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PIDE Working Papers 2010: 57 Corporate Governance in Pakistan: Corporate Valuation, Ownership and Financing Attiya Y. Javid Pakistan Institute of Development Economics, Islamabad and Robina Iqbal Freelance Researcher PAKISTAN INSTITUTE OF DEVELOPMENT ECONOMICS ISLAMABAD All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means—electronic, mechanical, photocopying, recording or otherwise—without prior permission of the Publications Division, Pakistan Institute of Development Economics, P. O. Box 1091, Islamabad 44000. Pakistan Institute of Development Economics, 2010. Pakistan Institute of Development Economics Islamabad, Pakistan E-mail: [email protected] org. pk Website: http://www. pide. org. pk Fax: +92-51-9248065 Designed, composed, and finished at the Publications Division, PIDE. CONTENTS Pages Abstract Chapter

1. Introduction 1. 1 Background 1. 2 Objectives of the Study 1. 3 Organisation of the Study Chapter 2. Overview of Corporate Governance in Pakistan 2. 1 Introduction 2. 2 Institutional Framework 2. 3 Code of the Corporate Governance 2. 4 Assessment of Corporate Governance 2. 5 Corporate Governance under Concentrated Ownership 2. Corporate Governance in South Asia 2. 7 Summary and Conclusion Chapter 3. Determinants of Corporate Governance 3. 1 Introduction 3. 2 Review of Previous Literature 3. 3 Corporate Governance Index 3. 4 Determinants of Corporate Governance 3. 5 Estimation Technique 3. 6 Empirical Findings 3. 7 Summary and Conclusion Chapter 4. Corporate Governance and Corporate Valuation 4. 1 Introduction 4. 2 Review of Previous Empirical Literature 4. 3 Data and Methodological Framework 4. 4 Empirical Findings 4. 5 Summary and Conclusion vii 1 1 3 4 4 4 5 9 10 12 13 16 16 16 17 18 20 21 22 24 25 25 26 29 31 36

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Pages Chapter 5. Corporate Governance and Corporate Ownership 5. 1 Introduction 5. 2 Review of Previous Literature 5. 3 Data and Methodological Framework 5. 4 Empirical Findings 5. 5 Summary and Conclusion Chapter 6. Corporate Governance and External Financing 6. 1 Introduction 6. 2 Review of Previous Literature 6. 3 Data and Methodological Framework 6. 4 Empirical Evidence 6. 5 Summary and Conclusion Chapter 7. Conclusion Appendi ces References List of Tables Table 2. 1 Table 2. 2 Table 2. 3 Table 2. 4 Table 2. 5 Table 2. 6 Table 2. 7 Table 2. 8 Table 2. 9 Table 3. 1 Table 3. 2 Table 4. Year Wise Distribution of Companies Provincial Wise Distribution of Companies Capitalisation Break Down for the Year 2007 KSE Performance at Glance Ownership Concentration of 50 Random Companies for Pakistan for 2003-2007 Inventors Composition in Listed Private Companies Ownership Composition of Pakistan’s Top 40 Listed Companies Basic Statistics of Corporate Sector of India Types of Financial Institutions in Bangladesh Summary Statistics of Corporate Governance Index Evidence on Determinants of Corporate Governance Evidence on Corporate Governance and Firm Performance (Tobin Q) 8 8 9 9 12 13 13 15 15 15 22 23 33 60 62 64 64 69 72 37 37 39 45 48 55 55 55 Table 2. 10 Dhaka Stock Exchange Select Statistics Pages Table 4. 2 Table 4. 3 Table 5. 1 Table 5. 2. 1 Table 5. 2. 2 Table 5. 3. 1 Table 5. 3. 2 Table 5. 3. 3 Table 5. 4 Table 6. 1 Table 6. Evidence on Corporate Governance and Firm Performance (ROA) Evidence on Corporate Governance and Firm Performance (D/P) Determinants of Concentration of Ownership by Top Five Shareholders Relation between Tobin Q and Ownership by Top Five Shareholders Relation between ROA and Ownership by Top Five Shareholders Evidence on Performance and Ownership Identity Evidence on Performance and Ownership Identity Evidence on Performance and Ownership Identity Evidence on Performance and Manager-Ownership Determinants of External Financing through Equity Evidence on Firm Performance and Need of External Finance 33 34 49 51 51 53 53 54 55 62 63 69 70 71 Table A1 Corporate Governance Index (CGI) Components Table A2 Description of Variables Table A3 List of Companies ABSTRACT In this study the relationship between corporate governance and corporate valuation, ownership structure and need of external financing for the Karachi Stock Market is examined for the period 2003 to 2008.

To measure the firmlevel governance a rating system is used to evaluate the stringency of a set of governance practices and cover various governance categories: such as board composition, ownership and shareholdings and transparency, disclosure and auditing. The sample consists of 60 non-financial firms listed on Karachi Stock Exchange and comprises more than 80 percent of market capitalization at Karachi Stock Market in 2007. The results confirms the theoretical notion that firms with better investment opportunities and larger in size adopt better corporate governance practice. The proposition that ownership concentration is a response to poor legal protection is also validated by the results. The more investment opportunities lead to more concentration of ownership and the ownership concentration is significantly diluted as the firm size expands.

The findings are consistent with theoretical argument claiming that family owners, foreign owners and bring better governance and monitoring practices which is consistent with agency theory. The results suggest that firms which need more equity financing practice good governance. The results show that firms with high growth and large in size are in more need of external finance. The relationship between external financing and ownership concentration is negative. The results reveal that the firms which practice good governance, with concentrated ownership, need more external finance which have more profitable investment opportunities and are larger in size are valued higher.

The interaction term of any variable with law enforcement term are not significant in any model suggesting that firm performance is not affected by rule of law in countries where legal environment is weak. These results adds an important link to the explanation of the consequences weak legal environment for external financing, corporate valuation and corporate governance. The results show that Corporate Governance Code 2002 potentially improves the governance and decision making process of firms listed at KSE. JEL classification: G3 F3 Keywords: Ownership Concentration, Corporate Governance, Firm Performance, External Financing, Panel Data Chapter 1: INTRODUCTION* 1. 1.

Background Good corporate governance contributes to sustainable economic development by enhancing the performance of companies and increasing their access to outside capital. In emerging markets good corporate governance serves a number of public policy objectives. It reduces vulnerability of the financial crises, reinforcement property rights; reduces transaction cost and cost of capital and leads to capital market development. Corporate governance concerns the relationship among the management, board of directors, controlling shareholders, minority shareholders and other stakeholders. In Pakistan, the publication of the SECP Corporate Governance Code 2002 for publicly listed companies has made it an important area of research of corporate sector.

A corporate governance system is comprised of a wide range of practices and institutions, from accounting standards and laws concerning financial disclosure, to executive compensation, to size and composition of corporate boards. A corporate governance system defines who owns the firm, and dictates the rules by which economic returns are distributed among shareholders, employees, managers, and other stakeholders. As such, a county’s corporate governance regime has deep implications for firm organisation, employment systems, trading relationships, and capital markets. Thus, changes in Pakistani system of corporate governance are likely to have important consequences for the structure and conduct of country business.

In its broadest sense, corporate governance refers to a complementary set of legal, economic, and social institutions that protect the interests of a corporation’s owners. In the Anglo-American system of corporate governance these owners are shareholders. The concept of corporate governance presumes a fundamental tension between shareholders and corporate managers [Berle and Means (1932) and Jensen and Meckling (1976)]. While the objective of a corporation’s shareholders is a return on their investment, managers are likely to have other goals, such as the power and prestige of running a large and powerful organisation, or entertainment and other perquisites of their position. In this situation, managers’ superior access to inside information and the relatively

Acknowledgements: The authors are Professor of Economics, Pakistan Institute of Development Economics, Islamabad and freelance researcher respectively. The authors wish to thank Dr Rashid Amjad, Dr Tariq Javed and Dr Idrees Khawaja for their valuable comments. They are grateful to Hafeez Ahmed and Shahab-u-Din for providing assistance in compiling data and Yasir Iqbal for computer assistance. Any remaining errors and omissions are the authors’ sole responsibility. 2 powerless position of the numerous and dispersed shareholders, mean that managers are likely to have the upper hand. The researchers have offered a number of solutions for this agency problem between shareholders and managers which fall under the categories of incentive alignment, monitoring, and discipline.

Incentives of managers and shareholders can be aligned through practices such as stock options or other market-based compensation [Fama and Jensen (1983a)]. Monitoring by an independent and engaged board of directors assures that managers behave in the best interests of the shareholders [Fama and Jensen (1983)]. Chief Executive Officer (CEO)’s who fail to maximise shareholder interests can be removed by concerned boards of directors, and a firm that neglects shareholder value is disciplined by the market through hostile takeover1 [Jensen and Ruback (1983)]. The code of corporate governance introduced by SECP in early 2002 is the major step in corporate governance reforms in Pakistan.

The code includes many recommendations in line with international good practice. The major areas of enforcement include reforms of board of directors in order to make it accountable to all shareholders and better disclosure including improved internal and external audits for listed companies. However, the code’s limited provisions on director’s independence remain voluntary and provide no guidance on internal controls, risk management and board compensation policies. The main focus of this study is to examine the relationship between corporate governance and corporate performance, corporate ownership, corporate financing for publicly listed Karachi Stock Exchange (KSE) firms.

Therefore, we attempt to identify the relationship between corporate governance proxies and firm value in our sample of KSE firms. This emphasises the importance of legal rules and the quality of their enforcement. In Pakistan, with traditionally low dispersion of ownership, the primary methods to solve agency problems are the legal protection of minority investors, the use of boards as monitors of senior management, and an active market for corporate control. In contrast to developed markets in Pakistan corporate governance is characterised by lesser reliance on capital markets and outside investors, but stronger reliance on large inside investors and financial institutions to achieve efficiency in the corporate sector.

In this case, outside (smaller) investors face the risk of expropriation in the form of wealth transfers to larger shareholders. According to Shliefer and Vishny (1997) corporate governance mechanisms are economic and legal institutions that can be altered through the political process. As regards governance reform, product market competition would force firms to minimise costs, and as part of this cost minimisation to adopt rules, including corporate governance mechanisms, enabling them to raise external capital at the lowest cost in the long run. On this evolutionary theory of A takeover which goes against the wishes of the target company’s management and board of directors. 1 economic change [Alchian (1950); Stigler (1958)], competition would take care of corporate governance. Corporate governance in agency theory perspective is referred to as separation of ownership and control [Barle and Means (1932)]. There are two most common approaches to corporate governance to protect investors’ rights. First approach is to give investors power through legal protection from expropriation by managers. Protection of minority rights and legal prohibitions against managerial self-dealing are examples of such mechanisms. The second major approach is ownership by large investors (concentrated ownership): matching significant cash flow rand control rights.

Most corporate governance mechanisms used in the world-including large share holdings, relationship banking, and even takeovers- can be viewed as examples of large investors exercising their power. We discuss how large investors reduce agency costs. While large investors still rely on the legal system, they do not need as many rights as the small investors do to protect their interests. For this reason, corporate governance is typically exercised by large investors. Despite its common use, concentrated ownership has its costs as well, which can be best described as potential expropriation by large investors of other small investors and stakeholders in the firm [Shliefer and Vishny (1997)]. 1. 2.

Objective of the Study The main focus of the study is to investigate does corporate governance matters in Pakistan equity market? What are its implications for corporate valuation, corporate, ownership and corporate financing? The first dimension of this issue is measuring the corporate governance in Pakistan. Corporate governance is interpreted as mechanism–both institutional and market based, that induces the self-interested managers (controllers of the firm) to make decisions that maximise the value of the firm to its shareholders (owners of the firm) [OECD (1999)]. The aim of these mechanisms is to reduce agency costs that arise from principle agent problem; and they could be internal and/or external in nature [Klapper and Love (2002)].

