Managerial Entrenchment and Open-Market Share Repurchases: The Case of Taiwan Ruei-Shian Wu College of Management Yuan Ze University 135 Yuan-Tung Road Chung-Li 32003, Taiwan Phone: 886-3-463-8800 ext.2195 Fax: 886-3-463-3845 E-mail: rswu@saturn.yzu.edu.tw The author gratefully acknowledges the financial support of the National Science Council and Yuan Ze University. I am grateful to the Taiwan Economic Journal database for the use of returns, repurchases, and corporate governance data. All remaining errors are my own. 1
Managerial Entrenchment and Open-Market Share Repurchases: The Case of Taiwan Abstract This study examines the impact of minority shareholder protection on open-market share repurchases. When controlling owners commit low level of equity investment but retain tight control of their firms, the discrepancy between voting rights and cash flow rights induces an entrenchment problem and undermines the protection mechanism of minority shareholders. This study finds that the market reaction to share repurchase announcements is contingent on the extent of minority protection. The efficacy of signaling by repurchase announcements is weakened for firms with more severe entrenchment problems, suggesting that repurchase announcements are less informative when firms are subject to a higher extent of managerial entrenchment. Moreover, the results show that lower minority protection is negatively associated with the long-term operating performance following repurchase announcements. 2
1. Introduction This study extends the literature on corporate governance and open-market share repurchases to investigate how the extent of minority shareholder protection affects firms open-market share repurchases. In recent decades, a rich literature on the influence of firms ownership structure has outlined the combinations of decision power and residual claims of firms (e.g., Fama and Jensen, 1983; Fan and Wong, 2002; Jensen and Meckling, 1976; Morck, Shleifer, and Vishny, 1988; Shleifer and Vishny, 1997). La Porta, Lopez-De-Silanes, and Shleifer (1999) argue that discrepancy between the ultimate controlling shareholders cash flow rights and voting rights means that the equity of shareholders other than the controlling shareholder does not fully represent their interests. A larger discrepancy between ownership and control enhances the possibility that ultimate controlling owners may exercise de facto expropriation or self-dealing transactions because expropriated resources benefit controlling owners at the expense of minority shareholders. Whether ultimate owners pursue personal utility-maximizing interests (i.e., empire building) or divert the firm s cash flows for private gain, minority shareholders rights are undermined through this entrenchment problem. The entrenchment effect is driven higher by a greater deviation of control rights from cash flow rights of the controlling owner. As the entrenchment effect increases, the level of 3
protection of minority shareholders' rights decreases because their equity comes to represent less and less of their interests. Minority shareholders and stakeholders may take into account a firm s ownership characteristics when responding to corporate decision making. This study focuses on open-market share repurchases because when a firm repurchases its own shares, it not only distributes cash to shareholders but also redistributes the firm s ownership structure. That is, controlling shareholders can use a share repurchase to strengthen their power over minority shareholders. To determine the impact of minority shareholder protection on this process, I detail the role of managerial entrenchment on the information content of open-market share repurchase announcements and firms post-repurchases operating performance. Unlike prior governance literature that primarily focuses on the dispersed ownership of the United Kingdom and the United States (Bradley and Chen, 2010) or the state ownership of China (Zou, Wong, Shum, Xiong, and Yan, 2008), I focus on the concentrated ownership of Taiwan s market. I use Taiwanese firm data to conduct this study because the agency problem between controlling owners and minority shareholders is mainly induced by concentrated ownership. Furthermore, Taiwan is characterized by weaker minority shareholder protection and more individual investors. 1 Therefore, the consequence of the managerial entrenchment on 1 According to the report of the Securities and Futures Bureau in Taiwan, the transactions conducted by domestic individual investors were approximately three-fourths of the trading value in the Stock 4
