The Impact of Related Party Transactions on Performance and Valuation of Malaysian Listed Firms: Testing the Influence of Corporate Governance

Transcription

1 The Impact of Related Party Transactions on Performance and Valuation of Malaysian Listed Firms: Testing the Influence of Corporate Governance Victor Gan A Thesis Submitted for the Degree of Master of Commerce Faculty of Business and Design Swinburne University of Technology April 2017

2 Abstract This study examines the impact of related party (RP) transactions on the performance and valuation of Malaysian listed firms. It also investigates the influence that corporate governance has on this relationship. This study uses a sample of 187 firms listed in Malaysia over the period of 2012 to 2014 for 531 firm-year observations. This study measures RP transactions using magnitude, number of transactions, and ratios. RP transactions are further broken down into tunnelling and propping type transactions for further testing. Performance and valuation are proxied by return on assets (ROA) and Tobin s Q respectively. Corporate governance is measured by indicators of both internal mechanisms (board of directors) and external mechanisms (ownership concentration, audit quality). This study finds empirical evidence that tunnelling RP transactions have a significant negative association with firm valuation. At the same time, propping RP transactions have a significant positive impact on firm valuation. This finding suggests that tunnelling RP transactions represent expropriation of shareholder wealth and are discounted by investors accordingly, whereas propping RP transactions are efficient transactions that benefit the firm. This finding is robust after controlling for leverage, firm size, and stock exchange index membership. Consistent with prior studies, this evidence confirms that investors in Malaysian firms perceive tunnelling RP transactions negatively as self-dealing resulting. This supports the conflict of interest view that tunnelling RP transactions are a front for extraction of private benefits from the firm resulting in a valuation discount. At the same time, evidence is presented in support of RP transactions as efficient transactions that can benefit firms operating in imperfect markets. ii

3 Declaration This thesis contains no material which has been accepted for the award to me of any other degree or diploma, except where due reference is made in the text of the thesis. To the best of my knowledge this thesis contains no material previously published or written by another person except where due reference is made in the text of the thesis. Victor Gan Faculty of Business and Design Swinburne University of Technology 6 April 2017 iii

4 Acknowledgment It has been through the counsel of many that this thesis is complete. I wish to record my thanks to my supervisors for their guidance and advice, to my parents and sister for their patience and understanding, and most of all to the LORD God from whom all knowledge and wisdom flows. iv

5 List of Tables Table 1 Summary of Tunnelling and Propping Definitions Table 2 Malaysian Corporate Governance Research Table 3 RP Transactions and Risks to Firm Valuation Table 4 Definitions of Shareholder Identity Table 5 Definition of Tobin's Q Equation Variables Table 6 Further Definitions of Tobin's Q Equation Variables Table 7 Definition of RP Transaction Variables Table 8 Further Definitions of RP Transaction Variables Table 9 Examples of Tunnelling and Propping RP Transactions Table 10 Definition of Corporate Governance and Ownership Concentration Variables Table 11 Definition of Return on Assets Table 12 Defintion of Control Variables Table 13 Summary of Companies Selected for Data Table 14 Descriptive Statistics for All Variables Table 15 Descriptive Statistics for RP transactions Table 16 Descriptive Statistics on RP Transaction Disclosure Table 17 Descriptive Statistics on Value of RP Transactions Table 18 Example of Variations in RP Transaction Disclosure Table 19 Pearson's Correlation Matrix Table 20 Effect of Related Party Transactions on Firm Valuation Table 21 Effect of Tunnelling and Propping Related Party Transactions Table 22 Impact of Corporate Governance and Ownership Concentration Table 23 Impact of Corporate Governance and Ownership Concentration on Tunnelling and Propping RP Transactions Table 24 Effect of Related Party Transactions on Firm Performance Table 25 Effect of Tunnelling and Propping Related Party Transactions on Firm Performance 90 Table 26 Impact of Ownership Concentration and Corporate Governance Table 27Impact of Ownership Concentration and Corporate Governance on Tunnelling and Propping RP Transactions Table 28 Factors Associated with RP Transactions Table 29 Summary of Results for Effect of Related Party Transactions on Firm Valuation and Performance Table 30 Summary of Results for Effect of Tunnelling and Propping Related Party Transactions Table 31 Summary of Results for Firm Valuation v