Internal mechanism deals with the composition of the board of directors, such as proportion of independent outside directors, distinction of CEO and chairperson etc. another important mechanism is ownership structure, or the degree at which the ownership by managers obvious trade-off between alignment and entrenchment effects. External mechanism on the other hand rely on takeover market in addition to regulatory system, where as the take over market act as a treat to existing controllers in that it enable outsiders to seek control of the firm if bad corporate governance results in significant gap between potential and actual value of the firm.

So given these mechanisms, it is investigated that the legal system is the only way to ensure good corporate governance. It is also examined that effective presence of these mechanisms positively associated with firm value. 4 The second dimension of this issue is to investigate the determinants of concentrated form of ownership structure in Pakistan and its affect on firm performance. The reason is that when the legal framework does not offer sufficient protection for the outside investors, entrepreneurs and original owners are forced to maintain large position in their companies which results in concentrated form of ownership [La Porta, Shleifer, and Vishny (1999)].

The third dimension of this study is to assess the determinants of firms to raise external finance through equity and to examine that the firms that rely more on external financing sources are performing better. 1. 3. Organisation of the Study Rest of the study is organised as follows. Chapter 2 provides overview of corporate governance in Pakistan and it also discuses the data used in the subsequent chapters. Chapter 3 measures the corporate governance by using 22 factors which constructs aggregate corporate governance index, and this index is divided in to three sub-indices. This chapter also discusses the determinants of corporate governance in Pakistan.

In Chapter 5, the determinants of ownership structure are explored. The effect of ownership structure with firm performance is also investigated. The identity of owners is then related to firm value. In the Chapter 6 examines the factors that influence the need of external finance in Pakistan and its effect on firm value. Chapter 7 concludes the study. Chapter 2: OVERVIEW OF CORPORATE GOVERNANCE IN PAKISTAN 2. 1. Introduction Corporate governance matters for the financial development by increasing the flow of capital to the capital market. East Asian financial crisis attract serious attention to importance of corporate governance in developing countries.

The OECD has established a set of corporate governance principles in 1999 that have become the core template for assessing a country’s corporate governance arrangements. La Porta, et al. (2000) Defined, “Corporate governance is, to a certain extent, a set of mechanisms through which outside investors protect themselves against expropriation by the insiders. ” They define “the insiders” as both managers and controlling shareholders. “Corporate governance comprises the private and public institutions (both formal and informal) which together govern the relationship between those who manage corporations and those who invest resources in corporations.

These institutions typically include a country’s corporate laws, securities regulations, stock-market listing requirements, accepted business practices and prevailing business ethics” [Omran (2004)]. Thus, changes in Pakistani system of corporate 5 governance are likely to have important consequences for the structure and conduct of country business. The issue of Corporate Governance of banks has also fundamental importance for emerging Economies. SBP restructured the regulatory framework governing the commercial banking industry and issued some guidelines for corporate governance. The study of Kalid and Hanif (2005) provides an overview of development in the banking sector and measures of corporate governance in Pakistan. Their study observes that SBP rganised its role as a regulator and supervisor and make the central bank relatively more effectively in recent years. Moreover, the legal and regulatory structure governing the role and functions of commercial banks has been restructured. However, as the process of corporate governance of banks in Pakistan is very recent, not enough information is available to make an assessment of the impact of these policies such as an evaluation of the improvement in bank efficiency or reduction in bank defaults. Securities and Exchange Commission of Pakistan issued Code of Corporate Governance in March 2002 in order to strengthen the regulatory mechanism and its enforcement.

The code of corporate governance is the major step in corporate governance reforms in Pakistan. The code includes many recommendations in line with international good practice. The major areas of enforcement include reforms of board of directors in order to make it accountable to all shareholders and better disclosure including improved internal and external audits for listed companies. However, the code’s limited provisions on director’s independence remain voluntary and provide no guidance on internal controls, risk management and board compensation policies. The plan of the chapter is as follows. The institutional framework is presented in Section 2. Section 3 briefly reviews the code of corporate governance of Pakistan.

The assessment of the code of corporate governance is provided in Section 4. Section 5 explores corporate governance under ownership structure of Pakistan. Section 6 concludes our discussion. 2. 2. Institutional Framework East Asian financial crisis and corporate failure like Enron have brought to light the importance of an effective institutional framework. In order to the improve value of the corporate governance for finance development of a country attention must be given to strengthen the institutional framework. That strong institutional framework would help in effective corporate management and for developing advanced capital markets that increases shareholder value and enhance corporate governance.

The establishment of the Security and Exchange Commission of Pakistan represents an important milestone in the development of the regulatory framework of the capital market in Pakistan. The S ecurities and Exchange 6 Commission of Pakistan (The Commission) was established in pursuance of the Securities and Exchanges Commission of Pakistan Act, 1997 and became operational on 1st January, 1999. It succeeds the Corporate Law Authority (CLA), which was a Government department attached to the Ministry of finance. It was initially concerned with the regulation of corporate sector and capital market. In accordance with the approved Corporate Plan, the Commission has been organised into the following six Divisions: • • • • • • Company Law Division. Securities Market Division. Specialised Companies Division.

Finance and Admin Division. Human Resource and Training Division. Insurance Division. Each of division is divided into Departments and Wings for effective administration. The Departments are headed by Executive Directors, with oversight by commissioners. 2 The continuing challenges of the Commission include: based on the regulatory principles develop a modern and efficient corporate sector and capital market; based on international legal standards. In order to foster principles of good governance in the corporate sector and protect investors through responsive policy measure and enforcement practice develop an efficient and dynamic regulatory body.

The SECP is governed by the Securities and Exchange Commission of Pakistan Act, 1997 which encompasses the constitution of the Commission appointment and terms and conditions of the Chairman and Commissioners, functions and powers of the Commission and financial arrangements. The Securities and Exchange Commission of Pakistan is administering many laws. These includes: insurance Ordinance, 2000 (previously as Insurance Act, 1938; The Securities and Exchange Commission of Pakistan Act,1997; The company ordinance, 1984 (amended and implemented in 2002); The Modaraba Companies and Modaraba (Floatation and Control) Ordinance, 1980; The Securities and Exchange Ordinance, 1969.

The Policy Board is established by the Securities and Exchange Commission of Pakistan Act, 1997 in order to provide guidance to the Commission in all matters relating to the functions of the Commission and formulation of the policies. The Policy Board consists of maximum nine members appointed by the Federal Government. Out of nine members five members would be as ex-officio members and five members would be from private sector. See official website of securities and Exchange Commission of Pakistan for detail; www. secp. org. pk. 2 7 A number of significant amendments in corporate laws were made with the objective of updating these laws to keep pace with developments in the corporate sector.

These include: amendm ents in Securities and Exchange Ordinance, 1969; Modaraba Companies and Modaraba (floatation and control) Ordinance, 1980; Companies Ordinance, 1984; the securities and exchange commission of Pakistan Act, 1997. Amendments in company ordinance, 1984, suggested by the SECP have been approved by the cabinet in 2002. The amendments mainly relates to incorporation of single member company. Because of this amendment an individual trader or manufacturer would be able to establish a company having its own separate entity and thus enjoying the privilege of limited liability. This new concept will help for expansion of a discipline corporate sector. The companies have been provided the period of four months in order to present audited account before shareholders.

The private companies which convert into public companies after one year of their incorporation have been exempted to hold their statutory meetings. The new amendments make it compulsory that copies of minutes of meetings will be provided to every director within 14 days of the date of such meetings. Appointment of a whole time qualified company secretary by a listed company has been made mandatory for efficient corporate compliance. Through these new amendments a company may remove its auditors through special resolution mean by the majority of 75 percent. However, appointment of new auditors in place of removed auditors will be made with the approval of the Commission.

Quorum of a general meeting of a public listed company has been increased from three members to ten members present in person representing not less than 25 percent of total voting power. Stock markets are important as a source of investment finance for corporations in developing countries. At present, three stock exchanges are functioning in Pakistan, namely Karachi Stock Exchange (KSE), Lahore Stock Exchange (LSE) and Islamabad Stock Exchange (ISE). Trading on all the three stock exchanges is fully automated (for performance see Table 2. 4). The three stock exchanges are also linked to the Central Depository System (CDS). Since the last decade, the capital markets of Pakistan have witnessed a substantial growth leading to a manifold increase in the trading volume.

The custody and safe keeping of physical certificates required maintenance of huge vaults by the individuals and institutions and the physical settlement of certificates was no longer feasible. Moreover, the manual system was also plagued by lengthy delays, risks of damage, forgeries and considerable time and capital investment. Central Depository Company of Pakistan Limited (CDC) was incorporated in 1993 and subsequently became operational in 1997 to manage and operate the Central Depository System (CDS). CDS is an electronic book entry system to record and transfer securities. Electronic book entry means that the securities do not physically change hands and the transfer from one client account to another takes place electronically. CDC provides the backbone for smooth and efficient settlement operations of the Pakistani capital market. Almost all of the total settlement of the stock exchanges is now done through the CDS. 3 To encourage corporate governance the institute of corporate governance of Pakistan a non-profit organisation is established under Section 42 of company ordinance, 1984. It is public private partnership. Securities and Exchange Commission of Pakistan, State Bank of Pakistan, three stock exchanges and banking and insurance institutions are founding members of this institution. In 2006 PICG in collaboration with IFC and State Bank of Pakistan conducted a conference of banking reforms in Pakistan.

The conference aspired to create increased understanding of the need for good governance among Pakistan’s banking sector. Charged Table 2. 1 Year Wise Distribution of Companies Financial Year 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 Incorporated Companies 968 1074 1169 1183 1553 2207 3078 6186 4703 No. of Equity Issue to Public (Rs bill) 0. 44 0. 00 2. 03 1. 99 5. 97 0. 98 48. 88 24. 34 9. 60 Source: Annual Report of SECP 2006-07. Table 2. 2 Provincial Wise Distribution of Companies 2005 2006 Province / Territory (% Share) (% Share) Punjab Sindh NWFP Baluchistan Islamabad Territory 43 39 11 1 6 39 29 9 4 19 2007 (% Share) 46 34 6 1 13

Source: Annual Report of SECP 2005, 2006, 2007. 3 See official website of CDC www. CDCPakistan. com. 9 Table 2. 3 Capitalisation Break Down for the Year 2007 Listed Com Paid Up Capital (Rs) Up to 10,000 1 100,000 to 500,000 1 500,001to1,000,000 0 1,000,001 to 10,000,000 34 10,000,000 to 100,000,000 226 1000,000,001 to 500,000,000 236 500,000,001 to 1,000,000,000 45 1,000,000,001 and above 69 Source: Annual Report of SECP 2007. Unlisted Private Public Com Com 448 20,607 343 7,037 105 4,566 343 10,804 662 3,168 224 319 32 29 36 18 SMCs 373 100 59 48 28 2 0 0 Total 24,429 7,481 4,730 11,229 4,084 799 106 123 Percentage 42. 87 14. 97 9. 46 22. 47 8. 17 1. 60 0. 21 0. 25 Table 2. KSE Performance at Glance 2004 KSE 100 Index 5,279. 18 Market Capitalisation (Rs bill) 1,421. 58 Turnover (Shares Mill) 389 Source: Annual Report of SECP 2004,2005,2006,2007. 2005 7,450. 12 2,068. 19 343 2006 9,981. 40 2,801. 28 321. 10 2007 13,772. 26 4,019. 46 367. 96 2. 3. Code of the Corporate Governance Many new financial instruments are introduced by the SECP in order to enhance corporate governance. The code of corporate governance was issued in March 2002 by the Security and Exchange Commission of Pakistan in order to improve transparency, governance and protect the interest of the investors by improving the disclosure in financial reporting of companies.