open-market share repurchases should be more pronounced, providing a stronger test of my hypotheses. Because the control and ownership structure dictates the incentives of the controlling shareholders and the agency problem between controlling owners and minority shareholders, I use the divergence between voting rights and cash flow rights to measure the tendency toward managerial entrenchment. A larger discrepancy between control and ownership not only generates a more severe managerial entrenchment problem but also signals less minority shareholder protection to the capital market. I begin by investigating whether managerial entrenchment decreases the credibility of the undervaluation signal delivered by open-market share repurchase announcements. I find that a higher fraction of shares announced to be repurchased serves as a stronger positive signal for repurchasing firms. However, a large divergence between control rights and cash flow rights erodes the optimistic signaling effect of repurchase announcements. Specifically, the significance of the positive abnormal announcement returns for the two- and three-day windows disappeared. Only the five-day abnormal returns surrounding repurchase announcements remain significant, at a 10% level. In other words, the encouraging signaling effect of repurchase announcements is offset or weakened by the lack of minority shareholder Exchange Market during 2000 to 2008. 5
protection within the repurchasing firms. I also test how managerial entrenchment effect determines firms post-repurchase operating performance to validate the informativeness of repurchase announcements. The entrenchment problem may induce controlling shareholders to opportunistically deprive minority shareholders of their rights by diverting the firms cash flows to their personal benefit. Therefore, I conjecture that managerial entrenchment is negatively associated with post-repurchase operating performance. The result shows that a larger discrepancy between voting rights and cash flow rights leads to a lower return on assets (ROA) and a lower change in ROA. Despite the prevalence of the studies on corporate governance and share repurchases, little evidence points to the impact of managerial entrenchment on repurchase programs. This study fills the gap in the literature on corporate governance and share repurchases by stressing the importance of minority shareholders protection for open-market share repurchases. I find that the market reaction to share repurchase announcements is contingent on the ownership structure. The efficacy of signaling by repurchase announcements is weakened for firms with more severe entrenchment problems. Moreover, minority shareholder protection not only affects outside investors wealth but also concerns long-term operating performance for repurchasing firms. The empirical results suggest that the detrimental influence from the 6
entrenchment problem on the operations may not be visible immediately but erodes profitability in the long run. This study proceeds as follows. In Section 2, I develop hypotheses regarding the impact of managerial entrenchment on open-market share repurchases. In Section 3, I characterize the measures of managerial entrenchment and signaling effects. I also provide the data selection procedure in this section. In Section 4, I report the models used to test the hypotheses and the empirical results. I conclude this study in Section 5. 2. Hypothesis Development This study investigates how the extent of minority shareholder protection affects firms open-market share repurchases. I begin by examining whether the signaling effect of an open-market share repurchase announcement is abated for firms with managers who are more likely to engage in managerial entrenchment, that is, for firms with low investor protection. If shareholders with few cash flow rights can control a firm through pyramidal or cross-holding structures, the controlling shareholders have higher financial incentives to expropriate outsider investors because expropriated gains benefit the controlling owners at the expense of minority shareholders. These ultimate controlling owners may exercise de facto expropriation or self-dealing 7
transactions (Fan and Wong, 2002). Furthermore, the controlling owners have discretion to use firm assets to pursue empire-building strategies and can exercise greater power over their firms (Baumol, 1959; Jensen, 1986). Therefore, a larger discrepancy between ownership and control enhances the possibility of expropriation by controlling owners and is a sign of low minority protection. Consequently, controlling owners of firms with low minority protection are more likely to act in their own interests and convey less favorable information through repurchase announcements among outside investors. Therefore, I conjecture that the larger divergence between control rights and cash flow rights within these firms results in less information content of their repurchase announcements and lower signaling effects to the capital markets. I use the divergence between control rights and cash flow right to measure the tendency of managerial entrenchment. The first hypothesis is developed as follows: H1: Firms with more issues related to managerial entrenchment are less likely to experience the positive signaling effect of open-market share repurchases. Because firms are not required to buy back shares after announcing share repurchase programs, prior studies criticize open-market repurchase programs as weak signals due to their lacking commitment (e.g., Chan, Ikenberry, Lee, and Wang, 2010; Comment and Jarrell, 1991; Vermaelen, 1981). Fried (2005) also suggests that 8