6 Table 32 Summary of Results for Firm Performance Table 33 Summary of Results for Factors Associated with RP Transactions Table 34 Summary of Duality Trend vi

7 Table of Contents 1 Introduction Research Motivations Problem Statement Research Question Research Objectives Significance of Contributions to Topic Assumptions and Limitations Structure of the Thesis Summary Literature Review Introduction The Role of Corporate Governance Introduction Development of Corporate Governance Related Party Transactions and Corporate Governance Internal and External Mechanisms of Corporate Governance Related Party Transactions and Theoretical Framework RP Transactions: Efficient Transactions or Conflict of Interest? Agency Theory and Conflict of Interest Transaction Cost Economics and Efficient Transactions RP Transactions as Source of Tunnelling or Propping Related Party Transactions and Earnings Management Factors Associated With Related Party Transactions Regulatory Background and Disclosure of Related Party Transactions Accounting Standards and Market Listing Rules Companies Act 1965 and 2007 Amendment Related Party Transactions and Disclosure The Malaysian Political Economy Corporate Governance in Malaysia Review of Existing Empirical Evidence Review of Studies on Firm Valuation Review of Malaysian Corporate Governance Studies RP Transactions and the Risks to Firm Valuation Impact of Ownership Concentration on RP transactions and Firm Valuation Development of Hypotheses vii

8 2.6.1 Related Party Transactions and Association with Firm Performance and Valuation Effects of Different Types of Related Party Transactions The Impact of Ownership Concentration and Corporate Governance Factors Associated with Related Party Transactions Summary Research Design Introduction Research Philosophy Theoretical Framework Model Specification and Operationalization of Variables Tobin s Q Related Party Transactions RP Transactions and Firm Valuation Corporate Governance, Ownership Concentration and RP Transactions RP transactions and Firm Performance Factors Associated with RP Transactions Control Variables Secondary Data and Quantitative Methods Sample Selection Data Source Summary Descriptive Statistics Introduction Variable Means, Medians, Standard deviation Issue Encountered During Data Collection Correlation and Multicollinearity Empirical Results Introduction RP Transactions and Firm Valuation Effect of Related Party Transactions on Firm Valuation Effect of Tunnelling and Propping Related Party Transactions Impact of Corporate Governance and Ownership Concentration RP Transactions and Firm Performance Effect of Related Party Transactions on Firm Performance Effect of Tunnelling and Propping Related Party Transactions Impact of Ownership Concentration and Corporate Governance viii

9 5.4 Factors Associated with RP Transactions RP Indicator Variables Ratio of Number of RP Transactions to Board Size Ratio to Total Value of RP Transactions to Firm Size Total Dollar Value of RP Transactions Discussion of Results Effect of Related Party Transactions on Firm Valuation and Performance Effect of Tunnelling and Propping Related Party Transactions Impact of Corporate Governance and Ownership Concentration Factors Associated with RP Transactions Conclusion Summary of Thesis Summary of Results Implications of Study Extending Existing Theory Extending Existing Malaysian Corporate Governance Research Investors and Public Stakeholders Regulators and Standard-setters Limitation of Study Future Research Direction Conclusion References ix

