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Pacific-Basin Finance Journal 13 (2005) 387 – 410

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Board composition and firm value under


concentrated ownership: The Canadian evidence
John Ericksona, Yun W. Parka,*, Joe Reisingb, Hyun-Han Shinc
a
California State University, Fullerton, CA 92834-6848, USA
b
Minnesota State University, Mankato, MN USA
c
Yonsei University, Seoul, Republic of Korea
Received 9 March 2004; accepted 4 November 2004
Available online 22 January 2005

Abstract

This paper examines the relation between board composition and firm value in the presence of
significant ownership concentration using publicly traded Canadian firms over the 1993–1997
period. The results indicate that greater board independence does not have a positive influence on
firm value and that poorly performing firms increase the proportion of outside directors in
subsequent periods. This may result from firms acting to appease unhappy investors by adding
outside directors. However, the results also indicate that directors from financial institutions can
provide monitoring benefits. Finally, the negative effect of dual class common stock on firm value is
mitigated by board independence, the participation of officers from financial institutions and audit
committee independence. These findings suggest that sound governance practices can enhance firm
value in countries with high ownership concentration even in the presence of strong minority
shareholder protection.
D 2005 Elsevier B.V. All rights reserved.

JEL classification: F30; G32


Keywords: Board composition; Agency theory; International comparison

* Corresponding author. CBE, Department of Finance, 800 N. State College Blvd, Fullerton, CA 92834-6848,
USA. Tel.: +1 714 278 5785; fax: +1 714 278 2161.
E-mail address: yunpark@fullerton.edu (Y.W. Park).

0927-538X/$ - see front matter D 2005 Elsevier B.V. All rights reserved.
doi:10.1016/j.pacfin.2004.11.002
388 J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410

1. Introduction

Corporate boards of directors have the fiduciary duty to ensure that the management
acts in the interest of all shareholders. However, there is mounting evidence questioning
the ability of boards of directors to mitigate agency problems in corporations. Therefore,
many view boards of publicly traded firms to be relatively passive entities, often
dominated by the managers whom they are charged with monitoring.
A properly constituted board should effectively monitor management and help enhance
firm value. The effect of board composition on firm value has been addressed by a number
of researchers.1 In studies examining U.S. firms, there is little evidence that firms with
more independent boards outperform other firms. For example, Morck et al. (1988);
Hermalin and Weisbach (1991); Mehran (1995), and Klein (1998) report an insignificant
relation between corporate board independence and various measures of firm performance.
Further, Agrawal and Knoeber (1996) and Bhagat and Black (2001) document a negative
relationship between board independence and firm value using various measures of firm
performance including Tobin’s Q. In particular, by conducting a large sample, long
horizon study, Bhagat and Black (2001) report evidence that low profitability firms
increase the independence of their boards of directors and firms with independent boards
appear to underperform other firms. Bhagat and Black (1999) suggest that supermajority-
independent boards may be suboptimal and that an optimal board contains a mix of inside,
independent, and even affiliated directors, who bring different skills and knowledge to the
board.
The effect of board composition on firm value is an issue in many countries. Because
high ownership concentration is the norm rather than the exception around the world
(LaPorta et al., 1999), an important issue that needs to be addressed is the effect that
outside directors may have on firm value in the presence of a high degree of ownership
concentration. Canadian capital markets provide an opportunity to study the relationship
between firm value and board composition in the presence of significant ownership
concentration. Similar to the United States, Canada is a country where public equity
markets are well developed. At the same time, however, a large number of publicly traded
firms in Canada are controlled by a large block holder or an affiliated group of investors.
By using Canadian data, it may be possible to determine the effectiveness of outside
directors in the presence of dominant shareholders.
When ownership is concentrated in a firm, there are potential conflicts of interest
between the dominant shareholders and dispersed minority shareholders. That is,
controlling shareholders may expropriate wealth from minority shareholders. Canadian
lawmakers provide minority shareholders with various forms of legal protection from
dominant shareholders (see Cheffins, 1999, for a review).2 Dyck and Zingales (in press)
show that the private benefits of control, measured by the control block premium, are

1
See Hermalin and Weisbach (2002) for a survey of the literature on the board of directors.
2
An example of the protection of minority shareholders is the Ontario Security Commission regulations that
stipulate that a major transaction between a corporation and a related party such as a controlling shareholder must
be disclosed in detail to all investors, scrutinized by a committee of outside directors, and approved by a majority
of all disinterested shareholders (see Ontario Securities Commission Policy No. 9.1, Part V, 1994).
J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410 389

present but are relatively small for Canadian firms suggesting that Canada does have a
relatively transparent governance system when considering both the legal and extra-legal
environment.3 Thus, Canadian boards operate in a unique jurisdiction where ownership is
highly concentrated but there is considerable protection of minority shareholders. In view
of this, our paper addresses the following question: Does an improvement in board
composition enhance firm value under concentrated ownership?
The contribution of this paper is to show that in an environment characterized by
ownership concentration and significant outside shareholder protection, attention to board
composition can improve firm value. Our findings suggest that firm value declines when
additional outside directors are appointed without regard to their expertise. We also find
that ownership concentration reduces firm value. However, when outside directors who are
officers of financial institutions are on the board or the proportion of outside directors on
the audit committee increases, the negative impact of concentrated ownership on firm
value is mitigated. This suggests that board composition may affect how well the board
monitors management.
The remainder of this paper is organized as follows. Section 2 discusses the relevant
literature and develops the research questions. Section 3 reviews the Canadian corporate
governance environment. Section 4 provides an overview of results. Section 5 provides a
description of the model, while Section 6 includes a description of the data. Employing
both univariate analysis and multivariate regression analysis, Section 7 investigates the
effect of board composition on firm value. Section 8 concludes the paper.

2. Related literature

Boards of directors are typically composed of inside directors and outside directors.
Outside directors are often viewed as representing outside shareholders while inside
directors are assumed to represent the management or controlling shareholders. However,
it is unclear whether outside directors represent outside shareholders more effectively than
management or controlling shareholders. The role of outside directors in the protection of
shareholders has long been a subject of much debate. Fama (1980) and Fama and Jensen
(1983) observe that outside directors compete in the outside directors’ labor market. They
have incentives to develop reputations as experts in monitoring management because the
value of their human capital depends primarily on their performance as monitors of the top
management of other organizations. However, the empirical evidence on the monitoring
effectiveness that outside directors provide is somewhat mixed. While several authors find
that independent outside directors protect shareholders in specific instances in which there
is an agency problem (Weisbach, 1988; Byrd and Hickman, 1992; Xie et al., 2003), others
find either no relation or a negative relation between outside directors and shareholder
welfare.

3
Dyck and Zingales (2004) note, however, that the private benefits of controlling shareholders such as prestige
and the reputation of being a controlling shareholder of a public firm do not always reduce firm value.
390 J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410

Hermalin and Weisbach (1991); Mehran (1995) and Klein (1998) report an
insignificant relation between board independence and accounting performance, while
Morck et al. (1988) and Hermalin and Weisbach (1991) use Tobin’s Q as a measure of
firm value and find no relation between the board independence and firm value. On the
other hand, Agrawal and Knoeber (1996) show that outsiders on the board affect firm
performance negatively even after accounting for the interdependence among various
corporate control mechanisms. More recently, by conducting a large sample, long
horizon study, Bhagat and Black (2001) report evidence that low profitability firms
increase the independence of their boards of directors and firms with independent boards
underperform other firms. Using a 1997 survey of 484 of the Standard and Poor’s P 500
firms, Bhagat and Black (1999) note that currently there are too few inside directors
(only one or two in more than half of the sample) and too many outside directors on the
board. In an attempt to reconcile the two conflicting sets of results on the interaction
between board independence and firm value, Hermalin and Weisbach (2002) suggest
that in an environment that is out-of-equilibrium, the relation between board character-
istics and firm performance can be viewed as a causal relation while in an equilibrium
environment, there should be no relation.
There is much research that looks at the issue of direct causality between board
structure and firm value focusing on whether or not board structure affects firm value.
However, Bhagat and Black (2001) document evidence of reverse causality by showing
that low profitability firms increase the independence of their boards of directors.
According to their study changes in firm value cause changes in board structure raising the
issue of endogeneity between firm value and board structure.