open-market share repurchase announcements could be only an attempt by managers to boost stock prices. If firms with a greater divergence between control rights and cash flow rights are more likely to announce share repurchases to facilitate controlling shareholders private interests instead of signaling undervaluation, these firms may experience a detrimental long-term post-repurchase operating performance. 2 Therefore, I further conjecture that the association between the divergence between control rights and cash flow rights and post-repurchase operating performance is negative. The second hypothesis is developed as follows: H2: Firms with more issues related to managerial entrenchment are more likely to experience a decrease in post-repurchase operating performance. 3. Research Design and Data 3.1. Managerial Entrenchment Measure The control and ownership structure dictates the incentives of firms controlling shareholders and the firms agency problem. La Porta et al. (1999) propose the concept of divergence between the controlling shareholders cash flow rights and 2 For example, Fan and Wong (2002) examine the relation between earnings and returns and suggest that controlling owners report uninformative earnings for their self-interested purposes and that outside investors perceive the owners incentives. Ginglinger and L Her (2006) report that the power of controlling shareholders is intensified through share reacquisition. 9
voting rights, suggesting that the equity of shareholders does not fully represent their interests. By means of pyramids and cross-holdings, controlling shareholders can become entrenched at the helm and typically have considerable power over firms in excess of their cash flow rights. These shareholders have power to designate and monitor managers and can expropriate minority shareholders, which is the central agency problem for these firms (Shleifer and Vishny, 1997). One way to mitigate the agency problem between controlling shareholders and minority shareholders is to increase the portion of controlling shareholders ownership stake. The costs of diverting the firm s cash flows for controlling shareholders private benefit increase as their cash flow ownership rises. Thus, when the cash flow rights of the controlling shareholders increases, the controlling shareholders have more incentives to be aligned with minority shareholders interests. 3 Conversely, when a large separation exists between voting rights and cash flow rights, the agency problem become more severe between controlling owners and minority shareholders (La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 2002), and the protection mechanism of minority shareholders is undermined. Therefore, I use discrepancy between control rights and cash flow rights to measure the tendency of managerial entrenchment. The higher degree of the divergence between control and ownership is 3 For a detailed discussion of the incentive effect related to managerial ownership, see Jensen and Meckling (1976). 10
the proxy for the greater tendency of managerial entrenchment. 3.2. Ultimate Controlling Shareholders, Voting Rights and Cash Flow Rights I identify controlling shareholders as ultimate owners in firms. I follow the definition of ultimate owners proposed by La Porta et al. (1999). Ultimate owners are defined as shareholders who have effective control for a firm and possess direct and indirect voting rights in the firm exceed 5 percent. Direct voting rights are granted by the ownership stake held by shareholders. Indirect voting rights are contributed from the other shares held by entities that the ultimate shareholder controls through the control chain. If more than one shareholder conforms to the control criteria, the shareholder with the largest voting stake is identified as the ultimate shareholder. In family-controlled firms, I assume that each family is a group of members related via blood or marriage that owns and votes its shares collectively. Because owners can leverage their control through cross shareholding or pyramidal structures, a separation in control and ownership is created. The ultimate owners control power is measured by the voting rights over a firm. The voting rights possessed by the ultimate controlling shareholders are the entirety of direct and indirect voting rights for a firm. The cash flow rights possessed by the ultimate controlling shareholders are the cash flows entitled directly corresponding to their share investments plus the product of the percentage of ownership shares through the 11