10 1 Introduction 1.1 Research Motivations Malaysia is a leading capital market in the region. According to the Securities Commission Malaysia s annual report, in 2014, the Malaysian capital markets size was RM2.76 trillion. Initial public offerings and other debt instruments raised RM91.9 billion during the year, and Malaysia also has the largest unit trust industry in Southeast Asia with RM343 billion in assets under management (Securities Commission Malaysia 2015). In line with the government s vision to build a strong capital market and attract investors, there is a need for continual study to understand how to build a strong regulatory and governance system. At the same time, the close ties between businesses and politics Malaysia represents a unique institutional and governance setting to be studied. This is characterized by the involvement of the government and political parties via policies to redistribute wealth along ethnic lines, which has influenced the development of business structures and governance in Malaysia (Munir & Gul 2010). Related party (RP) transactions are a key area of study in corporate governance and related topics such as accounting disclosure, investor protection and fraud. In one study comprising 448 firms over the period from 2005 to 2007, there were 4,044 RP transactions valued at RM65.2 billion by listed companies in Malaysia (Wahab et al. 2011, p.146). Such volumes and magnitude of RP transactions reflects its acceptance but also highlights the problems it can bring. RP transactions in Malaysia in the past have been singled out as abusive and as mechanisms for expropriation of wealth (Wahab et al. 2011, p.132). At the same time, RP transactions may actually have economic benefits to the firm and its stakeholders. In addition, while regulation, restrictions and guidelines are being formulated to constrain RP transactions, it must be noted that no country has totally banned RP transactions (Djankov et al. 2008, p.431). Within the current literature on RP transactions in other countries, there is no conclusive knowledge on the nature of the relationship between RP transactions and firm valuation and performance. There is also a distinct lack of studies on RP transactions in Malaysia. The majority of studies on RP transactions in this region focus on companies listed in China (Chen et al. 2011; Chen et al. 2012; Ge et al. 2012; Hu & Li 2010; Lo et al. 2010). 1.2 Problem Statement The need for research into RP transactions is important as Malaysia is a rapidly emerging economy. Each country has its own unique national character, and each corporation has its own unique background, environment and business objectives. The variances in corporate governance practice across the world make it almost impossible to define the term (Aguilera & Jackson 2003). Thus what is desirable from a corporate governance perspective in one scenario may not be so in 1

11 another (Haniffa & Hudaib 2006, p.1035). Differences in each country s legal system will afford varying levels of investor protection (Demirgüç-Kunt & Maksimovic 2002). Corporate governance or other alternative governance mechanisms such as ownership concentration may evolve to cope with legal gaps in investor protection (La Porta et al. 1996). Corporate governance can also develop based on previous governance and ownership structures, in a path dependent fashion (Bebchuk & Roe 1999; Licht et al. 2001). Malaysia s policy of ethnic based wealth redistribution over the last 40 years via the New Economic Policy (NEP) is a key source of path dependence in determining current governance practices. At the same time, these governance practices need to be considered within the social context in which they occur, in that they develop embedded within an existing social context (Gomez-Mejia & Wiseman 2005; Huse 2005). Although Malaysia is a leader in the region in the development of a comprehensive system of corporate governance, significant issues still remain in the areas of expropriation of minority shareholders (Tam & Tan 2007, p.220). Firstly, without a proper understanding of RP transactions and its impact on firm valuation and performance, it will be difficult to build a framework for further development of the Malaysian capital market. This could risk the Malaysian capital markets losing out regionally to more dynamic centres. Secondly, this is an opportunity for Malaysia to develop even further as a regional capital market of choice with the right regulatory stance, armed with a better understanding of the impact of RP transactions. 1.3 Research Question The complex interplay between RP transactions, firm valuation and performance, and corporate governance gives rise to specific research questions in a Malaysian context: Research Question 1: What is the relationship between RP transactions and firm valuation and performance of Malaysian listed firms? Research Question 2: What is the relationship between RP transactions, corporate governance and ownership concentration on firm valuation and performance? Research Question 3 What is the relationship between corporate governance and ownership concentration and RP transactions? 1.4 Research Objectives More specifically, the research objectives of this study can be expressed as follows: Research Objective 1 (RO1): To determine the effects of RP transactions on firm valuation and performance of Malaysian listed companies. Research Objective 2 (RO2): To determine the effects of RP transactions, corporate governance and ownership concentration on firm valuation and performance. 2