3. The Canadian corporate governance environment

In 1994 a report was issued, which contains a series of guidelines to be used as a


voluntary code of best practices for internal governance procedures, designed to
improve board monitoring (The Toronto Stock Exchange Committee on Corporate
Governance in Canada, 1994)4. The report, which is widely known as the Dey Report,
specifically recommends that the board of directors should be constituted with a majority
of unrelated directors and it defines an unrelated director as one who does not have
interests in or relationships with either the corporation or its significant shareholder such
that the shareholders other than the significant shareholder are fairly represented
(paragraphs 5.7 and 5.8). Therefore, the Dey Report specifically indicates that those
related to controlling shareholders of the firm are not considered as unrelated or outside
directors. Another noteworthy aspect of the Dey Report is that Canadian regulators
presented these guidelines as recommendations based on moral suasion rather than
coercive legislation.

4
According to a subsequent comprehensive survey entitled Five Years to the Dey (Toronto Stock Exchange and
Institute of Corporate Directors, 1999), which examines the corporate governance practices of Canadian
corporations, the Dey Report, which was not coercive, nonetheless largely shaped Canadian corporate governance
practices after its release.
J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410 391

Outside directors in Canada operate in a different environment than those in the United
States. Many Canadian CEOs are the founders and controlling shareholders of the firms
they manage, unlike in the United States and U.K. where most public companies are widely
held by individual investors (Daniels and Halpern, 1996). Since the agency problem faced
by minority shareholders is particularly acute under strong inside ownership concentration,
improvement in board composition may have a significant effect on firm value. Seen in this
light, our investigation deals more specifically with whether outside directors play a
significant role in improving firm value even in the presence of large block holders.
While outside directors are expected to curb agency costs, those with financial expertise
may be able to do so more effectively. Using evidence on earnings management, Xie et al.
(2003) document that the monitoring that outside directors provide improves when they
are financially sophisticated. Since officers of financial intermediaries are financially
sophisticated, the expectation is that they can be particularly helpful to the board in
reducing agency costs (Booth and Deli, 1999).
In addition, outside directors dispatched from Canadian financial institutions are more
likely to have a greater interest in and greater influence in monitoring management
because of the strong concentration of financial power in a relatively small number of
institutions. These institutions are large both in absolute terms and relative to the size of
the Canadian economy. The industry concentration became more pronounced after 1987,
when the structure of Canadian financial institutions moved from a separate system to a
universal banking system. For the study period of 1993 to 1997, the seven largest deposit-
taking institutions—the Big Six banks (Bank of Montreal, Bank of Nova Scotia, Canadian
Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada, and
Toronto-Dominion Bank) and Movement des Caisses Desjardins of Quebec—span all
aspects of financial intermediation. In 1999 the big six banks of Canada managed assets of
C$277, C$263, C$227, C$226, C$215, and C$72 billion, respectively. In the same year
Morgan Stanley MSCI Country Statistics reports an equity capitalization of C$783 billion
(U$502 billion) for Canada.
The market concentration in the life insurance industry is more extreme. Among life
insurers five independent companies—Manufacturers Life Insurance, Sun Life Assurance,
Clarica Life Insurance, Great West Life Assurance, and Canada Life Insurance—
accounted for more than 90% of the life insurance assets by the end of 1997. Pension
assets are also highly concentrated. The largest three pension funds—Caisse de Dépôt et
Placement du Quebéc (CDPQ), Ontario Teachers’ Pension Plan Board (Teachers’), and
Ontario Municipal Employee Retirement System (OMERS)—dominate the pension fund
market. Finally, the highly visible and concentrated investment banking industry was
essentially absorbed by the big banks.
With these kinds of resources, large financial institutions are able to provide credible
external monitoring of the managers of firms in which they invest. Because of a limited
number of investment candidates in the Canadian capital market, large financial
institutions can effectively monitor the managements of Canadian firms at a competitive
monitoring cost. Furthermore, large Canadian financial institutions have an incentive to
monitor corporate management because it is problematic for these financial institutions to
simply sell underperforming holdings given the relatively small size of the economy where
they primarily invest.
392 J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410

In view of the forgoing discussion of Canadian financial institutions, we expect that


directors who are officers of financial intermediaries improve firm value in Canada more
than other types of outside directors because (1) they are endowed with financial and
accounting savvy allowing them to monitor management more effectively, and (2) they are
able to provide pressure insensitive monitoring because of the market power of the
institutions they represent. Thus, we hypothesize that directors who are officers of
financial intermediaries enhance firm value by mitigating the agency problem of the
management as well as that of concentrated ownership as a result of their monitoring
ability.

4. Overview of results

To examine the impact of the board composition on firm value in the presence of
ownership concentration and comprehensive minority protection, this paper examines the
relation between outside directors and firm value in Canada. The evidence indicates that
firm value has a negative relation to the proportion of outside directors in Canada
suggesting that outside directors are generally not effective monitors in a Canadian-type
governance environment. Further, it appears that firm value has an impact on board
independence confirming the endogeneity of corporate board structure. That is, poorly
performing firms tend to add outside directors to the board. This can be interpreted as
evidence that poorly performing firms add outside directors simply to appease unhappy
investors. This explanation is consistent with that suggested by Agrawal and Knoeber
(1996) that poorly performing firms add additional outsiders to the board for political
reasons.
On the other hand, our results indicate that outside directors who are officers of
financial institutions appear to increase firm value. Having such directors on the board
may benefit firms because of their monitoring expertise. Furthermore, since they are likely
to represent the interests of financial institutions, they may be more independent and have
greater influence in monitoring management than other outside directors. This effect is
likely to be far stronger in Canada than in the United States given the relatively high
concentration of the Canadian financial industry.
Finally, we examine the effect on firm value of the interaction of board composition and
the controlling shareholders’ entrenchment in the form of dual class common shares. We
find that such entrenchment reduces firm value. However, its impact on firm value is
mitigated by outside directors serving on the board and particularly when outside directors
are officers from financial institutions or when outside directors serve on the audit
committee. These results are consistent with the notion that it is the expertise of outside
directors that impacts firm value positively.

5. Model

Our model is designed to examine firm value and board independence as a function of
ownership, control, board structure, and firm characteristics where we assume that the two
J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410 393

dependent variables are interrelated. As such we consider each dependent variable as a


function of the other.
In order to deal with the endogeneity problem that may exist between board
composition and firm value discussed earlier (see Bhagat and Black, 2001), the
specification of the firm value model in Eq (1) examines firm value at time t as a
function of the lagged independent variables at time t1.