chain of control. The entrenchment problem occurs when ultimate owners voting rights exceeds their cash flow rights. The problem becomes more severe as the deviation increases. 3.3. Open-Market Repurchase Announcement Returns I use cumulative abnormal returns (CAR) surrounding open-market share repurchase announcements to capture the signaling effect of repurchase announcements. I adopt CARs for the announcement windows of ( 2,+2), ( 1,+1), and (0,+1), where zero represents the announcement day to measure the market responses to the signal, that is, CAR( 2,+2), CAR( 1,+1), and CAR(0,+1). CARs are calculated as N b 1 CAR( a, b) ( AR i, t ), (1) N i 1 t a where CAR(a,b) is the average abnormal returns for the repurchase announcement window (a,b), and AR i, t is abnormal returns calculated by raw returns deducting expected returns. Similar to event studies literature, I use a market model to estimate CARs surrounding repurchase announcements. Following Brown and Warner (1985), I use the window spans from 161 to 61 days before each announcement to generate the system risk estimation. In contract to the traditional market model, which is under the assumption of homoskedasticity, I consider the heteroskedasticity of stock returns 12
and use the generalized autoregressive conditional heteroskedasticity (GARCH) model to estimate expected returns. 4 In my GARCH(1,1) model, the variance of the residual term of the ordinary least squares regression is assumed to be an autoregressive moving average model. 3.4. Data To examine the impact of the managerial entrenchment on open-market share repurchases, I construct a sample of open-market share repurchase with sufficient accounting data for Taiwanese publicly listed firms. I retrieve my data from the Taiwan Economic Journal database from August 2000 through 2009. 5 My sample contains 2,747 firm-years with repurchased shares in the Taiwanese Stock Exchange. To examine post-repurchase operating performance specific to Hypothesis 2, I exclude 327, 689 and 89 firm-year observations with insufficient accounting data for the 4, 8, and 12 quarters subsequent to the repurchase announcements, which yields 2,420, 1,731 and 1,642 firm-year observations over the sample period, respectively. Following prior studies (e.g., Babenko, 2009; Chan et al., 2010), the t-statistics and p-values are based on Huber White standard errors and, because a sample firm may make more than one repurchase announcement within a year, are statistically adjusted for nonindependence of observations within a year. 4 For the details, see Bollerslev (1986). 5 Share repurchase programs were first implemented in Taiwan in August 2000. 13
4. Empirical Analysis 4.1 Summary Statistics Panel A of Table 1 reports the summary statistics of 2,747 firm-year observations of open-market share repurchases, including the announced repurchase percentage (ARP), the buyback percentages (BP), and firms characteristics variables. The largest (smallest) ARP is approximately 39.74% (<0.01%). The mean (median) value of the ARP shares is 2.93% (2.51%) of total outstanding shares. The mean (median) value of BP is approximately 1.92% (1.58%) of total outstanding shares. In other words, repurchasing firms, on average, reduce roughly 2% of their liquidity after buying back their own equity in the capital market. The minimum (maximum) of COMPL is zero (100%), showing that some firms do not buy back any shares and some firms fully execute their repurchase programs. The mean (median) value of COMPL is 70.91% (85.83%). The divergence between control rights and cash flow rights (CV) ranges from zero to 56.61%. A value of zero suggests that some listed firms do not have cross holdings or a pyramidal structure. The mean (median) of CV is 5.17% (1.92%). A higher mean value relative to the median suggests that some firms have an extremely large divergence between their ownership and control. CD, 14
which is a CEO duality dummy that equals 1 if the CEO is the chairperson of the board, and zero otherwise, is an indicator variable of high CV (i.e., the top quintile of the divergence between control rights and cash flow rights); its mean value is 31.31%. Table 1 shows that the institutional ownership (IO) and management ownership (MO) account for roughly one-third (mean = 34.09%, median = 31.87%) and one-fifth (mean = 21.74%, median = 19.31%) of firm ownership, respectively. The mean (median) value of leverage ratio (LEV) is 38.33% (37.74%), and the mean (median) of the cash holding (CH) is 9.79% (5.71%). A higher mean value of CH relative to the median value suggests that some firms hold an extremely large amount of cash and cash equivalents to their total assets. Two-thirds of the sample firms are traded in the Taiwan Stock Exchange (TSE), and one-third are traded in over-the-counter transactions. Size (SIZE) is measured by the natural logarithm of the total assets and ranges from 12.69 to 21.90. The mean (median) value of SIZE is 15.58 (15.35). The mean (median) value of cash dividends to the market value (DIV) is 3.15% (2.45%). [TABLE 1 ABOUT HERE] Taiwanese firms are required to set up the range of the buyback price prior to executing the repurchase to prevent stock price manipulation. Specifically, firms must 15
