The implementation of corporate governance reforms has deep roots that relate to the historical experiences of the country and structural changes in the global economy, which also determine the nature of the reforms. CG reforms have gained attention over the last two decades due to unusual business practices and major corporate scandals around the world (e.g., BBCI bankruptcy, Enron, Worldcom and Tyco). In some cases, these events led to specific responses and implementation of new rules, laws and practices (e.g., Sarbanes-Oxley Act). These reforms are essential for both developed and developing countries in order to compete in a global economy.
Popescu (
2019) presents the fact that such regulation should consider not only corporate governance but also corporate social responsibility for their roles in determining financial (and non-financial) performance as the sustainable aspects and practices of entities worldwide. Nevertheless, such reforms will contribute to reaching this aim.
The expected effect of CG reforms is the generation of growth and development. Firstly, the reforms help to provide legitimacy for governments that want to develop a more efficient corporate structure in order to generate better conditions for growth and development. Secondly, reforms tend to contribute to increasing the number of available investment funds by expanding investment opportunities for foreign investors as well as for domestic institutional investors. This covers changing limits on foreign direct investment, facilitating agreements between domestic and foreign companies, and achieving current account convertibility for the repatriation of profits. These reforms not only increase the available investment funds but also contribute to the efficient allocation of such funds. Thirdly, CG reforms promote efficiency among domestic firms and enable them to compete with foreign companies that enter the market. CG reforms tend to increase market pressure for both financial and product markets through opening domestic markets to foreign investors, trade liberalization and FDI liberalization. These measures force domestic firms to be more innovative and to focus on export activities in order to face the competition in the market (
Reed 2002).
2.1. Corporate Governance Reforms and Firm Performance
Investor protection is a crucial aspect because, in many countries, expropriation of minority shareholders by the concentrated shareholders is practiced at a large scale.
La Porta et al. (
2000) argue that the fundamental premise of investor protection is preventing the expropriation of minority investors. The existing literature has demonstrated the implication of investor protection in various aspects. First, strong investor protection results in more accurate financial reporting (
Leuz et al. 2003) and more arbitrage (
Morck et al. 2000), both of which contribute to development capital markets.
La Porta et al. (
1998) show that countries with better investor protection have more extensive and deeper capital markets. Moreover, countries with higher investor protection have a higher valuation of listed firms relative to their assets (
La Porta et al. 2002;
Claessens et al. 2002). In countries with stronger investor protection, the shareholders are less likely to expropriate firms’ resources and more likely to invest in projects that benefit both majority and minority shareholders (
Wurgler 2000;
Shleifer and Wolfenzon 2002;
Bekaert et al. 2010). Therefore, firms can easily access external finance for valuable projects (
La Porta et al. 2006).
Mclean et al. (
2012) show that firms that are located in countries with stronger minority shareholders protection laws benefit more from investment and external finance, and this leads to higher firm performance. Furthermore, they argue that minority shareholders expropriation is the primary channel through which corporate governance affects the firm value.
Earlier studies examining the impact of corporate governance reforms focused on specific countries. In 1992, The Cadbury Committee in the U.K. issued The Code of Best Practice, which covers the suggestions on the structure and duties of corporate boards of directors. Most of the studies generally report little correlation, (
Coles et al. 2008), no correlation (
Hermalin and Weisbach 1991) or even negative association (
Agrawal and Knoeber 1996;
De Andres et al. 2005;
Cho and Kim 2007) between the board composition and the firm performance.
Dahya and McConnell (
2007) evaluate the impacts of the Cadbury Report representing an exogenous shock for U.K. firms. The critical question addressed is whether the U.K. firms that came into compliance with the Cadbury Report requirements experienced an improvement in their performances. The authors find that companies that add more outside directors to conform with the Cadbury standards experience a significant increase in the operating performance (ROA). The second part of the analysis considers the recommendation that involves the separation of CEO and Chairman of the Board positions, but the authors find no effect on firm performance or the stock price.