Firm valuet ¼ f ðownership concentrationt1 ; dual class of common stockt1 ;


board independencet1 ;
directors from financial institutions on the boardt1 ;
audit committee independencet1 ; board sizet1 ; firm sizet1 ;
financial leveraget1 Þ: ð1Þ

Ownership concentration is a control variable of considerable importance given that the


Canadian economy is structurally different from that of the United States and where high
ownership concentration is the rule rather than the exception. We anticipate a negative
relation between ownership concentration and the firm value if dominant shareholder
expropriation of private benefits exceeds the benefits of dominant shareholder monitoring
of executives.
We also expect a negative relation between the existence of dual class common stock and
firm value since dual class common stock will tend to increase the control of dominant
shareholders and, therefore, increase their ability to extract private benefits. Furthermore,
since dual class common stock indicates a divergence of cash flow rights and control rights,
controlling shareholders have greater incentive to extract the private benefits of control in
the presence of dual class common stock as they will bear a smaller fraction of the cost.
If an independent board can reduce agency problems, there should be a positive relation
between board independence and firm value. Likewise, we expect a positive relation
between the independence of the audit committee and firm value since an independent
audit committee can reduce agency problems in both widely held firms and closely held
firms. Alternately, the argument that firms add independent directors to placate
shareholders in the face of poor performance suggests that a more independent board or
committee could be associated with lower firm value.
Directors who are officers of financial institutions can provide monitoring benefits to
the board because of their financial expertise. Furthermore, they could be more
independent than other outside directors because, unlike the United States, Canada has a
highly concentrated financial services sector, so there may be less pressure to avoid
monitoring in exchange for business. Therefore, we expect a positive relation between
the presence of directors who are officers of financial institutions and firm value.
We control for board size because Yermack (1996) and others have shown that board
size has a negative influence on firm performance. Additionally, firm size and financial
leverage are widely used in the literature as control variables for firm specific effects. We
incorporate them here to control for firm-specific effects on firm value.
In order to examine the potential effect of firm value on board independence we
also propose a board independence equation. Similar to Eq. (1), this equation examines
394 J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410

board independence as a function of lagged firm value and governance variables to deal
with the endogeneity problem that may exist between firm value and board independence.
Board Independencet ¼ f ðownership concentrationt1 ;
dual class common stockt1 ; firm valuet1 ;
directors from financial institutions on the boardt1 ;
audit committee independencet1 ; board sizet1 ;
firm sizet1 ; financial leveraget1 Þ: ð2Þ
Ownership concentration is likely to be an important determinant of board
independence as dominant shareholders have significant input on who sits on the board.
We anticipate a negative relation between ownership concentration and board independ-
ence if dominant shareholders attempt to use their voting power to reduce independent
monitoring. Since the existence of dual class common stock will also tend to increase the
control of the dominant shareholders, we expect the sign on the relation between the
existence of dual class common stock and board independence to be the same as that of
ownership concentration.
We expect a positive relation between the independence of the audit committee and board
independence. Certainly having more outside directors on an audit committee is likely to
mean more outside directors overall. However, it is possible that a firm that feels it is
important to have strong outside director representation on the board may also feel the same
about audit committee representation. Likewise, we expect a positive relation between the
presence of directors from financial institutions and the degree of board independence since
having more outside directors allows more room for a director from such institutions.
Finally, we examine how changes in firm value are related to contemporaneous changes
in board structure variables. Having examined the relation between the variables across time,
it would be useful to look at observations taken during the same period to see if there is a
relation between the variables when measured concurrently as well. By looking at changes in
the board variables it should be possible to see if the parameter estimates in the earlier
equations are significant only in a lead/lag relation or if they are also significant con-
temporaneously. First differences are also used as many of the board parameters tend to be
fairly stable over time. The relation between these variables is provided in Eq. (3) below.

DFirm valuet ¼ f ðDownership concentrationt ; Dboard independencet ;


Ddirectors from financial institution on the boardt ;
Daudit committee independencet ; Dboard sizet ; Dfirm sizet ;
Dfinancial leveraget Þ: ð3Þ

6. Data

Board composition and ownership data are collected from proxy documents returned by
Canadian firms found in the Global Vantage database for the period between 1991 and
1997. Financial information for firms is collected from the Global Vantage database and
J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410 395

market information for firms is from the TSE-Western database. Canadian financial firms
are excluded from the sample since they are more closely regulated and their operation is
quite different than industrial firms.
Measures of firm value, ownership concentration, and board structure were calculated
for the 1993 to 1997 period. The resulting unbalanced panel consists of 679 firm years
(236 unique firms) as shown in Panel A of Table 1. We then construct a balanced panel
data set using only those firms for which a complete set of variables are available over the
full five years selected for the regression analysis. The paper reports only the results using
the balanced panel because the results using the unbalanced panel are qualitatively the
same. The balanced panel, which is also shown in Panel A of Table 1, has a total of 330

Table 1
Sample distribution
Panel A. Panel data structure
Year Unbalanced Balanced
panel panel
1993 78 66
1994 102 66
1995 126 66
1996 156 66
1997 217 66
Total 679 330

Panel B. Industry Distribution


Industry Number of firms Number of firm years Percentage
Balanced Unbalanced Balanced Unbalanced Balanced Unbalanced
panel panel panel panel panel panel
Metals and minerals 8 31 40 96 12.12 14.14
Oil and gas 13 37 65 117 19.70 17.23
Paper and forest products 7 17 35 52 10.61 7.66
Consumer products 6 15 30 52 9.09 7.66
Industrial products 15 61 75 181 22.73 26.66
Real estate and construction 0 0 0 0 0 0
Transportation and environment 3 11 15 33 4.55 4.86
Utilities 2 7 10 17 3.03 2.50
Communications and media 8 24 40 71 12.12 10.46
Merchandising 1 11 5 23 1.52 3.39
Others 3 22 15 37 4.55 5.45
Total 66 236 330 679 100 100
Panel A shows the distribution of both balanced and unbalanced panel data by year over the full period 1993–
1997. Note that results from the unbalanced panel are not reported in the paper since the unbalanced panel gives
qualitatively identical results as the balanced panel.
Panel B shows the industry distribution of the 66 Canadian firms with complete ownership, board, and accounting
data over the full period 1993–1997. The data for the firms are collected from the Global Vantage database for
financial information and the TSE-Western database for market information. Financial firms are excluded due to
structural differences associated with the Canadian financial institutions. The utilities in Canada appear to be far
less regulated than is typical in the United States; the standard deviation of the annual returns for the TSE utilities
is comparable to that of the TSE industrials.
396 J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410

firm years (66 unique firms observed over five consecutive years from 1993 to 1997).
Using the twelve Toronto Stock Exchange industry classifications, we show the industry
distribution of the sample firms in Panel B of Table 1. We use this industry classification in
order to find industry adjusted Q ratios in the following section.

6.1. Variable definitions

The data include ownership and governance variables as well as control variables. The
control variables include not only two different measures of firm value, but also firm size
and leverage. The ownership and governance variables include ownership concentration,
board size and independence, the existence of financial directors, outside directors on the
audit committee, and the existence of a dual class common stock issue.
Ownership concentration is measured by the fraction of voting rights held by the
dominant shareholders (M1) where dominant shareholders are defined as those who have
the largest block of shares. We also include a dummy variable indicating the existence of
dual class common stock (DC). Dual class common stock can allow a dominant
shareholder to attain control of a firm with a disproportionately smaller investment and
increase the ability to extract private benefits.
The board size (BSIZE) variable is included to control for the potential impact of
differential board size. Four additional board variables are included: board independence,
the existence of financial directors, outside directors serving on the audit committee, and
average board tenure.
Board independence is measured by the fraction of outside directors on the board (BI).
While outside directors have been defined in a number of ways in the literature (see, e.g.,
Rosenstein and Wyatt, 1990) we define company officers, family members of the
controlling shareholders, and related company officers as inside directors and others as
outside directors.
Directors who are officers of financial institutions are expected to be better monitors
because of their expertise. Furthermore, since they are likely to represent the interest of
financial institutions, they may be more independent than other outside directors. This
effect is likely to be far stronger in Canada than in the United States given the relatively
high concentration of the Canadian financial industry. The representation of financial
institutions on the board is measured by a dummy variable, FID, which takes on the value
of one if there are one or more directors who are officers of financial institutions.5
We also measure the degree of outside influence on the audit committee. An
independent audit committee could reduce agency problems in both widely held firms and
closely held firms through more effective monitoring. The independence of the audit
committee is measured by the proportion of outside directors on the committee (ODAC).
We use industry adjusted Q ratios and raw Q ratios as measures of firm value. The Q
ratio is measured as the sum of the market value of equity, the book value of preferred
stock and the book value of total debt divided by the book value of total assets. To