The Code of Corporate Governance is the results of the joint effort of Securities and Exchange Commission of Pakistan and Chartered of Pakistan in collaboration with Institute of Cost and Management Accountants of Pakistan (ICMAP) and three Stock Exchanges. The code includes many recommendations in line with international good practice. All listed companies publish and circulate a statement along with their annual reports to set out the status of their compliance with the best practices of corporate governance. The Code primarily aims to establish a system whereby a company is directed and controlled by its directors in compliance with the best practice so as to safeguard the interest of diversified stakeholders.

It proposes to restructure the composition of the board of directors in order to introduce broad based representation by minority shareholders and by executive and nonexecutive directors. 4 ’5 The Code emphasised openness and transparency in 4 All listed companies shall encourage effective representation of independent non-executive directors, including those representing minority interest, on their Boards of Directors so that the Board as a group include core competencies considered relevant in the context of each listed company (Clause (i) of Code of Corporate governance, 2002). 5 Implementation of the clause of non-executive directors is voluntary not mandatory. 0 corporate affairs and the decision making process and requires directors to discharge their fiduciary responsibilities in the larger interest of all stakeholders in a transparent, informed, diligent, and timely manner. The salient feature of the Code includes setting up of audit committees and internal audit functions by all listed companies [Code of Corporate Governance (2002)]. In August 2002 SECP launch a project on corporate governance in collaboration with UNDP and Economic Affairs Division of Government of Pakistan. This project is launched mainly for the implementation of code of corporate governance and strong regulatory frame work for the corporate sector in Pakistan.

In 2007 the Security and Exchange Commission of Pakistan, International Financial Corporation (IFC) and Institute of Corporate G overnance of Pakistan (PINCG) conducted a Survey on “Code of Corporate Governance of Pakistan”. The survey targeted the local listed and large local non-listed companies and financial sector institutions. Among the key findings in the survey, a major one is the need for creating awareness amongst the directors of companies about the benefits of the Code, so that they could go further than the tick-box approach to implementing the Code, and understand and implement the Code in its true spirit. Security and Exchange Commission of Pakistan developed a board development series (BDS) with the help of IFC. PICG conducted many workshops for the purpose of understanding corporate governance and responsibilities of boards of directors. 2. 4.

Assessment of Corporate Governance The SECP is enforcing corporate governance regulations SECP is receiving technical assistance from Asian Development Bank to improve corporate governance enforcement programme and also from World Bank is build awareness and training. Other elements of enforcement regime are not so strong ICAP has some self regulatory function and stock exchanges are lacked the resources and expertise to effective monitor implementation of the code. Karachi Stock Exchange has set up a Board Committee on the Code of Corporate Governance and a unit in the Company Affairs Department to monitor compliance with the code. The basic shareholders rights are protected in Pakistan at least laws in book.

The registration is secure and dematerialised through Central Depository Committee (CDC). Shareholders can demand a variety of information directly from the company and have a clear right to participate in Annual General Meetings (AGM). Directors are elected using a form of cumulative voting and can remove through share holder resolution. The changes in the company articles, increasing authorised capital and sale of major corporate assets are require shareholders approval. While more effective enforcement contributed to improve compliance, some companies do not hold annual general meetings 11 (AGMs) or hold in places where it is difficult for shareholders to reach.

The law also does not support voting by post or electronically. The concentrated control limits and influence of minority shareholders, and effectively reduce their protection from abuse. When families dominate the shareholders meeting and board, director’s accountability to other shareholders become critical and currently in Pakistan this accountability is absent in many companies. The shareholder recording process for share hold in the CDC works effectively. However, although the registration’s role has been reduced by the CDC’s operations, some inefficiency is still there. Some companies do not pay dividend on time, and take longer than 5 days to re-register share in t e name of h depository.

The annual reports of SECP suggest that the percentage of companies paying dividends is 35 percent and shareholders can complain SECP about non payment of dividends. The quality of disclosure has improved over last six years due to increasing monitoring role of the SECP and the requirement of code. Shareholders owning 10 percent or more of voting capital disclose their ownership and the annual report includes the pattern for major shareholdings. However pyramid structure, cross holdings and the absence of joint action make it difficult for outsiders to understand the ownership structure of companies, especially in case of business groups. The family owned companies are typically managed by owners themselves.

In case of state owned enterprises and multinationals there is often direct relationship between state/foreign owners and management again bypassing the boards. Many important corporate decisions are not made on Board AGMs level. The code explicitly mentions director’s duties to act with objective an independent judgment and in the best interest of company. In business groups boards are dominated by executive and non-executive members of controlling family and by proxy directors appointed to act on their behalf. Inter-looking directorships are often used to retain majority control. Family dominated boards are less able to protect minority shareholder’s rights and risk a loss of competitiveness as other boards become more professional.

The code strengthen the role of non-executive directors by restricting the percentage of executive director to 75 percent in non-financial firms and recommending that institutional investor in 75 percent in non-financial firms and recommending institutional investor be representation. However given the dominant ownership structure, this does not present controlling families from having disproportionate representation on the board. “The adoption of the Corporate Governance Code has improved the overall corporate structure and business environment by making the companies more responsible, and by ensuring transparency and accountability in the corporate and financial reporting framework. The inclusion of non-executive directors on the board is a big step forward as it will discourage the tendency of protecting personnel interests and motives at the expense of the minority 12 shareholders.

Moreover, the addition of the non-executive members has improved decision-making process, which is not only slow previously, but also opaque due to the lack of interest of the board of directors to meet as and when required”, Rias and Saeed (2005). In the view of Syed (2005) the publication of quarterly results by firms enables the investors to make better investment decision. Under the Code, listed companies shall share with SECP and stock exchange, all information that will affect the market price of its shares. The disclosure of material information ensures transparent trading. 2. 5. Corporate Governance under Concentrated Ownership Corporate ownership is very concentrated in Pakistan (see Table 2. 5).

The mean value of ownership concentration for the 60 companies for the year 2003-2007 shows that more than 50 percent of the shares are owned by top 3 shareholders. In Pakistan the main owners are local family-controlled business groups and the families behind them, the state, and the affiliates of multinational corporations (see Table 6). According to Gani and Ashraf (2005), “The business groups in Pakistan (previously known as twenty-two families) are informal combinations of legally independent business entities run by families. The family patriarch is the dominant shareholder and manager whereas the immediate and distant family-members help operate various firms within the business group”.

In many countries pyramidal ownership structures, which dominant shareholders and business groups use to enforce their control over firms within the group, are common. Pyramid ownership structures make it possible to control some firms even with a very small share of their total capital. The results of Gani and Ashraf (2005) suggest that for the perspective of external shareholder firms that are affiliated with business groups have lower transparency and weaker corporate governance mechanism. Consequently, the market participants discount the value of group firms even though they are more profitable than non-group firms. They interpret this evidence that the businessgroup mechanism in Pakistan makes it easier to expropriate minority shareholders than non group firms. Table 2. Ownership Concentration of 50 Random Companies for Pakistan for 2003-2007 Mean Median Minimum Maximum S. D T3 52. 0 50. 70 2. 5 96. 8 21. 0 T5 62. 39 64. 23 3. 5 99. 00 21. 17 T3: Percentage of ownership shares held by top three shareholders. T5: Percentage of ownership shares held by top five shareholders. 13 Table 2. 6 Inventors Composition in Listed Private Companies (Percentage Shares Owned by an Investor Type) Investor Type Direct Holding by Family Members NIT/ICP Financial Institutions Foreign Investors Joint Stock Companies Associated Companies of the Controlling Family Source: Cheema, Bari, and Siddique (2003). Textile 29. 3 8. 4 5. 1 1. 9 23. 2 17. 4 Non-Textile 9. 1 11. 1 8. 2 14. 3 16. 9 21. 4 Table 2. Ownership Composition of Pakistan’s Top 40 Listed Companies % of Top 40 Companies Non-financial 59. 0 12. 0 14. 0 15. 0 % of Top 40s Market Capitalisation All Non-financial 30. 2 29. 8 36. 5 36. 8 16. 3 15. 6 17. 0 18. 0 Ownership Type All Local Private Family -Based 52. 5 Government 12. 5 Semi-Government 22. 5 MNCs 12. 5 Source: Cheema, Bari, and Siddque (2003). Cheema, Bari, and Siddique (2003) summaries the corporate growth history of Pakistan, providing an overview of the ownership, state of financial market, and market dynamics. They highlight the salient feature of ownership structure of Pakistan’s top 40 listed companies in Pakistan (Table 2. 6). 2. 6.

Corporate Governance in South Asia The process of improving the best practice of corporate governance in South Asia is ongoing. Pakistan, Sri Lanka, and India recognise the importance of corporate governance. India issued Code of Corporate Governance in 1998, Pakistan issued Code of Corporate Governance in 2002, and Sri Lanka has also Code of Corporate Governance. Issuance of Code increased the transparency in the corporate sector of these countries. The four country comparative analysis by Sobhan and Wendy (2003) provide an immensely rich resource which can be mined for numerous lessons of experience and critical factors for corporate governance. They draw many important lessons from the four country reports on corporate governance.

In their view corporate governance cannot be introduced in isolation from a range of other reforms (macro-economic, micro-economic, accounting, legal, banking and institutional) – nor can these other reforms achieve all their objectives without corporate governance initiatives. Moreover there is the need to monitor the trends in different sectors of the markets. From the country reports they also 14 draw lesson that critical importance of the company and contract laws and the efficacy of the legal system should also be recognise. It is notable that all the countries have developed special commercial courts of one sort or another to handle the commercial disputes, but the reports all generate a sense of gloom, almost of despair, when it comes to the efficacy of the law, and of the need to modernise bankruptcy and liquidation proceedings. The

OECD and the World Bank Group have combined their efforts to promote policy dialogue on corporate governance and have established Regional Corporate Governance Round tables and assessment of corporate governance in close partnership with national policy-makers, regulators and market participants. It draws lessons from the 1997 Asian financial crisis, assesses progress and remaining challenges, and formulates common policy objectives and a practical reform agenda for improving corporate governance in Asia. 6 India has a sizeable corporate sector registered as closely- or widely-held companies under the Companies Act. Table 8 g ives the data for basic statistic of corporate sector of India for1997-2000. Since the first Corporate Governance ROSC assessment dated July 31, 2000, a series of legal and regulatory reforms have transformed the Indian corporate governance framework and improved the level of responsibility/accountability of insiders, fairness in the treatment of minority shareholders and stakeholders, board practices, and transparency In particular, the securities regulator introduced a corporate governance clause in the listing agreement that clarified many issues. Recent efforts to strengthen enforcement have enhanced investors’ trust in the market. The financial press is increasingly reporting violations of shareholder rights. These are positive drivers of change. However, enforcement and implementation of laws and regulations remain important challenges. ” ROSC (2004). In Bangladesh lending institutions are broadly categorised into banks and non-banking financial institutions.

Overall performance measures of the stock exchange show low trading volume, intermittent and very few new offerings, and declining valuations Sobhan and Wendy (2003). 7 “The Bangladesh Securities and Exchange Commission and the Institute of Chartered Accountants of Bangladesh have demonstrated a keen interest in implementing International Accounting Standards (IAS) and International Standards on Auditing (ISA) to upgrade the quality of corporate financial reporting. Various steps have already been taken; however, further results will require the design and implementation of a comprehensive action plan on accountancy reform. The accounting and auditing practices in Bangladesh suffer from institutional weaknesses in regulation, compliance, and enforcement of standards and rules.