provide information about the highest (price ceiling) and the lowest (price floor) repurchase prices and then terminate their buyback transactions when the buyback price falls outside the range. In my sample, 3.42% of the actual buyback transactions are terminated by reaching a buyback price ceiling (PCD), and 1.06% by reaching a price floor (PFD). Panel B of Table 1 shows the market responses surrounding share repurchase announcements. The mean (t-statistics) CAR over the window of ( 2,+2), ( 1,+1), and (0,+1) is 1.26% (8.40), 1.12% (9.61), and 1.70% (18.91), respectively. The significantly positive repurchase announcement returns echo prior studies (e.g., Ikenberry, Lakonishok, and Vermaelen, 1995; Vermaelen, 1981), suggesting that share repurchase announcements are regarded as a positive signal to the capital market. Table 1, Panel C, shows the long-term post-repurchase operating performance, measured by ROA. The mean (median) value of ROA over the four quarters subsequent to repurchase announcements, denoted as ROA4, is 5.49% (5.38%), and the mean (median) value of ROA over the eight quarters subsequent to repurchase announcements, denoted as ROA8, is 11.49% (11.12%). The significantly positive ROA4 and ROA8 suggest that repurchasing firms generally enjoy a positive operating performance for the four and the eight quarters following repurchase announcements. 16
Table 2 reports the Pearson and Spearman correlation coefficients for the control variables. The relation between CV and ARP is negative, suggesting that repurchasing firms with greater divergence between control and ownership announce a smaller percentage of buyback shares. Not surprisingly, a smaller portion of announced buyback shares leads to a smaller portion of buyback shares to outstanding shares. Therefore, the relation between CV and BP is also negative. Notably, the positive relation between CV and COMPL suggests that these firms have a higher completion rate of their repurchase programs. [TABLE 2 ABOUT HERE] 4.2. Managerial Entrenchment and the Signaling Effect of Open-Market Share Repurchase Announcements I study whether managerial entrenchment affects the information content of open-market share repurchase announcements. I use the divergence between control rights and cash flow rights to measure the extent of managerial entrenchment. A greater divergence between control and ownership is a proxy for the higher possibility of managerial entrenchment. I conjecture that repurchasing firms with managerial entrenchment are less likely to announce share repurchases to signal undervaluation and are more likely to motivated by the self-interests of the controlling shareholder to 17
improve EPS or solidify power. As a result, the information content within these repurchase announcements diminishes. I use the following model: CAR i,t = β 0 + β 1 ARP i,t-1 + β 2 CV i,t-1 + β 3 ARP i,t-1 *CV i,t-1 + β 4 IO i,t + β 5 MO i,t-1 + β 6 LEV i,t-1 +β 7 CH i,t-1 +β 8 TSE i,t-1 +β 9 SIZE i,t-1 +β 10 DIV i,t-1 +ε i,t, (2) where CAR is the CARs for repurchase announcement windows of ( 2,+2), ( 1,+1), and (0,+1), where zero represents the announcement day; ARP is calculated by the ratio of announced buyback shares to outstanding shares; CV is the difference between control rights and cash flow rights owned by the largest ultimate shareholders of the firm at the beginning of the announcement quarter; ARP*CV is the interaction between ARP and CV; IO (MO) is the percentage of shares held by institutional investors (managers) at the beginning of the announcement quarter; LEV is calculated by the ratio of total debts to total assets at the beginning of repurchase announcement quarter; CH is calculated by the ratio of cash and cash equivalents to total assets at the beginning of repurchase announcement quarter; TSE is a dummy variable that equals 1 if the sample firm stock is traded in the Taiwan Stock Exchange, and zero otherwise (i.e., traded as an over-the-counter stock); SIZE is measured as the natural logarithm of total assets at the beginning of repurchase announcement quarter; and DIV is calculated by the ratio of cash dividends to the market value at the beginning of repurchase announcement quarter. 18
Table 3 reports the impact of managerial entrenchment on the signaling effect by open-market share repurchase announcements. The coefficients of ARP on CAR(0,+1), CAR( 1,+1), and CAR( 2,+2) are 0.2742, 0.2815, and 0.4675, respectively. The significantly positive association between the portions of announced buyback shares and the CARs surrounding repurchase announcements suggests that the larger announced buyback portion serve as a stronger positive signal to the capital market. My result echoes the finding of Comment and Jarrell (1991). However, the negative association between the announcement returns and CV suggests that a higher divergence between control rights and cash flow rights offset the positive signaling effect of repurchase announcements; this finding supports my first hypothesis. Moreover, the positive signaling effect of ARP disappears for CAR( 1,+1) and CAR(0,+1) when CV is taken into account; that is, the coefficients of ARP*CV for CAR( 1,+1) and CAR(0,+1) are insignificantly positive. Only the coefficient of the interaction for CAR( 2,+2) is significantly positive, but the significance level decreases from 1% to 10%. [TABLE 3 ABOUT HERE] For the controls, I observe that, generally, higher management ownership increases the information content of the repurchase announcement. The negative associations between LEV and CARs, ranging from 0.0326 to 0.0148, show that the 19