12 Research Objective 3 (RO3): To determine the association between corporate governance and ownership concentration on RP transactions. 1.5 Significance of Contributions to Topic Firstly, the majority of studies on RP transactions in this region focus on companies listed in China (Chen et al 2011; Chen et al. 2012; Ge et al. 2012; Hu & Li 2010; Lo et al. 2010). Although current research into the area of RP transactions is limited, its effects can be widely felt. Secondly this study extends the usefulness of agency theory and efficient transactions in understanding the underlying nature of RP transactions. This investigation into the relationship between ownership concentration, governance structure and RP transactions can establish principles and characteristics of a strong governance system. Additionally, corporate governance and ownership concentration is seen to be a moderating factor in the effect of RP transactions. The effect of corporate governance to constrain RP transactions has been documented by previous researchers (Gordon et al. 2004b, p.36; Wahab et al. 2011, p.158), but no prior study has investigated the effect of ownership concentration on this relationship. This study is also unique in the use of multiple indicators of RP transactions that have been previously developed by researchers. Briefly, four (4) categories of variables representing RP transactions are identified. They are namely indicator variables, ratio of number of transactions to board size, ratio of total amount by firm size, and by total dollar value. Within these four categories, twelve (12) variables are defined, consistent with existing research into RP transactions and prior work by various researchers (Gordon et al. 2004a, p.11; Gordon et al. 2004b, p.24; Kohlbeck & Mayhew 2004, p.10; Ryngaert & Thomas 2007, p.11; Gallery et al. 2008, p.155; Kohlbeck & Mayhew 2010, p.121; Ge et al. 2010, p.137; Munir & Gul 2010, p.13; Wahab et al. 2011, p.140; Hu et al. 2012, p.63). Specific details of each variable are presented in later chapters on the operationalization of variables. Thirdly this study present empirical evidence that confirms prior studies but in a Malaysian context. By shedding light on this area, it is hoped that governance standards can be raised and help the capital market attract both foreign and local investors. It will also serve to inform the perspectives of all stakeholders, in particular investors and regulators, to give a clearer and more accurate picture on RP transactions. By doing so, Malaysia is one step nearer to becoming a developed nation and a leading capital market in the region. 1.6 Assumptions and Limitations Firstly the research is limited to the effects of RP transactions on Malaysian listed firms in the Trading sector. The Trading sector of Bursa Malaysia was selected over other sectors as it has the largest market capitalization by far when compared to any other sector. The selection of the Trading sector as the sample represents the best balance between achieving significant coverage 3

13 of the total market and limiting the costs of data collection. Within the Trading sector itself, a wide variety of businesses are represented. The diverse range of businesses undertaken by firms within the Trading sector allows for this study to take a good cross-section of related party transactions performed by various companies. Additionally, firms within the Trading sector are not separately regulated. This is unlike financial firms such as banks or insurers, which have additional oversight from the central bank. The central bank, Bank Negara Malaysia imposes additional regulations and prohibitions on related party transactions (Bank Negara Malaysia 2014). Such regulations may artificially distort the level of related party transaction undertaken by an entity. The limiting of the sample to only the Trading sector is a restrictive factor in that the results may not be extrapolated to be representative of Malaysian listed firms, or Malaysian firms as a whole, which are beyond the scope of this study. However, the findings may of this study are empirical evidence that may lead to informed perspectives on RP transactions and their effects. Secondly, the study assumes that all publicly available information is accurate. This is a limitation as many times there are specific mechanisms and schemes to conceal information for various reasons. In particular, due to the nature of RP transactions, concealment of such transactions in the context of its usage as a tool for expropriation should be expected. This study assumes RP transactions are the reported and disclosed RP transactions. Yet it is not unlikely that there are unreported RP transactions amongst the various transactions carried out by firms. Similarly, information about corporate governance is taken at face value, but this does not negate the fact that there are hidden directors or undisclosed levels of ownership (Juliarto 2012, p.69). However the study is not able to take this into account and it is assumed that publicly available information is representative of the variables being measured. Thirdly, although it is expected that RP transactions, and in particular tunnelling RP transactions, will have a negative relationship with firm valuation, there is a possibility that the entire Malaysian market as a whole is discounted due to RP transactions (Cheung et al. 2006, p.384). Despite the limitations and assumptions outlined above, this study presents empirical evidence that can give further insight into RP transactions and corporate governance. 1.7 Structure of the Thesis The remainder of the thesis is divided as follows. Chapter 2 lays out the theoretical framework, current regulatory requirements, review of existing studies, and development of hypotheses. In Chapter 3, based on the hypotheses, the research design is explained and operationalization of variables is listed. Chapter 4 has the descriptive statistics based on the sample data collected. 4

14 Chapter 5 discusses the results of the empirical testing. Chapter 6 concludes this thesis as well as outlining potential direction of any future research. 1.8 Summary This section introduces the problem statement and motivations for this study, as well as the research questions and research objectives. The significance of the contributions of this study to the topic are also outlined. Finally major assumptions and limitations of this study are explained. 5

