will bear all of the benefits but not all of the costs, these will be shared amongst all of the shareholders. Corporate Governance Codes are put in place to reduce these information and incentive asymmetries and make sure that the managers will maximize shareholder value at all times. 17

18 2.5 Hypothesis development This research aims to find a relationship between good corporate governance and higher stock returns in the Netherland. As described in section many research in this area has followed the research method by Gompers et al. (2003). Their methodology uses a governance index to proxy for the level of corporate governance. In this research I will use the level of compliance to The Dutch Corporate Governance Code as a proxy for good corporate governance. The Code consists of principles which can be regarded as a reflection of the general views on good corporate governance. Since the principles of the Code reflect the general views on good corporate governance, a high level of compliance to these principles will correspond with good corporate governance. Since good corporate governance is likely to reduce the information and incentive asymmetries associated with the separation of ownership and control it reduces agency costs. Merton (1987) shows that when the cost of obtaining reliable information decrease, investors will reduce their required rate of return which implies a higher current market value. The discussion in section showed that most research has found a positive relationship between corporate governance, stock returns and firm value. Therefore, I assume that companies that have good corporate governance will have higher stock returns and also higher firm as measured by abnormal returns. H1: A portfolio consisting of companies that have a high governance index earns abnormal returns, measured by α, than a portfolio that consist of firms that have a low governance index. Concentrated ownership reduces the incentive and information asymmetry that is associated with diffuse ownership. Therefore concentrated ownership minimizes the principal agency problem and reduces the costs associated with these problems. For this reason the expectation is that high ownership concentration works as a measure of good corporate governance. H2: A portfolio consisting of companies that have high ownership concentration earns significantly higher abnormal returns, measured by α, than a portfolio consisting of companies that have low ownership concentration. 18

19 The third indicator of good corporate governance in this research is the Bureau van Dijk independence indicator. This indicator shows the level of independence a company has with respect to its shareholders. The higher the level of independence, the greater the reassurance that monitoring is done effectively without any bias. Higher level of independence increases the reliability and minimizes the agency costs associated with inappropriate behavior by management. This research therefore expects that a high Bureau van Dijk independence indicator level corresponds with higher stock returns and higher firm valuations. H3: A portfolio consisting of companies that have a high independence indicator earns significantly higher abnormal returns, measured by α, than a portfolio consisting of companies that have a low independence indicator. 3 Research The objective of this research is to provide evidence for the hypothesized relationship between governance and expected rates of return within a single jurisdiction. This research does not look at the regulatory environment because it investigates firms within the same jurisdiction so the legal environment will affect them all similarly. Instead, this research focuses on the relationship between a set of governance proxies and expected returns in a cross-section of Dutch listed firms. The literature on this subject is limited. Research in this area up to this date took place in the U.S., U.K and Germany. As mentioned in the introduction, there is no study yet that has investigated the relationship between governance and stock returns in the Netherland. This research aims to fill this gap by shedding some light on this under researched area and could therefore be of potential value to Dutch (institutional) investors. The research question is : Does good corporate governance lead to higher stock returns for Dutch listed companies? To find an answer to this question it is important to know what constitutes good corporate governance and which companies have good corporate governance. These questions are answered and discussed in the following section. 19

20 3.1 Data and descriptive statistics This research aims to investigate the relationship between governance and stock returns within a single jurisdiction, the Netherlands. Therefore the sample that is used in this research consists of all Dutch listed companies at Euronext Amsterdam. This includes all AEX (Amsterdam Exchange Index), AMX (Amsterdam Midkap Index), AScX (Amsterdam Small Cap Index, and local funds. An overview of all the companies in the sample is provided in the Appendix 1. From all the companies in the sample Financial Service companies are excluded since they were subjected to the financial crisis of To determine the level of corporate governance for each company, this research uses three proxies. The use of more than one indicator reduces the bias in the research and increase the objectivity of the results. In the following paragraphs these indicators are discussed in more detail Level of compliance to the Dutch Corporate Governance Code The first indicator that serves as a proxy for good corporate governance is the level of compliance of Dutch listed firms to the Dutch Corporate Governance Code. The Dutch Corporate Governance Code which is also known as Code Tabaksblat, is a code of conduct for Dutch listed companies and its major aim is to increase transparency in financial reporting. The Code Tabaksblat applies to all the Dutch Listed companies who have their registered offices in the Netherlands. The Code contains principles and best practice provisions that are put in place to regulate the relations between the; management board, supervisory board, and the shareholders. For example, the supervisory board shall discuss at least once a year on its own, i.e. without the management board being present, its own functioning, the functioning of its committees and its individual members, and the conclusions that must be drawn on the basis thereof (The Dutch Corporate Governance Code). Another example is that is that a management board member can only be (re)appointed for a maximum period of four years. The principals reflect the general views on good corporate governance. These principals have been divided in the form of very specific best practice provisions. In governing the behavior 20