The preparation of financial statements and conduct of audits, in many cases, are not consistent with internationally acceptable standards and practices. Better-qualified 6 7 See White Papers on corporate governance in Asia, 2003. See Table 2. 10. 15 graduates generally do not join the accounting profession because it is not viewed as a stepping-stone to a rewarding and prestigious career. The out-ofdate legal requirements, widespread non-compliance with accounting and auditing standards, ineffective enforcement mechanism, poor quality accounting education and training, and inadequate adherence to professional ethics have contributed to the weakness of the financial reporting regime”, ROSC (2003). Table 2. Basic Statistics of Corporate Sector of India 1997 Number of Companies Closely held (Private limited) Widely held (Public limited including listed) Paid-up Capital (Rs Billion) Closely held (Private limited) Widely held (Public limited including listed) Government Companies Number of Companies Paid-up Capital (Rs billion) Source: Sobhan and Werner (2003). 386,841 64,109 588 1,257 1,220 797 1998 1999 2000 415,954 440,997 487,111 68,546 718 1,409 1,223 824 71,064 790 1,503 1,240 890 76,029 1,013 2,063 1,256 982 Table 2. 9 Types of Financial Institutions in Bangladesh Type of Financial Institution Number of Institutions Non-Bank Financial Institutions 28 State-owned Commercial Banks 4 Specialised and Development Banks 11 Private Commercial Banks 26 Islamic Private Commercial Banks 02 Foreign Commercial Banks 10 Source: Sobhan and Wendy (2003).

Table 2. 10 Dhaka Stock Exchange Select Statistics 1999 2000 No. of Listed Companies 221 230 Market Capitalisation ($ Mill) 870 1,165 Market Cap as % of GDP 2. 04% 2. 65% DSE All Share Price Index 647. 95 853. 75 Source: Sobhan and Wendy (2003). 2001 231 1,176 2. 52% 829. 61 2002 239 1,184 848. 41 16 2. 7. Summary and Conclusion The issue of corporate governance is important for developing countries because it is central to financial and economic development of a country. Pakistan has develop good corporate governance laws but with poor implementation of these laws together with political instability that adversely affect corporate governance.

Code of corporate governance is issued by SECP in March 2002. The adoption of the Corporate Governance Code has improved the overall corporate structure and business environment. The quality of disclosure has improved over last four years due to increasing monitoring role of the SECP and the requirement of code. In Pakistan the main owners are local family-controlled business groups and the families behind them, the state, and the affiliates of multinational corporations. Ownership is very concentrated in the few hands of large families. These families control ownership shares through pyramids and tunnelling. Business groups have lower transparency and weaker corporate governance mechanism.

Pyramid ownership structures make it possible to control some firms even with a very small share of their total capital. The basic shareholders rights are protected in Pakistan at least laws in book. The registration is secure and dematerialised through Central Depository Committee (CDC). Chapter 3: DETERMINANTS OF CORPORATE GOVERNANCE 3. 1. Introduction In the developed markets the subject of corporate governance is well explored as a significant focus of economics and finance research but there is also a growing interest across emerging markets in this area. In Pakistan, the publication of the Corporate Governance Code 2002 by SECP for publicly listed companies has made it an important area of research of corporate sector.

A corporate governance system is comprised of a wide range of practices and institutions, from accounting standards and laws concerning financial disclosure, to executive compensation, to size and composition of corporate boards. A corporate governance system defines who owns the firm, and dictates the rules by which economic returns are distributed among shareholders, employees, managers, and other stakeholders. As such, a county’s corporate governance regime has deep implications for firm organisation, employment systems, trading relationships, and capital markets. Thus, changes in Pakistani system of corporate governance are likely to have important consequences for the structure and conduct of country business. The plan of the chapter is as follows.

Section briefly reviews the literature in this area. The measurement of corporate governance index and its sub-indices is presented in Section 3. The Section 4 examines the determinants of corporate governance in case of Pakistan equity market. Last section concludes the study. 17 3. 2. Review of Previous Literature The assessment of the corporate governance for developed markets is well researched area. Studies have shown that good governance practices have led the significant increase in the economic value added of firms, higher productivity and lower risk of systematic financial failure for countries. It has now become an important area of research in emerging markets as well.

For US Firms a broad measure of Corporate Governance Gov-Score is prepared by Brown and Caylor (2004) with 51 factors, 8 sub categories for 2327 firms based on dataset of Institutional Shareholder Service (ISS). Their findings indicate that better governed firms are relatively more profitable, more valuable and pay more cash to their shareholders. Gompers, Ishii and Metrick (2003) use Investor Responsibility Research Centre (IRRC) data, and conclude that firms with fewer shareholder rights have lower firm valuations and lower stock returns. They classify 24 governance factors into five groups: tactics for delaying hostile takeover, voting rights, director/officer protection, other takeover defenses, and state laws.

Most of these factors are anti-takeover measures so G-Index is effectively an index of anti-takeover protection rather than a broad index of governance. Their findings show that firms with stronger shareholders rights have higher firm value, higher profits, higher sales growth, lowest capital expenditures, and made fewer corporate acquisitions. In past few years corporate governance has become an important area of research in Pakistan. Cheema, et al. (2003) suggests that corporate governance can play a significant role for Pakistan to attract foreign direct investment and mobilise greater saving through capital provided the corporate governance system is compatible with the objective of raising external equity capital through capital markets.

The corporate structure of Pakistan is characterised as concentrated family control, interlocking directorships, cross-shareholdings and pyramid structures. The concern is that reforms whose main objective is minority shareholder protection may dampen profit maximis ing incentives for families without providing offsetting benefits in the form of equally efficient monitoring by minority shareholders. If this happens the reform may end up creating sub optimal incentives for profit maximisation by families. They argue that a crucial challenge for policy-makers is to optimise the dual objectives of minority shareholder protection and the maintenance of profit-maximising incentives for family controllers.

There is a need for progressive corporations to take a lead in the corporate governance reform effort as well. Rais and Saeed (2005) analyse the Corporate Governance Code 2002 in the light of Regulatory Impact Assessment (RIA) framework and its enforcement and application in Pakistan in order to understand the dynamics of public decision making and assess the efficacy of the regulation policy of SECP in the arena of corporate governance. The analysis shows that though the listed companies are gearing themselves up to adopt the Code, there are some 18 constraints, and reservations about the way it was drafted and implemented. The study by Ghani, et al. 2002) examines business groups and their impact on corporate governance in Pakistan for non-financial firms listed on the Karachi Stock Exchange of Pakistan for 1998-2002. Their evidence indicates that investors view the business-group as a mechanism to expropriate minority shareholders. On the other hand, the comparative financial performance results suggest that business groups in Pakistan are efficient economic arrangements that substitute for missing or inefficient outside institutions and markets. The study by Ashraf and G hani (2005) examines the origins, growth, and the development of accounting practices and disclosures in Pakistan and the factors that influenced them. They document that lack of investor protection (e. g. minority rights protection, insider trading protection), judicial inefficiencies, and weak enforcement mechanisms are more critical factors than are cultural factors in explaining the state of accounting in Pakistan. They conclude that it is the enforcement mechanisms that are paramount in improving the quality of accounting in developing economies. Mir and Nishat (2004) and Shaheen and Nishat have done rating of corporate governance based on annual reports and survey data respectively for the year 2004 and relate this governance score with firm value. Javid and Iqbal (2007) used panel data from annual reports for 2003 to 2006 to measure factors of corporate governance. All these studies come to the conclusion that better governance practices increase the value of the firm.

The International Financial Corporation (IFC), SECP and Institute of Corporate Governance, Karachi undertook a survey to awareness the corporate governance for the year 2006. There is an increasing interest in analysing affect of corporate governance on stock market in Pakistan but many i sues in this area are uncovered. In s particular, firm-level corporate governance rating and its affect on the corporate valuation, corporate ownership and corporate financing are central issues of this area which needs in depth research. It is in this pers pective this study aims to make contribution in the literature on corporate governance. 3. 3. Corporate Governance Index It is expected that better corporate governance is correlated with better operating performance and higher market valuation in case of KSE listed firms.

In order to construct corporate governance index for the firms listed on KSE, a broad, multifactor corporate governance rating is done which is based on the data obtained from the annual reports of the firms submitted to SECP. The index construction is as follows: for every firm, there are 22 governance proxies or indicators are selected,8 these indicators are categorised into three main themes. The three categories or sub-indices consist of: eight factors for the board 8 The list of these variables is given in the Appendix. Table A2. 19 composition and i dependence index seven for ownership, shareholdings and n seven for transparency, disclosure and audit. The weighting is in the construction of index is based on subjective judgments. The assigned priorities amongst and within each category is guided by emp irical literature and financial experts in this area.

The maximum score is 100, then, a score of 100 is assigned if factor is observed, 80 if largely observed, 50 for partially observed and 0 if it is not observed. 9 The average is taken out to arrive at the rating of one sub-index. By taking the average of three sub-indices we obtain CGI for a particular firm. Each sub-index comprises of series of factors leading to measure corporate governance. Board composition index captures board autonomy, structure and effectiveness. Autonomy is measured through various indicators of board independence including percentage of nominees, outside and independent directors on board, separation of CEO and chairman, a separate CFO (Corporate Financial Officer).

The various measures of board effectiveness are chair CEO split, regularity of meetings, and attendance by outside board members, and creditor’s nominee on board. The separation of role of CEO and chair dilutes the power of CEO and increases board’s ability to properly execute the oversight judgment. It also critically evaluates executive directors and the presence of non-executive member on board reduces the influence of management on the board. Moreover a higher proportion of outside directors10 on the board lead to higher company performance. The CEO may find a smaller board more easily dominated and more manageable due to the potential for social cohesion [Shaw (1981)]. A large group of directors would require more time and effort on the part of CEO to build census for a given course of action.

Therefore if the board is large, its independence is increased in the sense that the CEO’s ability to influence is diluted and it is more difficult for the CEO to dominate the board. There is also some evidence in favour of larger boards. Chaganli, Mahajam and Sharma (1983) have studied the relationship between board size and bankruptcy and have found that non-failed firms in their sample, tended to have larger boards then the failed firms. Thus larger boards may be more independent of management and that is the reason that the larger boards are associated with higher performance. The ownership and shareholdings is the second aspect of corporate governance.

The purpose of this sub-index is to measure the degree to which the board a managers have incentives that align their interest with those of nd shareholders. The third sub-index deals with disclosures. It attempts to measure the public commitment of the firm to good governance. Components following This is based on the report of World Bank, Report on the Observance of Standards and Code (ROSC), Corporate Governance Country Assessment: Pakistan, June 2005. 10 Any member of a company’s board of directors, who is not an employee or shareholder in the company. 9 20 full disclosure of corporate governance practices, directors’ bibliography, and internal audit committee reduce information asymmetry and it is valued by investor [Klein, et al. (2005)]. 3. 4.

Determinants of Corporate Governance The purpose is to assess the factors that determine the corporate governance practices adopted by firms. It is expected that in case of Pakistan, variables such as concentration of ownership, need of external finance, profitable investment opportunities, and size of the firm are related to the firm’s decision to comply with the code of corporate governance. Ownership concentration is a substitute of weak investor protection [La Porta, et al. (1999)]. The more the concentration of ownership and larger the cash flow rights of large shareholders, the more is entrenched and more the large owners influence the decision-making process [Drobetz, Schillhofer, and Zimmerman (2004)].