5
Using the number of directors as the proxy for the monitoring of financial directors we obtain essentially
identical results as reported in the paper. We further break FID down into variables representing different types of
financial institutions. Such variables do not provide significantly different results than FID alone.
J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410 397

compute an industry adjusted Tobin’s Q, each firm is assigned to an industry using the
primary SIC code of the firm. For industry classification, we use the twelve Toronto Stock
Exchange industry classifications shown in Table 1. Next, the industry adjusted Q ratio
(ADJQ) is calculated by subtracting the industry average Q ratio from the firm’s Q ratio.6
The ADJQ is used because, when we use the raw Q we have to control for the industry
fixed effects using industry dummies, which can be multicollinear with other variables and
reduce the power of the regression. By using the ADJQ we can mitigate the
multicollinearity associated with using the raw Q because we do not have to use industry
dummies to control for the industry fixed effect. The ADJQ has the same information as Q
but with less potential specification problems.
Finally, variables are included for firm size and financial leverage, as they are widely
used in firm value models (Agrawal and Knoeber, 1996; Bhagat and Black, 2001) as
controls for firm specific effects on firm value. Firm size is measured by the natural log of
total sales (FSIZE). Financial leverage is the ratio of total debt to total assets (LEV).

6.2. Descriptive statistics

Table 2 shows the descriptive statistics of the variables. The average and median
percentage of voting rights of the dominant shareholders (M1) is 25.2% and 17.1%,
respectively. Such a result confirms that the control represented by voting rights is
typically concentrated heavily in the hands of a few shareholders in Canadian
corporations. Twenty-four percent of all firms in our sample have dual class common
stock, suggesting that dual class common stock is widely used to further entrench
dominant shareholders in Canadian corporations. It also appears to be common to have
outside directors make up a large portion of the board. The mean and median percentages
of outside directors on the board (BI) are about 69% and 70% respectively. About 39% of
the sample firms have board representation by employees of financial institutions.
The fraction of outside directors (ODAC) on the audit committee is on average about
0.87 with the median firm having only outside directors serving on that committee. That is,
the median audit committee consists solely of outside directors. Our sample firms range in
size, from $8 million in sales to $33,191 million. This is in contrast to most U.S. studies,
which use only the largest firms in the country. The presence of smaller firms in our
sample is due to the fact that Global Vantage follows Canadian firms that differ widely in
size. Finally, the average debt ratio (LEV) is 25%.
Table 3 reports Pearson correlation coefficients for the range of variables. Table 3
shows that generally the board variables tend to be moderately correlated with one another.
However, board size and firm size are highly positively correlated suggesting that as firm
size increases, the number of directors serving on the board also increases. The
concentration of ownership in the hands of the dominant shareholder is correlated with
the existence of dual class shares for the firm. Such a relation suggests that many dominant
shareholders use dual class shares to increase their control over the firm.

6
We also calculate the industry adjusted Q ratio (ADJQ) by dividing the firm’s Q ratio with the industry
average Q ratio. The results are qualitatively similar, however.
398 J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410

Table 2
Descriptive statistics
Variables Mean S.D. Minimum Median Maximum
ADJQ 0.055 0.695 1.220 0.191 3.893
Q ratio 1.094 0.725 0.140 0.919 5.323
M1 0.252 0.258 0.000 0.171 0.906
DC 0.239 0.428 0.000 0.000 1.000
NUMDIR 10.685 2.904 4.000 11.000 18.000
BSIZE 2.327 0.300 1.386 2.398 2.890
BI 0.686 0.156 0.286 0.700 0.938
FID 0.385 0.487 0.000 0.000 1.000
ODAC 0.866 0.162 0.500 1.000 1.000
LEV 0.253 0.154 0.000 0.243 0.736
SALES 1833 3763 8 684 33,191
FSIZE 6.471 1.489 2.079 6.527 10.410
The table shows descriptive statistics of variables used for the analysis. It uses panel data consisting of 66 firms
observed for five consecutive years from 1993 to 1997. Q ratios are calculated as the ratio of the sum of the
market value of equity, the book value of preferred stock and the book value of debt to total assets. The industry
adjusted Q ratio (ADJQ) is calculated by subtracting the industry average Q ratio from the firm’s Q ratio. M1 is
the fraction of voting rights of the dominant shareholder. DC is the dummy variable for dual class common stock.
NUMDIR is the total number of directors on the board. BSIZE is the natural log of NUMDIR. BI is the fraction of
outside directors on the board. FID is the dummy variable for the presence of directors who are officers of
financial institutions. ODAC is the fraction of outside directors on the audit committee. LEV is the ratio of the
sum of short-term debt and long-term debt to total assets. SALES is net sales in millions of dollars. FSIZE is the
natural log of SALES.

Table 3
Pearson correlation coefficients
ADJQ M1 DC BSIZE BI FID ODAC FSIZE LEV
ADJQ 1.000
M1 0.132*** 1.000
DC 0.311*** 0.259*** 1.000
BSIZE 0.204*** 0.163*** 0.083 1.000
BI 0.221*** 0.349*** 0.016 0.194*** 1.000
FID 0.007 0.107* 0.110* 0.323*** 0.195*** 1.000
ODAC 0.117* 0.023 0.079 0.312*** 0.470*** 0.078 1.000
FSIZE 0.229*** 0.143*** 0.113* 0.658*** 0.181*** 0.234*** 0.400*** 1.000
LEV 0.222*** 0.050 0.014 0.245*** 0.153*** 0.260*** 0.188*** 0.292*** 1.000
The table shows the correlation between the industry adjusted Q ratio and the lagged explanatory variables using
a panel data consisting of 66 firms observed for five consecutive years from 1993 to 1997. Q ratios are calculated
as the ratio of the sum of the market value of equity, the book value of preferred stock and the book value of debt
to total assets. The industry adjusted Q ratio (ADJQ) is calculated by subtracting the industry average Q ratio
from the firm’s Q ratio. M1 is the fraction of voting rights of the dominant shareholder. DC is the dummy variable
for dual class common stock. BSIZE is the natural log of the total number of directors on the board. BI is the
fraction of outside directors on the board. FID is the dummy variable for the presence of directors who are officers
of financial institutions. ODAC is the fraction of outside directors on the audit committee. FSIZE is the natural log
of net sales. LEV is the ratio of the sum of short-term debt and long-term debt to total assets. The statistical
significance is based on the probability that the correlation is equal to zero.
* Significant at 10 percent.
*** Significant at 1 percent.
J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410 399

The ownership concentration is also negatively correlated with board independence.


The negative correlation appears to suggest that the dominant shareholders avoid outside
monitoring. However if outside directors are added to the board to placate non-dominant
shareholders when the firm does poorly, the negative correlation may merely reflect a
lesser need for such appeasement when there is heavy ownership concentration. Not
surprisingly, there is a fairly strong positive correlation between board independence and
audit committee independence.