In response to some severe corporate accounting scandals, the U.S. Congress passed the Sarbanes-Oxley Act in July 2002 to strengthen financial reporting and corporate governance. The act aimed to prevent fraudulent accounting and management misconduct and consequently to reestablish investors’ confidence in the U.S. market. It enforced additional disclosure requirements and insisted on stronger oversight by proposing substantive corporate governance mandates, a new practice in the federal securities legislation. The impact of this legislation has been under debate for a long time because, despite the declared benefits, the business community had significant concerns about its costs.
Zhang (
2007) finds that the cumulative abnormal returns of the U.S. firms and foreign firms conforming with SOX are negative and statistically significant. The investigation performed by
Chhaochharia and Grinstein (
2007) concludes that firms that were less compliant with new governance rules realize a greater value improvement compared to more compliant firms. Similarly,
Li (
2014) examining the short- and long-term impact of SOX cross-listed foreign private issuers concludes that the costs of the compliance substantially exceed its benefits. On the other hand,
Bhagat and Bolton (
2013) find a significant negative relationship between board independence and firm performance during the pre-SOX period (before 2002) but a positive and significant relationship in the post-SOX period (after 2002). Between 2003–2007, greater board independence was positively associated with firm performance (
Bhagat and Bolton 2019). This outcome is explained by the fact that when a company switches from noncompliant to compliant with SOX requirements, the market response is positive. Moreover,
Bhagat and Bolton (
2019) show that there is a significant positive relationship between corporate governance and firm performance.
The discussion about the role of strong governance systems indicates that more efficient distributions of capital resources lead to economic growth and intensify the likelihood of investors receiving their required return (
La Porta et al. 1999). However, it is not clear how an economy with weak governance can improve investment and encourage economic growth. To investigate this,
Price et al. (
2011) examine the impact of compliance with Mexico’s Code of Best Corporate Practices on the firm performance and financial reporting transparency to evaluate the efficiency of the reform. In Mexico, as a developing economy with a significant lack of investor protection, concentrated ownership is generally the dominant ownership structure. Issued by the National Banking and Securities Exchange Commission, the aim of the Code was definitely to fortify the corporate governance system in Mexico in order to increase corporate transparency and to gain investor’s confidence. Some key specifications of the Code referred to the board structure (reducing the size between 5 and 20 directors and having at least 20% outside directors) and to the design of separate board committees to manage finance, auditing and executive compensation. Mexico showed an evident loyalty to the enhancement of governance transparency by insisting on reporting of compliance with the Code, as well as by improving the rights of minority shareholders in the Securities Market Laws of 2001.
Core et al. (
2006) show that compliance with the Code showed a dramatic increase over the sample period, from 28% to 79%. The growth in compliance can be explained by the hypothesis of
Bushman et al. (
2004), which says that when the protection of outside investors’ rights increases, their demand for financial and governance transparency also increases. Although compliance with the new Code significantly increased over time, the results show that this is not associated with significant improvement in the firm performance. However, there is one exception: greater audit committee compliance generates significantly better operating performance and market returns.
Based on the fact that independent directors are usually considered to be vital elements of sustainable corporate governance,
Black and Kim (
2012) employ 1999 Korean law as an exogenous shock to identify whether the board structure has an impact on the firm value. In 1999, as a reaction to the 1997–1998 East Asian financial crisis, Korea implemented new governance rules, which started to be effective entirely in 2001. The law requires large firms to have 50% outside directors and an audit committee with an independent director and at least 2/3 outside members. For smaller firms, the law demands at least 25% outside directors. The authors identify whether there is a considerable change in the market value of large firms relative to smaller firms both in size (Tobin’s Q) and in time. Considering the period before, during and after the reform started to be effective, the authors report a significant causal relationship between board structure and the firm value. Although the board independence contributes the most to the increased value of the value, audit committees also have a substantial impact on the performance.
India also experienced CG reforms in 2004 with the adoption of Indian Clause 49. It is classified as significant governance reforms with mandatory provisions, based on different active implementation periods for large, medium- and small-sized firms.
Black and Khanna (
2007) examine the market reaction of Indian firms to the announcement of the new CG reforms and find positive stock market responses. This result implies that the market accepts that the necessary CG reforms are beneficial and value-enhancing.