The concentration of ownership is negatively related to quality of corporate governance practices. In some firms the entrepreneur founders who used their own resources and retained earnings to finance their firms and have significant ownership stakes in the listed firms . This issue is addressed by using ownership concentration by top five largest shareholders. The firms with greater need of external financing practice high quality governance [Durnev and Kim (2006); Rajan and Zingales (1998)]. It is expected that there is negative association between ownership concentration and corporate governance and positive relation between external financing needs and quality of corporate governance.

Further, in countries with weak legal regimes firms have difficulty in raising external finance due to investors’ lack of trust in legal protection of their rights [La Porta, et al. (1998)]. In this study the significance of rule of law as determinant of corporate governance is analyzed. To assess influence of legal environment across the firm, this variable is introduced in interaction terms. To test the hypothesis that the quality of corporate governance is positively related to growth in investment opportunities, and negatively to concentration of ownership the model suggested by Dunev and Kim (2006) is estimated: CGI i = ? + ? 1EFi + ? 2Owni + ? 3Invi + ? 4Sizei + ? 5Lw i * EFi + ? 6 Lw i * Owni + ? it … (3. 1)

Where CGLi is a vector of corporate governance index, Ownt is the concentration of ownership held by top five shareholders, EFi is external finance that is calculated by multiplying market capitalisation of each firm with percentage of shares that are not taken by the top five shareholders of each firm, Invi is investment opportunities measured by the past growth in sales, Lwi is rule of law that is used for the proxy of enforcement of law, and Sizei is measured by the log of total asset. ?i is random error term. 21 The model (3. 1) develops the linkage between corporate governance and ownership concentration, need of external finance, quality of enforcement of law and other firm specific variables and interaction terms [Durnev and Kim (2006)].

In the set of control variables which include size (natural logarithm of assets) and investment opportunities (average sale growth) are used in estimation. Firm size and growth control for potential advantages of scale and scope, market power and market opportunities. The leverage (long term debt/total assets) controls for different risk characteristics of firm. Ownership concentration is expected to improve investor protection. In case of family ownership the entrepreneur have significant ownership stakes in the listed firms and use their own resources and retained earning to finance their firms, to capture concentration of ownership the percentage of ownership by top five largest shareholders is used.

A growing firm with large need of external financing has more incentive to adopt better governance practices in an attempt to lower cost of capital [Klapper and Love (2003) and Gompers, et al. (2003)]. The firms with more need of external finance would be more likely to choose better governance structure because firm’s insiders believe that better governance structure will further raise firm value they adopt good governance to signal that insider behave well and they can easily excess to external finances. 3. 5. Estimation Technique The panel data estimation technique is used because by pooling crosssection and time series the sample size increases.

The panel data take account of the endogenity and control for the firm specific effects. The Generalised Method of Moments is also used suggested by Georgen, et al. (2005). To obtain consistent estimates, the model is first differenced to estimate the fixed effects, then all right hand side variables in lag are used as instruments and thus eliminating inconsistency arising from endogenity [Arellano and Bond (1991)]. The consistency of GMM model depends on the validity of both of both the instruments and the assumption that the error terms do not exhibit serial correlation. Therefore two specification tests, Sargan test of over-identifying restriction and test that error term is not serially correlated are performed.

The failure to reject the null hypothesis in both tests gives support to GMM model [Arellano and Bond (1991)]. The following equation describes the relationship: Yit = ? + ? X it + µ it … … … … … (3. 2) Where Y and X have both i and t subscripts for i =1. 2, N firms and t = 1, 2,…T time period. Y represent the dependent variable in the model, Xit contain set of it explanatory variables. The previous empirical studies suggest that the Generalised Method of Moment (GMM) is more suitable method [Arellano and Bonds (1991)]. The lagged dependent variable is most likely to be correlated 22 with the firm specific effect and estimates using ordinary least square method (OLS) provided inconsistent and biased estimates.

To get the consistent estimation, the model is first difference to estimate the fixed effect and then we use the instruments on the right hand side variable using their lagged values to estimate the inconsistency which can be arising from endogenity of the regressors. For panel data we have six years of data and 60 firms of Karachi Stock Exchange (KSE). The Arellano and Bonds (1991) suggest that the estimation from GMM is first difference; which removes the time invariant µi and leave the equations automatable by instrument as described by the following equation: Yit – Yit-1 = a + (y it –y it-2 ) + ? (xit – xit-1 ) + (µi -µi ) + (v it –v it-1 ) … (3. 3) Which leads us to assume that there is no serial correlation in the disturbance term eit and all the lagged level of variables can be used as valid instruments in the first difference equation. 3. 6. Empirical Findings The model (3. ) develops the linkage between corporate governance and ownership concentration, need of external finance, quality of enforcement of law and other firm specific variables and interaction terms [Durnev and Kim (2006)]. Table 3. 1 presents the summary statistics of total corporate governance index CGIi and its sub-indices, which are Board Composition (Board i ), Ownership and Shareholdings (Share i ) and Disclosure, Transparency and auditing (Disci ). Table 3. 1 Summary Statistics of Corporate Governance Index Mean Max Min SD CGI Board Rights 54. 30 70. 42 30. 89 7. 99 1. 00 55. 58 87. 50 25. 00 16. 02 0. 62 1. 00 46. 97 78. 57 7. 14 16. 10 0. 57 0. 11 1. 00 60. 36 94. 29 30. 00 10. 93 0. 44 0. 05 0. 06 Disc

CGI Board Share Disc 1. 00 This Table 3. 1 provides the summary statistics of distribution of Corporate Governance index, and the sub-indices (Board, Shareholdings and Disclosure). This table also presents the pair-wise correlation between the indices. Appendix A gives detailed information on each sub-index. The maximum score is 100, which is assigned if indicator is observed, 80 if largely observed 50 for partially observed and 0 if it is not observed. The total index consist of governance proxies in three sub-categories and is constructed using the equal weighting scheme. The average rating of CGI is 54. 30 and it ranges 23 from 70. 42 to 30. 89.

The sub-index with highest rating is Disc (Disclosure, Transparency and Auditing), which can be explained by the fact that this area is emphasised by regulations of SECP. To investigate the determinants of corporate governance due to multicollenearity in ownership concentration and external finance firm corporate governance score is regressed on two set of determinants and results are reported in Table 3. 2. One set includes concentration of ownership and control variable and other determinants include external finance plus control variables. Ownership structure shows negative and significant relationship with CGI and Disclosure scores however, when use interaction term of own with law the result shows no impact of legal environment.

This suggests that weakness of investment protection and absence of corporate control firms rely on governance structure that is dominated by high concentration of ownership. The firm with concentrated ownership there is no reason to expect firms to disclose more. The inclusion of disclosure and transparency scores and other attributes are included in CGI scores also and they are not directly related to agency problem. In addition, this result indicates that negative relationship between corporate governance and ownership concentration is strong with weak legal regime. The Dunev and Kim (2006) have come up with same finding in case of US market. Table 3. Evidence on Determinants of Corporate Governance Determinants of Determinants of Determinants of Determinants of CGI Board Shareholdings Disclosure EF 0. 16** 0. 63** 0. 20*** 0. 29*** (1. 92) (1. 62) (1. 57) (1. 53) Own –1. 34** –0. 30*** –0. 23* –0. 29 (–1. 89) (–1. 47) (–2. 44) (–1. 33) Inv 0. 05** 0. 01*** 0. 12** 0. 03** 0. 11** 0. 11** 0. 13** 0. 04*** (1. 76) (1. 57) (1. 69) (1. 52) (1. 84) (1. 82) (1. 64) (1. 58) SIZE 0. 56*** 0. 69** 0. 62*** 0. 12** 0. 29*** 0. 29** 0. 18*** 0. 16** (1. 54) (1. 82) (1. 47) (1. 48) (1. 67) (1. 92) (1. 43) (1. 85) Lev 0. 14** 0. 05** 0. 31*** 0. 35** 0. 23*** 0. 17*** (1. 92) (1. 71) (1. 67) (1. 56) (1. 46) (1. 2) LAW*OWN 0. 12 0. 17 0. 11 0. 25 (1. 11) (0. 11) (0. 61) (0. 83) LAW*EF 0. 001 0. 01 0. 004 0. 02 (0. 56) (0. 89) (1. 02) (1. 11) Constant –0. 27 0. 48 0. 42 1. 11 –0. 23 –0. 14 (–0. 31) (1. 27) (0. 27) (1. 02) (–0. 07) (–0. 71) R2 0. 31 0. 31 0. 29 0. 30 0. 30 0. 29 0. 30 0. 31 Note: The *, ** and *** indicates the significance levels at 1 percent, 5 percent, and 10 percent respectively. Values in parenthesis are t-statistics. The results show positive association between need of external finance and corporate governance quality, because good practices are signal that insiders are adopting good practices. As a result the value of firm is higher and 4 entrepreneur can get easy and less costly access to external finance [Pistor, et al. (2003)]. The positive sign of the coefficient of size shows that large firms show better governance. Investment opportunities have positive impact both CGI and Disclosure scores. This confirms the theoretical notion that firms with better investment opportunities perform better corporate governance practice. The interaction terms of legal regime with external financing show positive and insignificant relationship with CGI and Disclosure scores which suggests that in legal environment which is less investor friendly firm specific factors matters more in choice of corporate governance practices. 3. 7.

Summary and Conclusion The corporate governance index and disclosure and transparency index are used wh ich are developed using the information from the annual reports of the companies. In order to construct corporate governance index for the firms listed on KSE, a broad, multifactor corporate governance rating is done which is based on the data obtained fro m the annual reports of the firms submitted to SECP. The index construction is as follows: for every firm, there are 22 governance proxies or indicators are selected , these indicators are categorised into three main themes. The three categories or sub-indices consist of: eight factors for the board composition and independence, seven for ownership, shareholdings and seven for transparency, disclosure and audit.

The sample firm consists of 00 firms which are active, representative of all non -financial sectors and comprises more than 90 percent of market capitalisation at Karachi stock market. In this Chapter, we presented a simple model of determinants of corporate governance. Our result shows that the strength of corporate governance systems is affected by the concentration of ownership, external financing needs of corporations, size, investment opportunities of the firm. Thus with good corporate governance standards in place; it is ultimately the financial market which rewards good governance practices and punishes bad governance. The results show that firms with high growth and large in size are in more need of external finance adopt better governance practices and are more transparent.

The firms with more concentrated ownership do not follow the good qualit y governance and disclose less. The law does not matter in adopting good practices. Our results also generally confirm the prediction of the theory that enforcement of law does not matter in investment growth and ownership structure in weak legal regime countries like Pakistan. Thus legal protection is essential for effective corporate governance. Our results adds an important link to the explanation of the consequences weak legal environment for financial market development, external financing, corporate valuation and corporate governance. 25 Chapter 4: CORPORATE GOVERNANCE AND CORPORATE VALUATION 4. 1.

Introduction Corporate governance is the means by which minority share holders are protected from the expropriation of the managers or controlling shareholders. Good corporate governance contributes to sustainable economic development by enhancing the performance of companies and increasing their access to outside capital. In emerging markets good corporate governance serves a number of public policy objectives. It reduces vulnerability of the financial crises, reinforces property rights; reduces transaction cost and cost of capital and leads to capital market development. Corporate governance concerns the relationship among the management, board of directors, controlling shareholders, minority shareholders and other stakeholders.