lower leverage ratio brings greater positive market responses to their repurchase announcements. Moreover, the significantly negative coefficients of CH range from 4.0062 to 1.8727, suggesting that lower cash holdings increase the repurchase announcement returns. This finding supports the conventional wisdom that lower cash holdings result in a less severe agency problem and, therefore, enhance the degree of information content of share repurchase announcements. 4.3. Managerial Entrenchment and the Post-Repurchase Operating Performance Because repurchasing firms with greater divergence between control rights and cash flow rights are more likely to exercise de facto expropriation or self-dealing transactions at the expense of minority shareholders, the higher tendency of managerial entrenchment may result in poorer post-repurchase operating performance. I therefore conjecture that long-term post-repurchase operating performance is negatively related to the severity of managerial entrenchment and predict that the divergence between control and ownership is negatively associated with the long-term operating performance following repurchase announcements. I use ROA to measure operating performance. The model for multivariate analysis is ROA4 i,t or ROA8 i,t =β 0 +β 1 CV i,t-1 +β 2 BP i,t-1 +β 3 ARP i,t-1 +β 4 ARP i,t *CV i,t-1 + β 5 IO i,t-1 + β 6 MO i,t-1 + β 7 LEV i,t-1 + β 8 CH i,t-1 + β 9 TSE i,t-1 + 20
β 10 SIZE i,t-1 +β 11 DIV i,t-1 +ε i,t, (5) where ROA4, ROA8, and ROA12 are the ROA over the 4, 8, and 12 quarters, respectively, following the repurchase announcement quarter. Table 4 shows the results of post-repurchase operating performance measured by ROA. The results of CV in Table 4 are accordance with my prediction that CV is negatively associated with the long-term operating performance over the 4, 8 and 12 quarters subsequent to repurchase announcements. However, the influence of CV is not significant on ROA4 but is significant on ROA8 and ROA12, suggesting that the negative effect from managerial entrenchment does not affect the firm s ROA until the second year. [TABLE 4 ABOUT HERE] Table 5 shows the results of post-repurchase operating performance measured by change in ROA. The change in ROA from announcement quarter (quarter 0) to quarter +4 is 0.1438, which is statistically significant at the 1% level. The change in ROA from quarter 0 to quarter +8 is 0.1981, which is statistically significant at the 10% level. Although the influence of CV on long-run operating performance fades out gradually, the significant results still indicate a less improvement in post-repurchase operating performance for firms with less minority protection. The positive coefficient 21
of IO shows that institutional investors may perform the monitorial function that results in a better operating outcome. I also find that dividend-paying firms with a smaller leverage ratio and greater cash holdings have better long-term operating performance following repurchases. [TABLE 5 ABOUT HERE] 5. Conclusion This study examines the impact of minority shareholder protection on open-market share repurchases. Shleifer and Vishny (1997) stress the consequence of the agency problem between controlling owners and minority shareholders. When controlling owners commit low level of equity investment but retain tight control of the firm, a discrepancy emerges between voting rights and cash flow rights. As the discrepancy increases, the agency problem between controlling owners and minority shareholders also increases (La Porta et al. 2002), which effectively undermines the protection mechanism of minority shareholders. Therefore, I use the deviation between control rights and cash flow rights to measure the tendency of managerial entrenchment. The higher degree of the divergence between control and ownership is proxy for the more severe entrenchment problem and thus the lower minority protection. 22
I find that the market reaction to share repurchase announcements is contingent on the extent of minority protection. The efficacy of signaling by repurchase announcements is weakened for firms with more severe entrenchment problems, suggesting that repurchase announcements are less informative when firms are subject to a higher degree of managerial entrenchment. Moreover, this study characterizes the consequence of long-term operating performance by considering of the entrenchment effect. The result shows that lower minority protection is negatively associated with the long-term operating performance following repurchase announcements. The finding provides evidence that the extent of minority shareholder protection should be taken into account when examining post-repurchase operating performance. 23