15 2 Literature Review 2.1 Introduction The purpose of this chapter is to review existing literature on RP transactions, reasons for this study, and to develop the hypotheses for testing. This chapter contains 5 sections. In the first section, the role and significance of corporate governance is examined. The concept of corporate governance itself, and traditional theories such as agency theory and transaction cost economics are considered. Both internal and external corporate governance mechanisms are also looked at. The second section examines the nature of RP transactions within the theoretical framework developed by other researchers. In particular, agency theory and transaction cost economics are used in building up the case for this study. In the following section, a detailed elaboration of the Malaysian context of RP transactions from the viewpoint of legislation and regulator-issued guidance is dealt with. Key aspects of the Malaysian political economy are also covered. The fourth section reviews existing studies and their results regarding RP transactions, corporate governance and firm valuation and performance. Finally, based on the arguments of the preceding chapters, and underpinned by the theoretical framework in place, the necessary hypotheses are developed and outlined. 2.2 The Role of Corporate Governance Introduction The issue of asymmetric information is the primary driver that necessitates the existence of corporate governance in the structure of a firm (Gordon 2004b, p.1). Corporate governance can be defined in many ways. The Organisation for Economic Co-operation and Development (OECD) gives a broad definition (OECD 2004, p.11): Corporate governance involves a set of relationships between a company s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. This view is representative of the state and understanding of corporate governance in the large majority of developed countries, in particular in those under the Anglo-American legal and economic environment (Shleifer & Vishny 1997, p.737). The definition given by the OECD is reflective of the external and internal structures and mechanisms, by which a company may attain its objectives and monitor its performance (Mallin 2013, p.15). The need for these structures and mechanisms would not exists if external providers of finance and other stakeholders had perfect information on the management of a firm. The external parties would be able to monitor, reward, 6

16 and penalize the behaviour of the managers, thereby preventing any self-dealing or expropriation of the firm (Gordon 2004b). A much narrower definition of corporate governance is given by Shleifer and Vishny (1997, p.737): Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. How do the suppliers of finance get managers to return some of the profits to them? How do they make sure that managers do not steal the capital they supply or invest it in bad projects? How do suppliers of finance control managers? This view is a very practical one, and deals exclusively with the potential for management to expropriate from the company, at the expense of the shareholders. It is only concerned with how investors will obtain a return from managers on the capital they have sunk in to a firm. This interpretation of corporate governance assumes separation of ownership and control and frames the governance structure from an agency problem perspective. However, it fails to bring up the potential conflicts of interest that may exist if the management is also a principal shareholder. This type of conflict is typically referred to principal-principal conflict (Shleifer & Vishny 1997, p.737; La Porta et al. 1999, p.471; Cheung et al. 2006, p.343). It involves the expropriation by the major shareholder against the minority shareholders. Additionally, other parties such as debtholders would not be covered by this definition Development of Corporate Governance Agency theory and the separation of ownership and control underpinned the early development of corporate governance (Smith 1904, Berle & Means 1932, Jensen & Meckling 1976, Fama & Jensen 1983). Management could not be expected to utilise capital within the company provided by external investors as diligently as if that same capital had been provided by themselves (Smith 1904). Early corporation law development was largely done with the intent on preventing outright expropriation by the management of a firm. This was evident in the 18th to 19th centuries in Britain as well as Europe (Shleifer & Vishny 1997, p.741). Consequently, courts and corporation law have in the past set the tone and laid down the rules by which the duties, rights and responsibilities of management were defined (La Porta et al. 1996). A key feature of the agency problem espoused by the separation of ownership and management model of Berle & Means (1932), Jensen & Meckling (1976), and Fama & Jensen (1983) is the that the conflict is between management and a wide shareholding base. In recent years this view of the agency theory that assumes diffused shareholding to be a given has increasingly been viewed as a Western and Anglo-American take on corporate governance (Juliarto 2013, p.2). A wide shareholding base is primarily a feature of major Western capital markets and is not 7