The better corporate governance leads to better firm performance by protecting the rights of outside investors from the expropriation of controlling shareholders. In Pakistan, with traditionally low dispersion of ownership, the primary methods to solve agency problems are the legal protection of minority investors, the use of boards as monitors of senior management, and an active market for corporate control. In contrast to developed markets in Pakistan corporate governance is characterised by lesser reliance on capital markets and outside investors, but stronger reliance on large inside investors and financial institutions to achieve efficiency in the corporate sector. In this case, outside (smaller) investors face the risk of expropriation in the form of wealth transfers to larger shareholders.

The main focus of this chapter is to examine the relationship between corporate governance and firm performance for publicly listed Karachi Stock Exchange (KSE) firms. In the firm level corporate governance characteristics we considered board composition and effectiveness, ownership and shareholding rights, auditing, transparency and disclosure quality. They are summarised in an aggregate corporate governance index (CGI) which is computed as sum of three indices. It is only investigated whether corporate governance broadly defined affect firm performance, but identify whether some corporate governance factors are more important than other corporate governance indices and firm value which is measured by Tobin Q, ROA and ROE with corporate governance practices adopted by these firms.

This study extends our earlier work [Javid and Iqbal (2007)] in several ways: by updating the data, adding more variables and using panel data estimation technique. It contributes to the emerging literature in Pakistan relating indices of corporate governance to firm level performance which is measured by Tobin Q (which is market performance measure and captures market penetration) and return on assets and return on equity (accounting 26 performance measures). This study adds to existing literature by applying the relevance of law for corporate governance in Pakistan and emphasises that beyond the law on book, law enforcement must be credible [La Porta, et al. (1999); Pistor, et al. ( 2000)].

The plan of the chapter is as follows. The review of empirical findings of previous research is presented in Section 2. Section 3 briefly reviews the corporate governance policy framework of Pakistan. Section 4 provides methodological framework and a description of the data. The results for the relationship between corporate governance and firm valuation are presented in Section 5 and last section concludes. 4. 2. Review of Previous Literature “In the new and evolving international environment with a large private sector and global integration of world capital markets, corporate governance has become the prominent topic of institutional reform.

For governments, encouraging better corporate governance practices in policy making enables firms to raise more domestic as well as foreign capital. For firms, an efficient market will differentiate between the firms that embrace best corporate governance practices and those who find corporate governance a distraction. Therefore firms attempting to drive their competitiveness and reduce the cost of capital will adopt best corporate governance practices. For investors, corporate governance will be put on par with financial indicators when evaluating investment decisions because corporate governance has a significant impact on equity performance and risk”, FTSE (2005). La Porta, et al. 1999) have shown that, for the 20 largest listed companies in 27 wealthy, industrialised countries, 36 percent are widely held, 30 percent remain family controlled, and 18 percent are state-controlled, using a 20 percent direct plus indirect ownership measure. “There are three general corporate governance models based on ownership: the separation of company ownership and control because shareholding is widely dispersed; a dominant owner who exercises control and appoints management; and an intermediate case where a large shareholder (a blockholder in the terminology) has veto power over major management decisions. Shareholder control may be achieved through majority ownership, or indirectly through the pyramiding of share ownership through affiliated companies that are part of the (family-controlled) business group.

In Korea, Indonesia, Thailand, and indeed most developing economies there is no separation of ownership and control; owners control their companies even when they are listed. The United States, United Kingdom and Japan are cases where, for most companies, shareholding is widely distributed, with no dominant blockholders. Even so, the US and the UK’s degree of emphasis on shareholder value and external market disciplines are at the other extreme from 27 the Japanese case. The continental European corporate governance systems are significantly different in some respects from the market-oriented AngloAmerican model. Each European country has its own distinct laws, institutions and norms.

Corporate governance in Germany and Japan are often compared since both have relied heavily on relationship banking and monitoring by major bank creditors, in contrast to the greater reliance on capital market finance in the US and UK”, Patrick (2001). “In recent years, there has been significant effort to understand the agency conflicts among the different agents related to the firm and the effectiveness of the internal and external control mechanisms in inducing managerial value-enhancing actions. These controls traditionally have been classified as internal or external. A recent group of studies in the area of corporate governance recognise the possible existence of interactions among the different control mechanisms.

In this sense, Williamson (1983) states the substitution hypothesis between internal and external control mechanisms, according to that, when the takeover market is weak, as in the case of the Spanish market, there is a greater role for internal control mechanisms. The alternative control mechanisms are grouped forming the corporate governance system. Traditionally these systems have been classified as external (market oriented) and internal (network oriented). The external systems, dominant in Anglo-Saxon economies, are based on the control exerted by the markets. These systems are characterised by the existence of a highly developed and liquid capital market, with a high amount of listed companies. The Spanish economy is characterised by a low proportion of listed companies compared to the US or the UK.

Moreover, the stock ownership is highly concentrated in the hands of non-financial companies, financial institutions and families. This lower development of the financial markets and the stability and concentration of stock ownership suggests that the Spanish corporate governance system is an internal one based on the board of directors and the supervisory role of large shareholders”, Fernandez and Arrondo (2005). There is a large of body of empirical research that has assessed the impact of corporate governance on firm performance for the developed markets [Anderson and Reeb (2004); Bahjat and Black (1999, 2001); Black, et al. (2003); Bradley (2004); Drobetz, et al. (2004); Durnev and Kim (2005); Roe, et al. (1996); Gompers, et al. 2003) and numerous others]. These studies have shown that good governance practices have led the significant increase in the economic value added of firms, higher productivity and lower risk of systematic financial failure for countries. The studies by Shleifer and Vishny (1997) and Hermalin and Weisbach (2003) provide an excellent literature review in this area. It has now become an important area of research in emerging markets as well [Klapper and Love (2003); Javid and Iqbal (2006) and Mir and Nishat (2004)]. 28 There are some empirical studies that analyse the impact of different corporate governance practices in the cross-section of countries.

A noteworthy study in this regard is done by Mitton (2001) find the firm-level differences in variables are related to corporate governance has strong impact on firm performance during East Asian Crisis in Korean, Malaysian, Indonesian, Philippines and Thailand. The results suggests that better price performance is associated with firms that have indicators of higher disclosure quality, with firms that have higher outside ownership concentration and with firms that are focused rather than diversified. Most of the empirical work for exploring possible relationship between corporate governance and firm performance is done for developed markets. For US Firms a broad measure of Corporate Governance Gov-Score is prepared by Brown and Caylor (2004) and their findings indicate that better governed firms are relatively more profitable, more valuable and pay more cash to their shareholders. Gompers, et al. 2003) show that firms with stronger shareholders rights have higher firm value, higher profits, higher sales growth, lowest capital expenditures, and made fewer corporate acquisitions. It is expected that limiting board size is to improve firm performance because the benefits by larger boards of increased monitoring are outweighed by the poorer communication and decision-making of larger groups [Lipton and Lorsch (1992) and Jensen (1993)]. The study by Yermack (1996) provides an inverse relation between board size and profitability, asset utilisation, and Tobin’s Q which conform this hypothesis. Anderson, et al. (2004) come to conclusion that the cost of debt is lower for larger boards, because creditors believe these firms are having more effective monitors of their financial accounting processes.

Brown and Caylor (2004) find that firms with board sizes of between six and 15 have higher returns on equity and higher net profit margins than do firms with other board sizes. The relation between the proportion of outside directors, a proxy for board independence, and firm performance is inconclusive. Fosberg (1989), Weisbach (1991) and Bhagat and Black (2002) find no relation between the proportion of outsider directors and various performance measures. Baysinger and Butler (1985) and Rosenstein and Wyatt (1990) on the other hand show that the market rewards firms for appointing outside directors; Brickley, et al. (1994) find a positive relation between the proportion of outsider directors and the stock market reaction to poison pill adoptions; and Anderson et al. 2004) show that the cost of debt, as proxied by bond yield spreads, is inversely related to board independence. The studies that using financial statement data and Tobin’s Q find no link between board independence and firm performance, while those using stock returns data or bond yield data find a positive link [Hermalin and Weisbach (1991) and Bhagat and Black (2002)]. Brown and Caylor (2004) do not find Tobin’s Q to increase in board independence, but they do find that firms 29 with independent boards have higher returns on equity, higher profit margins, larger dividend yields, and larger stock repurchases, suggesting that board independence is associated with other important measures of firm erformance aside from Tobin’s Q. The evidence on the association between audit-related governance factors and firm performance is mixed. Brown and Caylor (2004) show that independent audit committees are positively related to dividend yield, but not to operating performance or firm valuation. Klein (2002) documents a negative relation between earnings management and audit committee independence, and Anderson, et al. (2004) find that entirely independent audit committees have lower debt financing costs. The separation of CEO and chairman affects firms’ performance because the agency problems are higher when the same person holds both positions.

Yermack (1996) shows that firms are more valuable, when the CEO and board chair positions are separated. Core, et al. (1999) finds that CEO compensation is lower when the CEO and board chair positions are separate. Brown and Caylor (2004) conclude that firms are more valuable when the CEO and board chair positions are separate. In past few years corporate governance has become an important area of research in Pakistan. Mir and Nishat (2004); Shaheen and Nishat (2004) empirically test the link between corporate governance structure and firm performance for Pakistan using one year cross firm data and find a positive relation between governance and firm performance measures.

Javid and Iqbal use panel data analysis and document a positive and significant association between the quality of firm-level corporate governance and firm performance for the period 2003 to 2006. There is an increasing interest in analysing affect of corporate governance on stock market in Pakistan but many issues in this area are uncovered. In particular, the firm-level corporate governance rating and its affect on the valuation of the firm, which is central issue of this area needs in depth research. It is in this perspective this chapter aims to make contribution in the literature on corporate governance. 4. 3. Data and Methodological Framework 4. 3. 1.

Data To asses the relationship corporate governance and firm valuation at firm level, data of 60 non-financial firms listed on Karachi Stock Exchange is used. 11 The data set is obtained from the annual reports of these firms for the year 2003 to 2008. Data on rule of law has been taken from World Bank governance 11 List of companies is provided in Appendix Table A1. 30 indicators. The ranking of rule of law as ranging from 0 to 1 for Pakistan is 0. 34 as average of five years. That indicates very poor legal environment for Pakistan in term of enforcement of law. 12 The Corporate Governance index and sub-indices are developed in Chapter 3. The size is defined as natural logarithm of total asset and growth of sales is taken as investment opportunities.

The leverage is defined as ratio of book value of long term debt to book value of total asset. The data of all these variables are obtained from the annual reports of the listed firms in the sample. The panel data models are used and GMM is adopted as estimation technique discussed in Chapter 3. 4. 3. 2. Empirical Methodology It is well established that country’s laws of corporate governance affect firm value. 13 The objective is to examine whether variation in firm-specific governance is associated with differences in firm value, when they have different characteristics (size, investment opportunities and leverage) and doing business in poor legal environment. 4 To explore the relationship between corporate governance and firm valuation: Tobin’s Q, return on assets, return on equity and dividend pay-out ratio. To test the hypothesis that the firms with good corporate governance practices are valued higher, the model proposed by Black, et al. (2003) is used which is as follows: Perfi = ? + ? 1CGI i + ? 2Invi + ? 3Levi + ? 4Size + ? 5Lwi * CGI i + ? it (4. 1) Where Prefi is performance measure Tobin’s, D/Pi , ROA i and ROEi are used to measure firm performance, CGIi is a vector of corporate governance index, Invi is investment opportunities measured by the past growth in sales, Lw i is rule of law that is used for the proxy of enforcement of law, and Sizei is measured by the log of total asset. ?i is random error term.