21 of the management board, the supervisory board, and shareholders, these provisions can be seen as standards that should be followed. These provisions can be seen as the general principles of good corporate governance. Listed companies may however deviate from these provisions. They need to justify their deviation in the comply or explain report. A company isn t allowed to deviate from a best practice provision when this corresponds with a statutory rule, not even when an explanation is given. An example of this is the part of the Code that deals with the audit committee. The Code has a long-term objective, in that it is based on the principle that a company is a long-term alliance between all of the various parties involved in the company (The Dutch Corporate Governance Code). The Code further states that the management board and the supervisory board have the responsibility of ensuring the continuity of the enterprise and creating long-term shareholder value, while at the same time equally weighing the interest of all stakeholder groups into their decisions. There are five different chapters present in the code: (I) compliance with and enforcement of the Code, (II) the management board, (III) the supervisory board, (IV) the shareholders and the general meeting of shareholders, and (V) the audit of the financial reporting and the position of the internal audit function and the external auditor. In all of these chapters you will find principles and best practice provisions for listed companies. In total the code consists of 129 principles and best practice provisions. The Code is based on the two-tier board system. The two-tier board system is a system in which there is a separate supervisory board that oversees the actions taken by the management board. In the fiscal year starting 2004 the code became effective and in 2009 a new revised code came into force in which the way the management board, supervisory board, and the shareholders, fulfill their tasks gained additional performance. The revised code also changed the scope of the In Control Statement (ICS) from the whole organization being in control to control over the reliability of the financial reporting process. It is recommended that listed companies include a chapter in their annual report that outlines their compliance with the Code in the so called comply or explain report. However, there are no sanctions when a company chooses not to comply, but explains, its deviation from the best practice provisions. 21

22 The Governance Index To measure firm-specific corporate governance quality, this research uses a Governance index, hereafter referred to as GI, as the measure. The index construction is very straightforward. For every individual company the number of non compliance provisions are counted. This number of non-compliance provisions are multiplied with a factor of 5. This is done to create a wider range in the GI s and it might make it easier to make comparisons amongst the companies. Then this number is subtracted from the total number of provisions, which is 129, in order to get the number of comply provisions for each individual company. However, for some companies certain provisions of the Code are not applicable. Since this indicator wants to measure the level of non-compliance, provisions that are not applicable to a company cannot be counted as a deviation from the code and are excluded from the total count of all the provisions. This means that if a company has five provisions that are not applicable to them, due to size or structure for instance, their total number of provisions to comply with is 124. The level of compliance is then calculated by dividing the number of compliant provisions by the total of 124. As a result, the number of provisions that are complied with within each individual company will determine the score of their Governance Index (GI). As mentioned before, all of the provisions are equally weighted because this research makes no attempt to reflect the relative importance of the individual provisions but use this approach since it is transparent and allows for easy interpretation. In order to make a true comparison in stock returns, the criterion for the sample is that the stock data has to be available for the three year period. After filtering for the before mentioned criteria, the total sample size was 77 companies. Table 1 represents the descriptive statistics of the governance index (GI) based on the level of compliance to the Dutch Corporate Governance Code. Tabel 1 Dutch Corporate Governance Code compliance : Descriptive statistics N Mean Median Mode Std. Dev. Min Max

23 The fifteen companies with the highest scores (ranging from 10 till 9.2) are placed in the High Governance Index portfolio (HGI). The fifteen companies with the lowest GI score (ranging from 6.8 till 3.7) are placed in the LGI portfolio (Low Governance Index). Table 2 presents the selected companies for the HGI portfolio and LGI portfolio including their scores on the governance index. Tabel 2 Sample compliance to Dutch Corporate Governance Code High GI portfolio Index Low GI portfolio Index Philips 10 Fornix 6.8 Ahold 9.6 Reed Elsevier 6.5 ICT 9.6 Pharming Group 6.5 Xeikon 9.6 Fugro 6.5 Asml 9.2 Amsterdam Commodities 6.5 Bam 9.2 Heineken 6.2 Boskalis Westminster 9.2 Reesink 6.1 DSM 9.2 HES Beheer 6.1 Heijmans 9.2 Brill 6.1 KPN 9.2 DPA Group 5.7 Macintosh 9.2 AND International 5.6 Publishers Oranjewoud 9.2 AFC Ajac 5.6 SBM 9.2 NEDAP 3.8 TOM TOM 9.2 Porceleyne Fles, De 3.4 SIMAC 9.2 Groothandelsgebouwen Ownership concentration The second indicator that this research uses to proxy for corporate governance is the level of ownership concentration. The implications of ownership concentration are usually discussed in the context of the agency theory. As mentioned in the literature review low ownership concentration may create free-riding problems and high monitoring costs for the company owners. When there is a concentration of ownership, the incentives of these large block holders and the company will be more aligned. This means that the shareholders will have greater incentives to monitor management and make sure that the company is run in their interest. In this research the assumption is made that companies with a high ownership concentration represent 23