The number of studies examining the impact of exogenous changes in CG practices on firm performance is limited, especially for a worldwide sample. The quality of CG could also be affected by several corporate board reforms, which also aim to improve the firm value. These reforms are recommended for greater board independence, audit committee independence and separation between chairman and CEO positions. Scholars give considerable attention to these reforms because they can be used as exogenous shocks for the investigation of the relation between board compositions and firm performance. A unique study by
Fauver et al. (
2017) investigates the relationship between corporate board reforms and firm value around the world, focusing on 41 distinct countries from 1990 to 2012. The authors conclude that the board reforms have a significant positive impact on the firm value. This finding is in line with the studies that assess the impact of board independence on the firm performance (
Luan and Tang 2007;
Dahya et al. 2002,
2008;
Aggarwal et al. 2010;
Liu et al. 2015;
Zhu et al. 2016;
Uribe-Bohorquez et al. 2018).
2.2. Corporate Governance Reforms Protecting Minority Shareholders and Firm Performance
Improvements in corporate governance aim to mitigate agency conflicts between management and shareholders, which is called the traditional principal-agent problem (
Renders and Gaeremynck 2012). On the other hand, the principal-principal agency conflict arises when concentrated shareholders abuse their ownership control to extract private benefits at the expense of minority shareholders (
Jensen and Meckling 1976). In the principal-principal agency conflict (
Thomsen et al. 2006), concentrated shareholders have the power as well as the incentive to divert corporate resources to themselves. The corporate governance research shows that such conflicts are more pronounced in countries with weak legal protection of minority shareholders (
Claessens and Fan 2002;
La Porta et al. 2000;
Young et al. 2008). Expropriation can happen in different ways: in some countries, the concentrated shareholders directly steal profits, while in other countries, they sell the assets that minority shareholders have financed to another entity they own at a price below the market price (
La Porta et al. 2000).
Even though the literature does not provide direct evidence for the positive impact of protecting minority shareholders reform on the firm performance, the arguments mentioned above highlight the possible positive impact of the reforms. When a country introduces reforms, which aim to limit the opportunistic behavior of controlling shareholders, minority shareholders feel more confident, because the risk of not getting a return is diminished (
Roe 2000;
Bae et al. 2012). As a consequence, the firms benefit more from external finance and increases in performance, suggesting the following hypothesis:
Hypothesis 1 (H1). Corporate governance reforms protecting minority shareholders have a positive effect on the firm performance.
2.3. The Role of Financial Leverage
The choice of capital structure is definitely one of the most crucial decisions that managers face because the changes in leverage ratio can influence the financing capacity of the firm, cost of capital, investment strategy, risk and shareholders’ wealth but also the performance (
Cai and Zhang 2011). In
Jensen and Meckling (
1976) agency cost model, higher leverage results in higher agency costs based on the conflicting interests between shareholders and debtholders. The conflict is based on the inequality of gains between shareholders and debtholders: once an investment brings returns above the debt value, the shareholders’ value increases with additional returns. This will mean that shareholders will benefit more in firms with low leverage with an increase in the firm value after the reforms.
Based on the debt overhang theory of
Myers (
1977), which implies that higher leveraged firms will forgo positive net present value projects in the future because, in some cases, the outcome of these investments for shareholders is lower than the initial investment after fulfilling all debt obligations. From another point of view, debt can also create financial distress—the “bankruptcy effect”. An increase in financial leverage can undermine the expectations of stakeholders, leading to a decrease in the firm market value. Debt is considered a costly mechanism because it diminishes access to credit and increases the cost of the relationship with stakeholders by forcing firms to engage in actions that are detrimental for debt holders and non-financial stakeholders (i.e., employees, suppliers and customers) (
Opler and Titman 1994). The literature suggests that higher debt causes greater financial distress, and this lowers corporate performance. Holding a larger amount of debt can be harmful because it increases the risk associated with firms’ businesses, making firms less attractive to the investors and consequently reducing their possibilities to raise additional capital in the future (
Smith and Watts 1992).
In light of the arguments discussed above, we expect that an increase in the firm’s leverage will weaken the positive impact of reforms protecting minority shareholders on the firm performance. The reforms will be more effective for firms with low leverage, and therefore the second hypothesis is as follows:
Hypothesis 2 (H2). The positive relationship between corporate governance reforms protecting minority shareholders and the firm performance is weakened by financial leverage.