7. Empirical results

7.1. Firm value analysis

An examination of firm value should indicate the impact of board composition on


minority shareholders. Table 4 shows a univariate analysis between firm value and board
independence. The observations are ranked according to the level of board independence
for each year. The firms in the quartiles with the greatest and the least independence are
chosen for the analysis for each year. Firm value, estimated using industry-adjusted Q
ratios, is calculated within each quartile for the following year. Tests of differences in
means between the firm values in the two quartiles are run for the years 1994 to 1997.
Despite consistent differentials between the two groups, the annual differences are
generally not significant due to a small number of observations. However, when
aggregated over the full period, the results become highly significant. The results in Table
4 suggest a potential negative relation between the two variables.
Moving to multivariate analysis, Table 5 reports the result of estimating the Eq. (1)
using the Parks (1967) generalized least squares method for panel data as described in

Table 4
Firm value quartile analysis
Difference in mean firm value
Year Top quartile firms in BI Bottom quartile firms in BI Difference
1994 0.219 [16] 0.204 [16] 0.423 (1.41)
1995 0.201 [17] 0.123 [16] 0.324 (1.37)
1996 0.185 [16] 0.095 [16] 0.281 (0.94)
1997 0.206 [19] 0.400 [17] 0.607 (1.85)*
Aggregate 0.214 [68] 0.201 [65] 0.415 (2.84)***
This table reports univariate analysis of firm value between the top quartile subsample and the bottom quartile
sub-sample ranked in terms of board independence (BI). Across the sample period firm value is measured at time
t and board composition is measured at t1. Firm value is measured by the industry adjusted Q ratio and board
independence is measured by the proportion of outside directors on the board. The industry adjusted Q ratio is
calculated by subtracting the industry average Q ratio from the firm’s Q ratio. Q ratios are calculated as the ratio
of the sum of the market value of equity, the book value of preferred stock and the book value of debt to total
assets. The number of firms in the quartile appears in square brackets to the right of the mean firm value for each
year. The t-statistics, calculated assuming unequal variances, appear in parentheses underneath the differences.
The statistical significance reported is two-tailed.
* Significant at 10 percent.
*** Significant at 1 percent.
400 J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410

Table 5
Firm value regression analysis
Ind. variables Industry adjusted Q ratio Q ratio
Constant 1.618 (5.41)*** 3.061 (8.32)***
M1 0.190 ( 2.36)** 0.068 ( 0.91)
DC 0.421 ( 13.14)*** 0.365 ( 15.37)***
BSIZE 0.373 ( 3.27)*** 0.627 ( 5.87)***
BI 1.208 ( 5.72)*** 0.837 ( 5.23)***
FID 0.240 (3.56)*** 0.231 (3.52)***
ODAC 0.550 (3.90)*** 0.115 (0.70)
FSIZE 0.032 ( 2.84)*** 0.015 (0.97)
LEV 0.837 ( 6.24)*** 0.843 ( 3.41)***
R-square 0.24 0.44
Sample size 264 264
The table uses regressions on panel data to estimate firm value as a function of the lagged board structure. To
estimate the model we use the Parks (1967) generalized least squares method for panel data as described in
Kmenta (1986, pp.616–625). M1 is the fraction of voting rights of the dominant shareholder. DC is the dummy
variable for dual class common stock. BSIZE is the number of directors on the board. BI is the fraction of outside
directors on the board. FID is the dummy variable for the presence of directors from financial institutions. ODAC
is the fraction of outside directors on the audit committee. FSIZE is the natural log of total sales. LEV is the ratio
of the sum of short-term debt and long-term debt to total assets. The dependent variable for the first regression is
the industry adjusted Q ratio. The industry adjusted Q ratio is calculated by subtracting the industry average Q
ratio from the firm’s Q ratio. Q ratios are calculated as the ratio of the sum of the market value of equity, the book
value of preferred stock and the book value of debt to total assets. In the last regression unadjusted Q ratios are
used as the dependent variable and industry dummies are used to control for industry fixed effects. The regression
coefficients of industry dummies are not reported. Q ratios are calculated as the ratio of the sum of the market
value of equity, the book value of preferred stock and the book value of debt to total assets. The t-statistics in
parentheses are adjusted for cross-sectional heteroskedasticity and autocorrelation. The statistical significance
reported is two-tailed.
** Significant at 5 percent.
*** Significant at 1 percent.

Kmenta (1986, pp. 616–625), which adjusts for cross-sectional heteroskedasticity and
autocorrelation. In the first regression, we use the industry adjusted Tobin’s Q as the
measure of firm value. In the second regression the unadjusted Tobin’s Q ratio is used as
the dependent variable. All the independent variables are measured at time t1 when
estimating the Q ratio or adjusted Q ratio at time t.
The coefficient of dominant shareholder voting rights in the regression of the industry
adjusted Q is negative and significant, although the coefficient is not significant in the
unadjusted Q ratio regression. The findings suggest that the existence of a dominant
shareholder has a significant negative effect on firm value compared to other firms within
the industry. This result provides some support for the argument that there is expropriation
of wealth from minority shareholders to dominant shareholders in the firm. Also in support
of this interpretation the existence of dual class common stock (DC) has a highly
significant negative relation with firm value in both regressions.
A significant negative coefficient for the board independence variable (BI) indicates
that firm value has a negative relationship with the proportion of outside directors in
Canada. It also implies that outside directors are generally not effective monitors in a
J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410 401

Canadian-type governance environment. This is consistent with the results of Hermalin


and Weisbach (1991); Agrawal and Knoeber (1996), and Bhagat and Black (1999) who
point out that poorly performing firms are likely to add additional outside board
members. This can be explained if poorly performing firms add outside directors
simply to appease unhappy investors rather than for the purpose of increasing firm
value.
This Canadian result is consistent with that of Bhagat and Black (2001) who also
document the negative effect of board independence on firm value in the United States.
Further, Bhagat and Black (1999) suggest that an optimal board contains a mix of inside,
independent, and even affiliated directors, who bring different skills and knowledge to the
board. Similar to Bhagat and Black (1999), we document that a shift in board composition
has also occurred in Canada from boards dominated by the inside directors to boards
dominated by outside directors.
Our results also suggest that the type of outside director on the board can make a
difference. The existence of financial institution directors on the board has a significant
positive effect on firm value. This is true for both regressions. This result suggests that in
the Canadian corporate governance environment it is not the proportion of outside
directors on the board that affects firm value but the type of director. More specifically, this
result is consistent with the hypothesis that directors from financial institutions provide
monitoring benefits to the firm.
We note that this result is also consistent with the lender monitoring hypothesis
discussed in Fama (1985). The positive and significant correlation between FID and LEV
in Table 3 suggests that there is a lending relation between financial institutions with
which FIDs are affiliated and firms where FIDs serve as directors. Therefore, FID may
also proxy for lender monitoring.
Moreover, there is also evidence that the greater the proportion of outside directors
on the audit committee, the more they contribute to firm value. This result is consistent
with the hypothesis that expertise counts for directors since the members of the audit
committee are generally chosen from those members of the board that have superior
accounting and financial expertise.7 Thus, even with a high degree of dominant
shareholder ownership, adding knowledgeable board members who have greater expertise
and greater incentives to participate in corporate governance will tend to increase firm
value.
In unreported regression estimations, we divide the sample into larger firms and
smaller firms by size to investigate any possible differences between larger firms and
smaller firms. The parameter estimates of the sub-samples are consistent with those of
the overall regressions. Similarly, unreported regressions examine the non-linear effect
of board independence on firm value using the square of the board independence

7
To determine whether the outside directors on the audit committee in our sample are indeed selected for their
financial expertise, we measure the proportion of those outside directors with considerable business and financial
expertise on the audit committee. We consider unrelated company officers, financial institutions officers, former
bankers, consultants, and corporate directors as well as corporate lawyers as directors with financial expertise.
Similar to Xie et al. (2003), who use essentially the same classification scheme, we find that most of the outside
directors on the audit committee (88.8%) in our sample appear to have financial expertise.
402 J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410

variable (BIP2). Since BIP2 turns out to be highly collinear with BI, we regress BIP2
on BI and extract the residuals of BIP2. We then use these residuals in the place of
BIP2 in the regression equation. The coefficient estimate of the residuals of BIP2 is
not significant suggesting that the effect of board independence on firm value does not
have a non-linear component.