17 representative of the shareholding structures in other parts of the world, for example in Africa, Asia, the Middle East and South America. In these markets researchers have found that ownership is more concentrated, and controlling shareholders have higher stakes in the companies they own (La Porta et al. 1999, p.471; Claessens et al. 2000, p.81; Faccio et al. 2001, p.54; Claessens et al. 2002, p.2741; Young et al. 2008, p.196). In emerging and developing markets, the focus of corporate governance shifts from mitigating principal-agent conflicts to restraining principal-principal conflicts (La Porta et al. 1999, p.471). This becomes an issue that is more pressing in view of the fact that many emerging markets do not have adequate corporate governance systems and the necessary legal recourse in place for the protection of minority shareholders (La Porta et al. 1999, p.471; Liu & Lu 2007, p.881). This problem is further exacerbated by the high ownership concentration that is a feature of listed companies in many of these markets (Claessens et al. 2000, p.81). In Asia, much research has been conducted, particularly in China. The issues faced are exemplary of the complexity of managing the different interests in a country with a developing capital market, high ownership concentration, and relatively weak corporate governance (Jian & Wong 2003; Chen et al. 2009, p.285; Hu et al. 2009, p.190; Hwang et al. 2013, p.292). Listed firms in such an environment typically have a large controlling shareholder. This shareholder would have the ability to select, monitor and control management. This give power to the controlling shareholder to expropriate funds that should be used for the benefit of all investors (Huyghebaert & Wang 2012, p.308) Related Party Transactions and Corporate Governance Gordon (2004b, p.35) finds that corporate governance and external monitors such as lenders are associated with a reduced dollar amount of RP transactions in the United States. In Malaysia Wahab et al. (2011, p. 158) found that RP transactions are linked to a reduction in firm return on assets. In the same study the authors find that external monitoring such as a big-four auditor and the level of board independence have a moderating effect on the performance-reducing impact of RP transactions. The study however did not differentiate between different types of RP transactions, and only concentrated on the effect on asset return rather than firm valuation. This is consistent with the Kohlbeck and Mayhew s (2004, p. 20) study which also found that higher levels of board independence were associated with less RP transactions. Other governance mechanisms such as the presence of audit committees were also found to affect the level of RP transactions disclosed by a company (Cheung et al. 2009, p. 924). Studies on internal and external governance measures to protect minority investors from the majority have also been conducted. As the gap between the major shareholders control rights and cash flow rights increases, so does the level of RP transactions that a firm engages in (Huyghebaert & Wang 2012, p.308). In this particular study, it was also found that state-owned 8

18 firms were associated with more RP transactions, possibly to subsidise other financially weak state-owned firms. Corporate governance mechanisms such as the board of directors and independent directors were unable to limit this relationship. The concept of ex ante and ex post RP transactions has also been examined. Ex ante refers to RP transactions entered into when the counterparty is already a related party. Ex post refers to RP transactions initiated before the counterparty becomes a related party and the effects on firm valuation and performance. An examination of small to medium-sized American firms finds no relationship between RP transactions and firm performance or valuation in general. However when RP transactions are differentiated between ex ante and ex post, there is a significant difference (Ryngaert & Thomas 2012, p.845). In particular, ex post transactions have a negative relationship with firm performance and value, and in fact are associated with future financial distress in firms. Ex ante transactions show no such relationship. An examination of the key issues regarding regulation of RP transactions is the focus of a paper by Trivun et al. (2012, p.15). They conclude that approval and disclosure of such transactions, as well as holding board members and the controlling shareholder responsible if the firm suffers economic losses due to the RP transactions, are key issues. This is further enhanced by having a clear definition of RP transactions and an effective enforcement regime Internal and External Mechanisms of Corporate Governance The established view of research into corporate governance generally divides governance mechanisms into two broad categories, namely internal and external mechanisms. Internal mechanisms comprise primarily the board of directors, as well as ownership structure (e.g. ownership concentration and large blockholders) (Shleifer & Vishny 1997, p.737; Boubakri et al. 2005, p.369; Jiang & Peng 2011, p.15; Huyghebaert & Wang 2012, p.308). External mechanisms would include the regulatory and legal environmental, institutional development, leverage and the takeover markets (Shleifer & Vishny 1997, p.737; Claessens & Fan 2002, p.71; Boubakri et al. 2005, p.369; Wahab et al. 2011, p.131; Huyghebaert & Wang 2012, p.308). The primary pillar of modern corporate governance in the firm is the board of directors. The board is the pinnacle of the systems put in place to monitor, reward and penalize management of the company (Fama & Jensen 1983, Jensen 1993, p.831). The board also serves as the first line of defence against issues that may escalate into the crisis stage. Unfortunately few boards have served this internal control mechanism effectively over the past few decades (Jensen 1993, p.831). There is some evidence that research is progressing in understanding the complexities behind board effectiveness. It is presumed that if the board is effective, the value of the firm will increase (Amran 2004, p.48). 9