2.5. The Role of Corporate Governance Approaches
Although corporate governance reforms are adopted all over the world, countries differ in reform approaches. There are two main reform approaches: “rule-based” and “comply-or-explain”. The rule-based approach, based on the assumption of “one size fits all”, requires mandatory compliance. The one-size-fits-all mandatory regimes implicitly assume that the same recommendations are efficient for all types of firms (
Romano 2005). The comply-or-explain mechanism assumes that it is not possible to adopt a one-size-fits-all approach because companies subject to the corporate governance reforms differ in terms of size, structure and organization (
MacNeil and Li 2006). It is based on the idea that the fundamental determinants of the type and severity of agency costs are companies’ ownership and control structures, which differ across countries and industries, and that corporate governance practices should reflect such differences (
Chen and Nowland 2010). Voluntary compliance offers the possibility to choose whether to comply or not with the reforms, but also it requires firms to explain the adoption of an alternative approach (
Aguilera and Cuervo-Cazurra 2004;
Haxhi and Van Ees 2010). The effectiveness of these reform approaches is still under debate because the rule-based approach induces the risk of being overregulated while the comply-or-explain regulations work as suggestions and do not have enough power. Some scholars argue that the comply-or-explain approach is flexible and more beneficial, while the rule-based approach usually does not add value and creates additional costs for firms (
Adams et al. 2010). Others say that the comply-or-explain approach does not lead to an increase in firm value because firms intentionally do not comply with the reforms to avoid corporate governance improvements (
Zadkovich 2007). Recent literature argues that the comply-or-explain approach leads to improvements in firm value because firms have the possibility to adopt personalized governance practices based on firm-specific circumstances (
Luo and Salterio 2014), but the comply-or-explain approach is also associated with a greater increase in firm value than rule-based reforms (
Fauver et al. 2017). However, based on the argument above, the outcome related to the effect of reforms protecting minority shareholders could be different, as we state as follows:
Hypothesis 4 (H4). The positive relationship between corporate governance reforms protecting minority shareholders and the firm performance is more pronounced in countries with a rule-based CG approach.
2.6. The Role of Debt Enforcement
Reforms protecting minority shareholders from management abuse and controlling shareholders intend to strengthen the position of minority shareholders. Specifically, the reforms minimize the agency conflict between concentrated owners and minority shareholders. However, once the power of minority shareholders increases, it leads to the strengthening of the conflict between shareholders and debt holders. The agency theory argues that this conflict induces agency costs in the form of exaggerated dividend payments, asset substitution, and underinvestment (
Jensen and Meckling 1976;
Smith and Warner 1979). In particular, excessive dividend payments result in wealth transfers from creditors to shareholders; as a consequence, the company escapes from the burden of debt at the expense of creditors. Higher debt enforcement intensifies the shareholder-creditor conflict by decreasing the payoffs to both shareholders and creditors (
Fan and Sundaresan 2000;
Favara et al. 2017).
In a recent study,
Favara et al. (
2017), discussed the implications of debt enforcement on investment, assets growth and risk-taking across 41 countries. The outcomes of the study show that a lower debt enforcement results in more investment, higher asset growth and less risk-shifting. As suggested by
Myers (
1977), the conflict between shareholders and creditors encourages firms to practice underinvestment, and this leads to a significant decrease in firm performance due to rejecting positive NPV projects. In countries with low debt enforcement, this conflict is weakened, and companies invest more than in countries with high debt enforcement. As discussed by
Favara et al. (
2017), imperfect debt enforcement firstly increases the probability of recovery in default and then decreases the underinvestment as well as asset substitution generated by agency conflicts. In turn, firms will perform better in countries with low debt enforcement.
In light of the arguments and studies discussed above, we expect that stronger debt enforcement will create more conflicts between shareholders and debt holders with the reforms protecting minority shareholders. Therefore, these reforms will be more effective for firms located in countries with weak debt enforcement. Our next hypothesis is therefore as follows:
Hypothesis 5 (H5). The positive relationship between corporate governance reforms protecting minority shareholders and the firm performance is weakened by high debt enforcement.