It is expected that firms that are adopting better governance practices with better investment opportunities and larger is size should have higher valuation. In exploring that good corporate governance cause higher firm valuation, an important issue is endogenity [Black, et al. (2003) and others ]. The firms with higher market value would be more likely to choose better governance structure because the firm’s insiders believe that better governance structure will 12 Although as Pakistan belongs to common law countries legal origin. In view of La Porta, et al. (1997) common law countries provide strong investor protection in term of law on books.

The ranking of rule of law indicate the fact that enforcement of law is very low against high ranking on law on books. 13 La Porta, et al. (2002) show that firm value is positively associated with the rights of minority shareholders. Daines (2001) finds that firms incorporated in Delaware have higher valuations than other U. S. firms. 14 As indicated by the ranking of rule of law by World Bank. 31 further raise firm value. In addition, the firms adopt good governance to signal that insiders are doing well to raise the firm value. A growing firm with large need of external financing has more incentive to adopt better governance practices in an attempt to lower cost of capital [Klapper and Love (2003) and Gompers, et al. (2003)].

These investment opportunities are reflected in the valuation of the firm, implying a positive association between governance and firm performance. Therefore, in estimating governance-performance relation the panel data estimation technique is used to control for endogenity. To deal with issue a set of control variables is included following Kaplan and Zingales, (1997); Black, et al. , (2003) and Klein, et al. (2005). The firm performance is regressed on corporate governance indices and other control variables. Along with three governance indices, board, shareholdings and disclosure, a set of control variables which include size (ln assets), leverage (debt/total asset ratio) and investment opportunities (growth rate of sales) are used in estimation.

Firm size and investment opportunities control for potential advantages of scale and scope, market power and market opportunities. The leverage controls for different risk characteristics of firm. 4. 4. Empirical Findings To investigate whether differences in the quality of firm level corporate governance also help to explain firm level difference in performance, we regress firm performance measures on index of corporate governance (CGIi ) and control variables The firm’s performance is measured by Tobin Q, ROA, ROE and D/P and the results are reported in Tables 4. 1, 4. 2, and 4. 3. The results of association between corporate governance indices and Tobin Q are presented in Table 4. 1.

The Tobin Q is regressed on the total corporate governance index CGIi with each sub-index add one by one along with set of control variables There is positive and significant relationship between CGIi and Tobin’s Q supporting our hypothesis that corporate governance affects firm value. The CGIi remains positive but significance level reduces with adding more explanatory variables. This shows that the inclusion of firm characteristics have improved the specification of the model. Therefore we find evidence that corporate governance effects firm’s performance. This result suggests that a certain level of governance regulations in emerging market like Pakistan has not make the overall level of governance up to a point that governance remain important for investor.

The inter-firm differences in firm characteristics matters to investor in valuing firm. This result is also conformed by several studies for developing markets as well as developed markets [La Porta, et al. (2002) and Drobetz, et al. (2004)]. The financial control variables are for the most part statistically significant. Investment opportunities have positive impact aggregate corporate governance index and sub-indices. This confirms the theoretical notion that firms with better investment opportunities perform better corporate governance 32 practice. The firm size has positive and significant association with firm performance. The leverage is positively and significantly related to firm performance.

The interaction terms of legal environment with corporate governance show positive and insignificant relationship with Tobin Q which suggests that in legal environment which is less investor friendly firm specific factors matters more in choice of corporate governance practices. The results based on total corporate governance suggest that corporate governance does matter in Pakistani stock market. However these findings do not fully reveal the importance of each category of corporate governance to firm performance. The results regarding relationship of firm value with three subindices and all control variables. These results indicate that two sub-indices except disclosure have positive and some significant impact on firm performance.

The board composition and ownership and shareholdings have some significant influence on firm performance. However investors are not willing to pay a premium for companies that are engaged in open and full disclosure. The results based on sub-indices reveal importance of board composition, ownership and shareholdings with firm performance and this evidence is also supported by other studies [Klein, et al. (2005)]. The board composition index has a positive and statistically significant effect on firm performance and when entered in model with other sub-indices it remains positive but become insignificant but coefficient of determination has improved.

This past evidence generally failed to find any clear relation between board composition and firm performance. The survey of literature concludes that the evidence on this matter is ambiguous [Bahjat and Black (1999, 2000) and Hermalian and Weisbach (2003)]. The ownership and shareholdings sub-index has a positive effect on Tobin Q when it is entered into model alone however, when include with other sub-indices but this effect is turned insignificant. These results show that most of the firms have ownership with dominant block holder or have ownership concentration and in block holder firm board independence is not associated with good performance.

The assumption of agency theory does not fully apply to these firms where the alignment of ownership and control is tighter thus suggesting the need of outside directors on the board of these firms. As control variables are included specification of model improves. The results of firm performance including control variables are also consistent with prior research. The coefficient of size is positive and significant in most of the cases. This shows that the listed firms that are likely to grow faster usually have more intangible assets and they adopt better corporate governance practices. The coefficient of investment opportunities is significant and positive because higher growth opportunities are associated with higher firm valuation.

The coefficient of leverage is positive and significant, is consistent with the prediction of standard theory of capital structure which says that higher leverage increase firm’s value due to the interest tax-shield [Rajan and Zingales (1998)]. 33 The interaction terms of legal environment with corporate governance sub indices show positive and insignificant relationship with firm performance indicating that in weak legal regime the firm chose to adopt better governance practices. Table 4. 1 Evidence on Corporate Governance and Firm Performance (Tobin Q) Variables CGI Board Share1 DIS 0. 03** 0. 02* 0. 003* (1. 98) (2. 04) (3. 51) SIZE 0. 05* 0. 04* 0. 04* (5. 27) (4. 46) (3. 5) Lev 0. 06* 0. 06* 0. 04* (3. 70) (4. 00) (2. 16) LAW*CGI 0. 003 0. 05 0. 01 (0. 06) (0. 71) (0. 91) Constant –0. 07 –0. 15 0. 04 (–0. 37) (–0. 23) (0. 18) R2 0. 29 0. 28 0. 28 Note: The *, ** and *** indicates the significance levels at respectively. Values in parenthesis are t-stat istics. INV Model 1 0. 03** (1. 97) Model 2 Model 3 Model 4 Model 5 0. 01* (5. 04) 0. 04** (3. 14) 0. 02* (2. 06) 0. 01 (1. 41) 0. 04 0. 01 (0. 18) (0. 18) 0. 003 0. 002* (2. 36) (2. 15) 0. 05* 0. 04* (4. 20) (3. 05) 0. 06 0. 06* (4. 06) (2. 09) 0. 02 0. 001 (0. 99) (0. 01) –0. 15 –0. 06 (–0. 79) (–0. 80) 0. 29 0. 30 1 percent, 5 percent, and 10 percent Table 4. Evidence on Corporate Governance and Firm Performance (ROA) Variables CGI Board Share1 DIS 0. 02** 0. 02*** 0. 01** (1. 39) (1. 46) (1. 32) SIZE 0. 26* 0. 29* 0. 27* (6. 62) (6. 29) (5. 26) Lev 0. 33* 0. 33* 0. 33* (5. 31) (4. 26) (3. 26) LAW*CGI –0. 11 –0. 42* –0. 03 (–0. 51) (–1. 11) (–0. 08) Constant 0. 26 0. 22 0. 31 (0. 33) (0. 29) (0. 40) R2 0. 29 0. 29 0. 28 Note: The *, ** and *** indicates the significance levels at respectively. Values in parenthesis are t-statistics. INV Model 1 0. 39** (1. 52) Model 2 Model 3 Model 4 Model 5 0. 13* (2. 00) 0. 01 (1. 23) 0. 21** (1. 84) 0. 13*** (1. 52) 0. 23* 0. 06 (2. 71) (1. 26) 0. 03* 0. 0*** (2. 36) (1. 38) 0. 28* 0. 8*** (2. 85) (1. 69) 0. 31* 0. 06* (4. 88) (2. 09) 0. 44* –0. 10 (1. 26) (0. 46) 0. 71 –0. 06 (0. 91) (–0. 80) 0. 27 0. 31 1 percent, 5 percent, and 10 percent 34 Table 4. 3 Evidence on Corporate Governance and Firm Performance (D/P) Variables Model 1 Model 2 Model 3 Model 4 Model 5 CGI 0. 01** (1. 64) Board 0. 02* 0. 01 (2. 06) (1. 13) Share1 0. 01 0. 01 (1. 41) (1. 37) DIS 0. 01* 0. 02 (2. 44) (0. 51) INV 0. 22** 0. 22** 0. 17*** 0. 12*** 0. 01** (1. 96) (1. 88) (1. 65) (1. 59) (1. 84) SIZE 0. 03* 0. 04*** 0. 02*** 0. 02 0. 01* (2. 02) (1. 38) (1. 40) (0. 91) (2. 05) Lev 0. 02** 0. 06* 0. 03** 0. 01** 0. 02* (1. 90) (2. 02) (1. 83) (1. 84) (2. 2) LAW*CGI 0. 16 0. 26 0. 04 0. 05 0. 13 (0. 81) (1. 17) (1. 02) (1. 21) (1. 11) Constant –0. 62 –2. 13 –0. 77 –0. 80 1. 65 (–0. 71) (–1. 50) (–0. 81) (–0. 38) (0. 94) R2 0. 30 0. 28 0. 29 0. 29 0. 31 Note: The *, ** and *** indicates the significance levels at 1 percent, 5 percent, and 10 percent respectively. Values in parenthesis are t-statistics. The results based on association between ROA and corporate governance and ROE and corporate governance are almost same. In Table 4. 2 the results regarding relationship of firm value using return on assets with aggregate corporate index and three sub-indices and all control variables are presented.

The evidence suggests that corporate governance affects corporate valuation in Pakistani; however, the importance of each category of corporate governance is not same in explaining firm performance. These results indicate that two subindices: board composition and disclosures have positive and some significant impact on firm performance. The ownership and shareholdings have no significant influence on firm performance. These results show that most of the firms have ownership with dominant block holder or have ownership concentration and in these firms the return on assets are not associated with good performance. The large sized firms with more investment opportunities and which are levered have high return on asset.

As regards the quality of legal environment the interaction terms of rule of law with corporate governance show no relationship with return on asset which suggests that in weak legal environment the law does not matter in firm valuation [La Porta, et al. (2000)]. 35 To investigate the relation between firm value measured by dividend payout ratio and corporate governance D/P is regressed on corporate governance and firm attributes: investment opportunities, size, leverage and size. Positive and significant coefficient of CGI reveals the fact that firms with higher-quality corporate governance are valued higher and distribute the dividend more. When D/P is regressed on sub-indices of corporate governance, the board composition and disclosure and transparency index have positive and significant results but positive and insignificant for shareholder and ownership indices.

In general the ownership and shareholders rights that align the managers and shareholders interest are significantly valued by investors. This is also true for board composition and independence index. Both sub-indices board and disclosures have positive association with firm performance. These results are consistent with agency theory which focuses on monitoring of managers whose interests are assumed to diverge from those of other share holders. However the assumptions of agency theory are not applied to block holder owned firms. Most of the firms listed on KSE are family owned or institution owned. In these firms the alignment of ownership and control is tight and thus suggesting the need of outside directors on the board.

Interaction term for CGI with law has the expected positive sign for Pakistan with poor legal e nvironment is consisted with notion that positive relationship between corporate governance and valuation is stronger in weak legal regime . The study by Dernev and Kim (2006) also conclude that high class corporate governance is valued higher in case of US market. Investment opportunities have positive and significant impact on corporate valuation measured by the D/P in all specifications. Our results confirm our predictions that firms with better investment opportunities have higher dividend payout ratio. The coefficient of size is positive and significant in most of the cases. This shows that the listed firms that are likely to grow faster usually have more intangible assets and they adopt better corporate governance practices.