7.2. Board independence analysis

A further question is that of the determination of board independence. The prior


section showed evidence that board independence reduces firm value in the following
period. An obvious corollary would be to determine if firm value impacts board
independence in the following period. Table 6 examines a univariate analysis in which
the firms are ranked by firm value and divided into quartiles. The top and bottom
quartiles are chosen and board independence is determined for the following period. We
then test for differences in mean board independence between the two quartiles. Again,
by aggregating over all years to deal with the small annual sample, the results are
consistent with the notion that poorly performing firms have more outside directors in
subsequent years.
Table 7 examines board independence in a multivariate regression framework. We
find that the coefficient of firm value is negative and significant suggesting that
weaker firm performance tends to lead to greater board independence in the next year.
We also find that board independence is highly negatively related to dominant
shareholder ownership. The results suggest that dominant shareholders attempt to use
their voting power to reduce the degree of board independence for entrenchment
purposes.

Table 6
Board independence quartile analysis
Difference in mean board independence
Year Bottom quartile firms in firm value Top quartile firms in firm value Difference
1994 0.686 [16] 0.605 [16] 0.081 (1.77)*
1995 0.733 [16] 0.658 [16] 0.075 (1.52)
1996 0.724 [16] 0.636 [16] 0.088 (1.70)*
1997 0.718 [16] 0.683 [16] 0.035 (0.64)
Aggregate 0.715 [64] 0.645 [64] 0.070 (2.78)***
This table reports univariate analysis of board independence between the top quartile subsample and the bottom
quartile sub-sample ranked in terms of firm value. Across the sample period, board composition is measured at
time t and firm value is measured at t1. Firm value is measured by the industry adjusted Q ratio and board
independence is measured by the proportion of outside directors on the board. The industry adjusted Q ratio is
calculated by subtracting the industry average Q ratio from the firm’s Q ratio. Q ratios are calculated as the ratio
of the sum of the market value of equity, the book value of preferred stock and the book value of debt to total
assets. The number of firms in the quartile appears in square brackets to the right of the mean board independence
for each year. The t-statistics, calculated assuming unequal variances, appear in parentheses underneath the
differences. The statistical significance reported is two-tailed.
* Significant at 10 percent.
*** Significant at 1 percent.
J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410 403

Table 7
Board independence regression analysis
Ind. variables Model 1 Model 2 Model 3
Constant 0.437 (9.93)*** 0.443 (8.64)*** 0.389 (4.79)***
ADJQ 0.054 (7.30)*** 0.077 (4.90)***
Q ratio 0.051 (5.71)***
M1 0.268 (12.17)*** 0.235 (10.63)*** 0.295 (7.52)***
DC 0.007 (0.68) 0.001 (0.14) 0.012 (0.54)
BSIZE 0.013 (0.77) 0.062 (3.55)*** 0.009 (0.23)
FID 0.025 (3.32)*** 0.036 (3.86)*** 0.034 (1.76)*
ODAC 0.269 (6.40)*** 0.228 (5.78)*** 0.298 (5.09)***
FSIZE 0.008 (1.49) 0.009 (1.54) 0.011 (1.40)
LEV 0.016 ( 0.64) 0.062 (1.72) 0.005 ( 0.09)
R-square 0.40 0.46 0.40
Log likelihood 90.39
Sample size 264 264 264
This table examines board independence at time t as a function of firm value at t1 using a panel data. For
Models 1 and 2, we use the Parks (1967) generalized least squares method for panel data as described in Kmenta
(1986, pp. 616–625). For Model 3, we use tobit regression where the limit observation is 0.5. The dependent
variable, BI, is the fraction of outside directors on the board. ADJQ is the industry adjusted Q ratio. Q ratio is the
unadjusted firm’s Q ratio. The Q ratios are calculated as the ratio of the sum of the market value of equity, the
book value of preferred stock and the book value of debt to total assets. The industry adjusted Q ratio is calculated
by subtracting the industry average Q ratio from the firm’s Q ratio. M1 is the fraction of voting rights of the
dominant shareholder. DC is the dummy variable for dual class common stock. BSIZE is the natural log of the
number of directors on the board. FID is the dummy variable for the presence of directors who are officers of
financial institutions. ODAC is the fraction of outside directors on the audit committee. FSIZE is the natural log of
total sales. LEV is the ratio of the sum of short-term debt and long-term debt to total assets. The tests control for
industry fixed effects in the second regression model. However, the coefficients on the industry dummies are not
reported. The t-statistics adjusted for cross-sectional heteroskedasticity and autocorrelation appear in parentheses.
The statistical significance reported is two-tailed.
* Significant at 10 percent.
*** Significant at 1 percent.

Board independence is not significantly related to the existence of dual class stock in
any of the specifications. Board independence is, however, significantly related to having a
director from a financial institution on the board and having outside directors on the audit
committee. We note that both of these regressors could be casually related. For example, if
financial directors were added to the board, it would seem reasonable that they would be
more likely to be added to the audit committee given their financial expertise, thereby
increasing audit committee independence.
If board composition is required to have a strict majority of outside board members,
the lower limit of the BI variable will be 0.5 and this variable will be censored at this
point. However, the corporate governance regulation during the study period was not
coercive but was based on moral suasion. Consistent with this regulatory framework
about 12% (41 out of 330) of the observations fall below the blimitingQ observation
with the minimum percentage of outside directors on the board in our sample being
28.6% (Table 2) showing that the BI is not strictly censored at 50%. However, since
there is a strong tendency for the firms to maintain a majority of outside directors
consistent with the censoring argument, we re-estimate the board independence
404 J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410

equation using tobit regression with the limiting value of 50%. The tobit estimation
result, which is reported in the last column of Table 7, gives qualitatively the same
result as the OLS panel regression.

7.3. Contemporaneous relations

We also examine contemporaneous changes in the board control variables as a


robustness check. In the previous tables firm value is significantly related to the prior
period’s board independence variable while board independence is similarly significantly
related to the prior period’s firm value. An obvious question, however, is whether the
relations survive when examined contemporaneously. To the extent that the prior results
are robust, the significant relation between the two variables should remain when
contemporaneous changes are examined. Table 8 examines changes in firm value and
board independence. The dual class variable was not included due to the lack of significant
year-to-year changes in the variable.
In Table 8 panel data from 1993 to 1997 is used to estimate the relation. Clearly, the
negative relation between firm value and board independence survives even when looking
at year-to-year changes. Similarly, the positive estimates for directors from financial