19 Board size is a factor that can contribute to elevating the board s effectiveness (Jensen 1993, p.865). It is argued that the larger the board, the less effective it becomes. Coordination between members and going through processes with a large number of members outweighs the benefits from having more individuals to draw on (Jensen 1993, p.865). This also makes it easier for management to influence or manipulate. Empirical findings in the United States (Yermack 1996, p.185), Europe (Eisenberg et al. 1998, p.35), Singapore and Malaysia (Mak & Kusnadi 2005, p.301) support this view. In each of the previous studies, the researchers found that larger board sizes were negatively related to firm value. This is consistent with prior research in organizational behaviour that finds small groups being more effective than larger groups in decision making (Mak & Kusnadi 2005, p.391). Additionally the risk of a large board being captured and controlled by the CEO or management is higher than that of a small board (Jensen 1993, p.831). From a practical stand, a large board consumes more in terms of remuneration, which is a direct usage and drain on firm resources (Mak & Kusnadi 2005, p.391). Finally, a large board may be a symptom of a predisposition of the existing board to add directors rather than replace them. This causes an expansion in board size over time. The issue that arises is that the underlying reason for such addition rather than replacement could be the board culture which avoids conflict and is content to merely rubber-stamp decisions (Jensen 1993, p.831; Mak & Kusnadi 2005, p.391). At the same time, larger boards may contribute to an increased access to resources, as well as a wider range of experience which reduces risk to the firm (Haniffa & Hudaib 2006, p.1038). This enhances corporate governance, as a variety of skills, experiences, knowledge and expertise can be had with a larger board (Ghazali 2010, p. 112). A larger board also may have increased capability to monitor management as the number of directors increases (Sulong & Noor 2008, p. 62). Board size is therefore an important corporate governance variable that must be taken into account. In the latest iteration of the Malaysian Code on Corporate Governance (MCCG), the code recommends having a board composed of a majority of independent directors if the chairman is not an independent director (Securities Commission Malaysia 2013). Board independence is important in ensuring an effective control environment for management (Fama & Jensen 1983). Independent directors have incentive to develop their reputation as experts on decision making, and to be seen as watchdogs, with the main purpose of taking care of shareholder interests (Fama 1980, Fama & Jensen 1983). It is argued then that a larger proportion of independent directors on the board ensures better monitoring and alignment of shareholder interest as the independent directors wish to maintain their reputation as experts in decision control (Fama & Jensen 1983). They have no economic interest in the firm and do not participate in day to day operations, and are therefore able to provide objective assessments of the decision making process at the board level (Rahmat 2013, p. 73). At the same time, arguments have been put forth on opposing 10