The coefficient of leverage is positive and insignificant, which is contrary with the prediction of standard theory of capital structure which says that higher leverage increase firm’s value due to the interest taxshield [Rajan and Zingales (1998)]. The result of interaction term of rule of law with corporate governance does not have any significant impact on the valuation of the firm. These results indicate that legal framework is not providing relevant information regarding firm dividend pay-out in case of Pakistan. However, these findings are consistent to some extent with the notion that positive relationship is between governance and valuation is stronger in weak legal regimes [La Porta, et al. (1997)].

This explains the reason of mixed relation between firm valuation and corporate governance in US firms which are subject to strongest legal framework worldwide [La Porta, et al. (1998) and Dunev and Kim (2006)]. 36 When dividend pay-out is used as performance measure the aggregate corporate governance and the board composition and independence has a positive and statistically significant affect on firm’s dividend payout and when entered in model with other sub-indices. The ownership and shareholdings subindex has a positive effect on firm performance when it is entered into model alone and also when is included with other sub-indices but this affect is marginally significant or it remains positive but become insignificant but coefficient of determination has improved.

These results show that most of the firms have ownership with dominant block holder or have ownership concentration and in block holder firm board independence is not associated with good performance. The assumption of agency theory does not fully apply to these firms where the alignment of ownership and control is tighter thus suggesting the need of outside directors on the board of these firms. As control variables are included specification of model improves. The results of dividend payout regressed on corporate governance including control variables are also consistent with prior research [Arnott and Asness (2003) and Shaheen and Nishat (2004)].

There is positive association between corporate governance and dividend payouts consistent with the theoretical notion that the firms that are better governed payout more. The coefficient of size is positive and significant in most of the cases. This shows that the listed firms that are likely to grow faster usually have more intangible assets and they adopt better corporate governance practices. The coefficient of investment opportunities is significant and positive because higher profitable opportunities are associated with higher firm valuation. The coefficient of leverage is positive and significant, is consistent with the prediction of standard theory of capital structure which says that higher leverage increase firm’s value due to the interest tax-shield [Rajan and Zingales (1998)].

The interaction terms of legal regime with investment opportunities show positive and insignificant relationship with CGI, board, shareholdings and disclosure scores which suggests that in legal environment which is less investor friendly firm specific factors matters more in choice of corporate governance practices. These results are consistent theoretical proposition of La Porta, et al. (1999) and with empirical findings by Durnev and Kim (2006) and Pistor, et al. (2003). 4. 5. Summary and Conclusions The relationship between corporate governance variables has been widely analysed for the developed markets but very little work has been done on how a broad ange of governance mechanism factors effect the firm performance in thinly traded emerging markets. In this study we fill this gap by analysing the relationship between corporate governance and firm performance for the Karachi Stock Market. To proxy for firm-level governance we use a rating system to evaluate the stringency of a set of governance practices and cover 37 various governance categories: such as board composition, ownership and shareholdings and transparency. Our sample firm consists of 50 firms which re active, representative of all non-financial sectors and comprises more than 80 percent of market capitalisation at Karachi stock market.

The results document a positive and significant relation between the quality of firm-level corporate governance and various firm performance measures. In general the ownership and shareholders rights that align the managers and shareholders interest are significantly valued by investors. This is also true for board composition and independence index. Both these sub-indices have positive association with firm performance. These results are consistent with agency theory which focuses on monitoring of managers whose interests are assumed to diverge from those of other share holders. However, the assumptions of agency theory are not applied to block holder owned firms. Most of the firms listed on KSE are family owned or institution owned.

In these firms the alignment of ownership and control is tight and thus suggesting the need of outside directors on the board. However, the results show that open and transparent disclosure mechanism that reduces the information asymmetry have no affect on firm performance. This is due to the reason that we have used the annual reports as data source and these reports do not reveal all the information required for rating corporate governance. As regards the quality of legal environment the interaction terms of rule of law with corporate governance show no relationship with firm performance; which suggests that even firms in weak legal environment can enjoy high valuation if they adopt better quality governance and disclose practices [La Porta, et al. (2000)].

Our results show that Corporate Governance Code 2002 potentially improves the governance and decision making process of firms listed at KSE. Large shareholders still have a tight grip of companies. However, one can argue that adequate firm-level governance standard can not replace the solidity of the firm. The low production and bad management practices can not be covered with transparent disclosures and transparency standards. Chapter 5: CORPORATE GOVERNANCE AND CORPORATE OWNERSHIP 5. 1. Introduction The nature of relation between the ownership structure and corporate governance structure has been the core issue in the corporate governance literature. From a firms’ perspective, ownership structure determines the firms’ profitability, enjoyed by different stake-holders.

In particular, ownership structure is an incentive device for reducing the agency costs associated with the separation of ownership and management, which can be used to protect property rights of the firm [Barbosa and Louri (2002)]. With the development of 38 corporate governance, many corporations owned by disperse shareholders and are controlled by hire manager. As a results incorporated firms whose owners are dispersed and each of them owns a small fraction of total outstanding shares, tend to underperformed as indicated by Berle and Means (1932). Latter this theoretical relationship between a firm’s ownership structure and its performance is empirically examined by Jensen and Meckling (1976) and Shlefier and Vishny (1986). La Porta, et al. 1997, 1998, 1999 and 2000) have shown that the countries with weak legal environment, the original owners tries to ma intain large positions in their corporations which results in concentration of ownership. Equity ownership by insiders can align insider interest with those of shareholders, thereby leading to greater firm value [Klapper and Love (2002)] In underdeveloped markets in addition to weak legal enforcement reasons, due to underdeveloped nature of financial markets that would allow limited access to external financing and result in predominance of family firms [La Porta, et al. (1997, 1998) and Pistor, et al. (2003)]. In case of Pakistan the majority of the firms are owned by the family or institution [Cheema, et al. (2003) and Iqbal (2006)].

Further the researchers have comprehensively studied the conflict between managers and owners regarding the functioning of the firm for developed markets, although, the research on understanding the differences in behaviour of different shareholder identities is limited for emerging markets. Corporate Governance reforms started with the introduction of Corporate Governance Ordinance in 2003. There is little work done to examine the association between corporate governance and corporate ownership pattern in case of Pakistan. Cheema, et al. (2003) has identified only the nature of corporate ownership structure in Pakistan without analysing its impact on corporate performance.

Iqbal (2006) has investigated the relationship between performance and ownership shares of different categories of shareholders such as family ownership foreign investors’ ownership and institutional share holders but has not included the effect of other variable that might influence ownership concentration. She comes up with conclusion that the positive relationship between ownership concentrations as measured by top five shareholders and firm performance in general. We want to fill the gap of needed research area on the relation between corporate ownership and corporate governance in context of Pakistan. The association between equity ownership and firm performance is also investigated. The focus of this chapter is to investigate whether the equity ownership structure matters in case of Pakistan and its implications for corporate governance and corporate valuation. The remaining of this chapter is organised as follows.

Section 2 reviews the important empirical studies concerning the relationship between corporate governance, ownership structure. In Section 3, the empirical s1pecification of the model is described. Section 4 presents the discussion of the empirical results. Last section concludes this chapter and gives policy implications. 39 5. 2. Review of Previous Literature One of the earliest treatments of ownership and control issues is the seminal work of Berle and Means (1932). Early work in this area was largely descriptive [Mean (1930, 1931)]. As research became systematic in approach, researchers relied primarily on agency theory to guide their studies.

The central premise of this theory is that managers, as agents of shareholders (principals), can engage in decision making and behaviours that may be inconsistent with maximis ing shareholders wealth [Fama and Jensen (1983); Jensen and Meckling (1976)]. As evidence of its applicability to ownership studies, agency theory has been characterised as “a theory of the ownership (or capital) structure of the firm” . More resent research has also noted the dominance of agency theory as the guiding framework for corporate governance studies generally ownership studies more specifically such as Daily, et al. (1998) and Dalton, et al. (2003)]. Agency theory suggests that the corporate form of rganisation characterised by a professional management with little ownership operating business on the behalf of a large number of widely dispersed shareholders represent an archetypal principal agent problem [Eisenhardt (1989)]. Managers who disregard shareholder interest may be ousted by powerful shareholders or by hostile takeovers. This presupposes that shareholders have an interest to indulge in monitoring managerial behaviour. However, shareholders differ with respect to incentives to spend resources on monitoring. Shareholders owing a miniscule proportion of shares of a firm have very little incentive to devote the necessary time and effort on voicing their view. Resource-based theory suggests that considerable resource heterogeneity exists among various shareholders categories.

For an emerging economy firm, these differences arise from shareholders being foreign or domestic and financial or non-financial. The impact on firm performance of these owners with diverse resource endowments is expected to differ as a consequence of this heterogeneity in resources and organisational capabilities. A feasible solution to the agency problem that arises from separation of ownership and control is that managerial interests can be aligned with those of shareholders through equity ownership [Himmelberg, et al. (1999)]. There is another focus of the ownership studies to reduce the agency problem– institutional investors and large block-holders.

Institutional investors and large block-holders control an increasing amount of corporate equity. Many shareholders in these categories will take active interest in the governance of firms in which they invest because their ownership stakes do not permit them to easily divest the equity they hold in firms not meeting their performance expectations [Lane, et al. (1998)]. If these individuals or groups sold their equity, given their relative large equity positions, it would trigger a precipitous decline in the value of their holdings. 40 Since Berle and Means ( 932) the separation of corporate ownership 1 from control has given rise to large literature devoted to elaborating, refuting or testing it.

Hassen (1983) argued that if, as Berle and Mean claimed, corporate officers are promoting their own financial interests at the expense of the shareholders, then the remedy is to encourage shareholders to pay an active role in nominating and electing directors and thus influence the selection of the officers who run the enterprise. While Jensen and Meckling (1976) argue that introduction of managerial share ownership may reduce these agency problems, thus aligning the interest of managers and shareholders. The potential problems associated with the separation of ownership and control in the corporate is subject of research for many decades and have witness an evolution from concentrated ownership to increasingly diffuse ownership.

This trend towards increasing separation of ownership from management is documented by Berle and Means (1932) and they argue that managers might guard their own interest at the shareholders’ expense. Later Jensen and Meckling (1976), assert that firm value is reduced when ownership and control are separated rather than combined due to added costs of monitoring and the managers participate in activities that may not enhance firm value for the owners. In all other organisation configuration in which the decision-making and ownership functions are separated, costs are increased by the residual claimants since the potential exists for the different individual to pursue potentially conflicting optimisation paths [Daily and Dollings (1992)].

However, Fama (1980) and Fama and Jensen (1983a,1983b,1985) maintain that there are efficiencies to separating ownership and control into decision-making and risk-bearing functions which make dispersed ownership advantageous because the efficiency gains outweigh the agency costs. The findings of Graff (1950) and Feinberg (1975) suggest that organisations with combined ownership and control, owner-operators may choose to exchange profits for other benefits, such as choosing current over future consumption [Fama and Jensen (1985)] and on-the-job non-pecuniary consumption [Demsetz (1983)]. Consequently, such organisations will likely be undervalued by the market.

Although there is a presumption in the literature that large shareholders have power and stronger incentive to ensure shareholder value maximisation [Jensen and Meckling (1976); Zeckhouser and Pound (1990); Burkart (1997)] the theoretical relationship between large owners and firm value is ambiguous. 15 The empirical evidence on corporate governance suggests that large owners have stronger incentive and better opportunities to exercise control over manager than small shareholders. Claessen, Djankov, and Pohl (1996, 1999) find evidence of a positive relation between shareholding concentration and firm 15 Some authors find a relationship between ownership concentration and firm value

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