Table 8
Effect of changes in board independence on changes in firm value
Ind. variables D Industry adjusted Q ratiot
Constant 0.012 (1.44)*
DM1t 0.138 (1.84)*
DBSIZEt 0.003 (0.38)
DBIt 0.463 (3.15)***
DFIDt 0.109 (10.11)***
DODACt 0.444 (4.22)***
DFSIZEt 0.045 (1.53)
DLEVt 0.155 (1.50)
Log likelihood 46.51
Sample size 264
This table examines the effect of changes in board composition variables on changes in firm value using panel
data. To estimate the model, we use the Parks (1967) generalized least squares method for panel data as described
in Kmenta (1986, pp. 616–625). Change in firm value is measured by the change in industry adjusted Q ratio. The
industry adjusted Q ratio is calculated by subtracting the industry average Q ratio from the firm’s Q ratio. Q ratios
are calculated as the ratio of the sum of the market value of equity, the book value of preferred stock and the book
value of debt to total assets. DM1 is the change in the voting interest of the largest block. DBSIZE is the change in
the number of directors. DBI is the change in the fraction of outside directors on the board. DFID is the change in
FID, which is the change in the number of directors who are officers of financial institutions. DODAC is the
change in the fraction of outside directors on the audit committee. DFSIZE is the percentage change in the firm
size where the firm size is measured by net sales. DLEV is the change in the financial leverage where the financial
leverage is measured by the ratio of the sum of short-term debt and long-term debt to total assets. All changes are
contemporaneous. The t-statistics adjusted for cross-sectional heteroskedasticity and autocorrelation appear in
parentheses. The statistical significance reported is two-tailed.
* Significant at 10 percent.
*** Significant at 1 percent.
J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410 405

Table 9
Comparison of time series variations of Q ratios vs. board and ownership variables
Variables Mean S.D. Coefficient Percent of firms
of variation with zero S.D.
ADJQ 0.055 0.232 4.182 0%
Q ratio 1.094 0.254 0.232 0%
M1 0.252 0.057 0.226 18%
DC 0.239 0.007 0.029 98%
NUMDIR 10.685 0.428 0.040 21%
BSIZE 2.327 0.069 0.030 3%
BI 0.686 0.056 0.082 2%
FID 0.385 0.154 0.400 68%
ODAC 0.866 0.060 0.069 42%
The table shows the time series variability of Q ratios as opposed to board and ownership variables of the sample
firms. It uses a panel data consisting of 66 firms observed for five consecutive years from 1993 to 1997. We first
estimate the time series standard deviation of Q ratios and adjusted Q ratios for each firm and average these across
firms. Then, we estimate the time series standard deviation of board and ownership variables for each firm and
average these across firms. Finally, we calculate the coefficients of variation by dividing the standard deviation by
the sample average. We also report the percentage of firms with zero time series standard deviations.
Q ratios are calculated as the ratio of the sum of the market value of equity, the book value of preferred stock and
the book value of debt to total assets. The industry adjusted Q ratio (ADJQ) is calculated by subtracting the
industry average Q ratio from the firm’s Q ratio. M1 is the fraction of voting rights of the dominant shareholder.
DC is the dummy variable for dual class common stock. NUMDIR is the total number of directors on the board.
BSIZE is the natural log of NUMDIR. BI is the fraction of outside directors on the board. FID is the dummy
variable for the presence of directors who are officers of financial institutions. ODAC is the fraction of outside
directors on the audit committee.

institutions and for outside directors on the audit committee also are consistent with our
previous estimates.

7.4. Endogeneity

In an effort to circumvent the endogeneity problem that affects the OLS estimation
models, a heuristic approach is used to investigate qualitatively the likely direction of
causality. The heuristic consists of comparing the variabilities of the Q ratios and adjusted
Q ratios with those of board and ownership variables. If the former are clearly larger than
the latter, it is more plausible that the variation in Q is bcausedQ by the variation in board
and ownership structure rather than the converse, i.e., direct causality is more likely than
reverse causality.8
Table 9 shows the time series variabilities of the Q ratios as well as the adjusted Q
ratios as opposed to board and ownership variables of the sample firms. It uses panel data
consisting of 66 firms observed for five consecutive years from 1993 to 1997. The
estimated time series standard deviations of the Q ratios and the adjusted Q ratios for each
firm are averaged across these firms. We do the same for the estimated standard deviations
of the board and ownership variables. Finally, we calculate the coefficients of variation by

8
We thank a referee for the suggestions leading to Table 9 and discussion concerning it.
406 J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410

dividing the standard deviation by the sample average. We also report the percentage of
firms with zero time series standard deviations.
The CV of the adjusted Q is 4.182 and that of the raw Q ratio is 0.232, which are
substantially larger than those of the ownership and board variables (with the exception of
FID). The percentage of firms with a standard deviation of zero for both the adjusted and
raw Q ratios is zero while those for the ownership and governance variables range from
2% to 98%. This comparison of variabilities as measured by the coefficient of variation as
well as the percentage of firms with zero standard deviation indicates that Q ratios and
adjusted Q ratios are clearly more variable than board and ownership variables. This result
is consistent with the interpretation that direct causality is more likely than reverse
causality.
An alternative and more direct way to deal with endogeneity in this context is to carry
out an event study.9 For example, an event study which examines the effect of
announcements of outside directors joining the board may allow us to better determine
the existence or non-existence of direct causality. Using the announcements of director
appointments for the study period of 1993 to 1997 found in the CBCA (Canadian Business
and Current Affairs) as well as Canadian Newsstand databases we identify 11 usable
appointment announcements of outside directors.10
We use the standard market adjusted return model to find the cumulative average
abnormal return (CAAR) of the sample where the market index used is the TSE 300 Total
Return Index.11 The abnormal return is simply the total daily return of the issue minus the
corresponding market return. A cumulative abnormal return over [1, 1] event window
was calculated for each firm. The 3-day CAAR is 0.848%, which is statistically
insignificant ( p-value is 0.16). This result, albeit based on a very small sample size, is not
inconsistent with the result from the regression analysis, which indicates that outside board
appointments in the period did not improve firm value.12 Clearly, however, this event
study does not address reverse causality at all. Furthermore, the very small number of
usable announcements found in the CBCA and Canadian Newsstands databases does not
allow us to investigate the announcement effect of directors from financial institutions
joining the board or events which reduce inside voting interests.

9
Again, we thank the referee for this suggestion regarding how we might better address the endogeneity
problem.
10
Using search tools, we identified 210 new director appointment announcements in the databases during the
study period. After removing announcements made by firms which are not found in the TSE/Western database
and inside director announcements related to appointments of CEOs or other officers of the firm to the board as
well as announcements of outside director appointment which occur simultaneously with other major corporate
announcements, the sample of outside director announcements is reduced to 11.
11
The TSE 300 daily price index is a float weighted price index of the top 300 (ranked by dollar value of float
outstanding) stocks listed on the Toronto Stock Exchange. The TSE Total Return Index is identical to the TSE 300
Price Index in terms of securities included. However, the value of the index incorporates dividends as well
changes in price. When we use the CFMRC (Canadian Financial Market Research Center) value weighted index
to calculate the market return adjusted abnormal return, we also get qualitatively the same result. Finally, when we
use the market model, we get qualitatively the same result.
12
We believe the reasons why we capture only 210 announcements are (1) most Canadian firms did not
dadvertiseT these announcements in the newspapers during the period and (2) the CBCA and Newsstand data
bases did not make an effort to capture director announcements during the period.
J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410 407

A further robustness check is to use two-stage least squares regressions to examine the
potential endogeneity of board independence. While simultaneous regressions can deal
with the bias induced in OLS results by endogeneity, they are often more sensitive than
OLS to model misspecification. Furthermore, since it is difficult to identify appropriate
instrument variables to carry out the two stage regression analysis correctly for the two
equations on hand, we rule out this approach.

7.5. Outside directors and dual class common stock

Given the strong significance of dual class stock in the firm value regressions, which
lends support to the dominant shareholder expropriation hypothesis, we pursue a more in-

Table 10
Firm value, outside directors and dual class common stock
Ind. variables Model 1 Model 2 Model 3 Model 4
Constant 1.830 (5.81)*** 1.663 (5.73)*** 1.752 (5.77)*** 1.480 (4.57)***
M1 0.227 (2.62)** 0.148 (1.97)** 0.192 (2.27)** 0.179 (2.32)**
DC 1.618 (7.81)*** 0.591 (13.73)*** 1.646 (4.50)*** 0.096 (0.40)
BSIZE 0.365 (3.59)*** 0.363 (3.16)*** 0.296 (2.49)*** 0.367 (3.10)***
BI 1.554 (6.45)*** 1.151 (5.47)*** 1.169 (5.56)*** 1.238 (5.47)***
DC*BI 1.806 (6.31)***
FID 0.221 (4.50)*** 0.146 (1.84)* 0.207 (3.05)*** 0.231 (3.41)***
DC*FID 0.405 (4.66)***
ODAC 0.532 (4.09)*** 0.472 (3.10)*** 0.219 (1.25) 0.571 (3.74)***
DC*ODAC 1.385 (3.59)***
LTENURE 0.069 (1.55)
DC*LTENURE 0.156 (1.27)
FSIZE 0.028 (2.59)*** 0.031 (2.86)*** 0.036 (3.73)*** 0.034 (2.88)***
LEV 0.783 (6.17)*** 0.903 (6.50)*** 0.909 (6.52)*** 0.805 (7.23)***
R-square 0.27 0.26 0.26 0.24
Sample size 264 264 264 264
The models of firm value as a function of outside directors in dual class common stock firms use balanced panel
data. To estimate the model, we use the Parks (1967) generalized least squares method for panel data as described
in Kmenta (1986, pp. 616–625). The panel consists of 66 Canadian firms observed over the 1993–1997 period.
We measure firm value at time t and explanatory variables at t1. We measure the firm value using the industry-
adjusted Q ratio. The industry adjusted Q ratio is calculated by subtracting the industry average Q ratio from the
firm’s Q ratio. Q ratios are calculated as the ratio of the sum of the market value of equity, the book value of
preferred stock and the book value of debt to total assets. M1 is the fraction of voting rights of the dominant
shareholder. DC is the dummy variable for dual class common stock. BSIZE is the natural log of the number of
directors on the board. BI is the fraction of outside directors on the board. FID is the dummy variable for the
presence of directors who are officers of financial institutions. ODAC is the fraction of outside directors on the
audit committee. LTENURE is the natural log of the average tenure of all directors. FSIZE is the natural log of net
sales. LEV is the ratio of the sum of short-term debt and long-term debt to total assets. In all regressions industry
adjusted Q ratios are used as the dependent variable. The interaction variables tested are as follows: DC*BI is the
interaction of DC and BI; DC*FID is the interaction of DC and FID; DC*ODAC is the interaction of DC and
ODAC; DC*LTENURE is the interaction of DC and LTENURE. The t-statistics adjusted for cross-sectional
heteroskedasticity and autocorrelation appear in parentheses. The statistical significance reported is two-tailed.
* Significant at 10 percent.
** Significant at 5 percent.
*** Significant at 1 percent.
408 J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410

depth analysis of the effect of the board composition on the relation between firm value
and the dual class variable. Table 10 reports the regression results of four alternative
specifications using the adjusted Q ratio as the dependent variable.
In Model 1 the interaction of dual class common stock and board independence is
examined by including an interaction term between the two.13 The coefficient estimate of
DC*BI is positive and significant. Indeed the introduction of DC*BI actually increases the
significance of BI. The positive interaction term suggests that greater board independence
can alleviate some of the agency problems associated with dual class common shares.
Although independent directors do not appear to benefit the firm overall, they appear to be
able to reduce some of the loss in value from the existence of dual class common equity.
In Model 2, we test the hypothesis that directors who are officers of financial
intermediaries enhance firm value by mitigating the agency problem of concentrated
ownership by examining the interaction of DC with FID. Much like the board
independence interaction term, the results indicate that a firm that has a director from a
financial institution will partially alleviate the negative impact of the existence of dual
class common stock on firm value.
The fraction of outside directors on the audit committee may have a positive effect on
firm value since they are likely to be more independent and more sophisticated in
accounting and finance than other outside directors. The interaction of DC and ODAC in
Model 3 is positive and significant, suggesting again that more sophisticated directors tend
to temper the negative impact of the existence of dual class common stock.
Directors with long tenure should become more knowledgeable about the firm and
could have a positive influence on firm value. Model 4 examines the effect on firm value
of the interaction of DC and LTENURE, where LTENURE is the natural log of the average
tenure of all directors on the board. The coefficient of the interaction term lacks
significance. This suggests that longer tenured directors do not reduce agency problems in
dual class common stock firms.
For three of the four models in Table 9, the results are highly suggestive that a properly
designed board can alleviate some of the agency problems associated with dual class
common shares. The evidence in Table 9 suggests the complexity of the interactions of the
board composition variables.

8. Summary and conclusions

Even in an economy with strong legal protections for shareholders, a well-structured


board can enhance shareholder value through monitoring managerial behavior. Further-
more, a well-structured board is not necessarily an outsider-dominated board as is
commonly assumed. The evidence presented in this paper indicates there is a negative
relation between board independence and firm value. This result is inconsistent with the

13
Since DC*BI is highly collinear with both DC and BI, we also use its residuals as the regressor. First, we
regress the cross product on both DC and BI, collect the residuals, and then use them as the regressor. The
residuals of DC*BI are expected to contain all the information which is not collinear with DC and BI. The result
is essentially identical.
J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410 409

argument that greater board independence provides monitoring benefits. But, this negative
relation is consistent with the explanation that poorly performing firms add additional
outside board members primarily to appease unhappy investors. At the same time, our
evidence appears to suggest that greater board independence does not lead to better
performance in the future. Therefore, our results are consistent with the explanation that
adding directors in order to placate unhappy shareholders has a negative impact on firm
performance.
On the other hand, the evidence also suggests that the presence of outside directors who
are officers of financial institutions increases firm value in Canada. The higher value
appears to come from their ability and incentive to monitor effectively. Similarly, the
existence of outside directors appears to increase firm value if they also sit on the audit
committee. In other words, their role on a board is valuable when they can supply their
expertise to the company’s audit committee.
It should also be noted that it is possible that officers of financial institutions are
selected to provide their expertise on the capital market to the board and the management.
That is, in addition to their monitoring role, the directors who are officers of financial
institutions may play a role in advising management. There are studies that indicate that
the value of outside directors comes from their expertise. Rosenstein and Wyatt (1990)
show a positive stock price reaction to the appointment of outside directors even when
outside directors already constitute a majority, suggesting that outside directors provide
expertise to management that improves its decision making.
Finally, our results also suggest that there is a negative relation between the existence of
dual class common stock and the value of the firm but adding additional outside directors
to the board reduces the negative impact of dual class common shares on firm value. This
would suggest that even though board independence by itself reduces firm value, it
alleviates the agency problems created by dual class common stock. Agency costs brought
on by dual class common stock also appear to be mitigated by the presence of outside
directors who are officers from financial institutions and outside directors that sit on the
audit committee. It appears that firms add outside directors to the board when the firm is
doing poorly, but the additional directors do not appear to be able to change the
performance of the firm. Taken together, our findings suggest that sound governance
practices can enhance firm value in countries with high ownership concentration.
LaPorta et al. (2000) present a perspective that the legal environment is important for
the protection of minority shareholders. Dyck and Zingales (in press) report evidence that
there is considerable protection of minority shareholders in Canada. However, our findings
suggest that board structure is an important factor in providing shareholder protection even
in the presence of a legal environment giving minority shareholders significant protection.
Nevertheless, we cannot completely rule out the problem of endogeneity between firm
value and board independence. To this extent our evidence is not entirely robust.

Acknowledgement

We thank Ko Wang, Su Chan, Mark Stohs, Zekiye Selvili and Mengxin Zhao for their
helpful comments.
410 J. Erickson et al. / Pacific-Basin Finance Journal 13 (2005) 387–410

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