20 perspectives on board independence. Independent directors, by virtue of their lack of day to day involvement, have limited time commitment to the company (Amran 2004, p.51) Additionally they normally will not have shares in the firm, thus contributing to a lack of incentive to perform a monitoring function (Amran 2004, p.51). Generally, the evidence supports higher board independence as having a positive impact on firm valuation and performance, and this is reflected in policy makers choices in mandating board independence via codes such as the MCCG. Duality refers to the practice whereby the CEO and Chairman of the board are one and the same person (Rahmat 2013, p.67). It is a widely accepted practice that is prone to be subject to conflicts of interest if performed by the same individual (Jensen 1993, p.866). The function of the chairman is to monitor and evaluate the CEO. Therefore if the CEO were to assume the position of chairman also, it would be difficult in practice to achieve the function of chairman performed in an independent manner (Jensen 1993, p.866). This also creates an atmosphere at the board level that lacks independence and is characterized by conflict of interest (Amran 2004, p.52). Such an environment can reduce the role of independent directors to mere rubber stampers, and not able to protect the interests of shareholders (Amran 2004, p. 53). In the context of a market with concentrated ownership, a controlling shareholder can dominate management by ensuring that the chairman and CEO are both the same appointed individual. This can contribute to principalprincipal conflict that results in expropriation of minority shareholders (Jensen 1993, p.866). Duality reduces the check and balance that should exist between the two positions of chairman and CEO, and enable self-dealing behaviour to be unchecked (Rahmat 2013, p.67). Ownership structure can act as both an internal corporate governance mechanism and also a source of agency conflict (Shleifer & Vishny 1997, p.737; Gordon et al. 2004b, p.36; Boubakri et al. 2005, p.377). Ownership concentration refers to the ownership of large blocks of shares by investors, as opposed to diffused shareholding where many investors own many small blocks of shares (Shleifer & Vishny 1997, p.754). It is easier for a single shareholder or a small number of shareholders to act together to maintain their interests by monitoring, rewarding and penalizing management as they have the necessary incentive to protect their investments (Shleifer & Vishny 1997, p.754). The large shareholder has the most to gain from any effort expended in watching over management (Gordon et al. 2004b, p.36). This can be contrasted to the scenario of diffused ownership, whereby no single small shareholder will want to act, as this will lead to a marginal benefit for that individual while benefitting the remaining shareholders for free (free rider problem) (Shleifer & Vishny 1997, p.756). At the same time, ownership concentration can have its own costs to the remaining shareholders. A large controlling shareholder can also more easily control management by appointing key posts and engage expropriation of minority shareholders (Shleifer & Vishny 1997, p.758; Claessens et al. 2000, p.81). 11

21 Two major aspects of ownership structure have been researched. They are the level of ownership concentration, and the identity of the owners (Boubakri et al. 2005, p.376; Juliarto 2012, p.29). The identity of owners may be generally categorized as follows: government, local institutions, foreign investors, employees and individuals (Boubakri et al. 2005, p. 375). This study groups these into 2 even broader categories, namely institutions (government, local institutions, and foreign investors) and families (employees and individuals). The identity of the shareholder in a concentrated ownership situation can have very different impacts. For example having an institution as a controlling owner may lead to better monitoring and oversight of management, whereas having a family as a large shareholder tends to lead to higher rates of expropriation of minority shareholders (Ismail & Sinnadurai 2012, p.255; Juliarto 2012, p.30). These issues arise as large shareholders represent their own interests, which may or may not be the same as the interests of the minority shareholders (Shleifer & Vishny 1997, p.758). Family ownership in particular is an aspect that is common among Asian firms (Claessens & Fan 2002, p.71). Typically the family will have a controlling stake in the firm, or the firm will be part of a larger group controlled by the family (Juliarto 2012, p.31). On one hand family ownership may assist to align the interests of the shareholders with management (Jensen & Meckling 1976, p.305; Fama & Jensen 1983). On the other hand, the risk of expropriation of minority shareholders is also increased (Faccio et al. 2001, p.54). Audit quality can serve as an effective external governance measure. The role of the independent auditor is increasing users confidence in financial statements by expressing an opinion as to their fairness of presentation and reliability of reported figures (Rahmat 2013, p.75). The Companies Act 1965 requires auditors to be independent and have the right to address the shareholders in a general meeting, thus fulfilling the public role of a public accountant (Wahab et al. 2011, p.198). Although there is a general requirement for financial statements to be audited, the quality of the auditor may vary. A more reputable auditor is likely to be more effective in preventing financial statement misreporting and self-dealing activities as they have more of reputation to protect (Wahab et al. 2007, p.108). At the same time, a more credible auditor might be appointed by a company that has a propensity for more self-dealing to enhance the legitimacy of their transactions and to play a certification role (Wahab et al. 2011, p.198; Gordon et al. 2007, p.83; Fan & Wong 2005, p.35). The auditor in each of these situations would play the role of an external corporate governance mechanism. In a large number of studies, audit quality is proxied by the usage of Big 4 or Tier 1 public accounting firms (Rahmat 2013, p.75; Wahab et al. 2011, p.198; Chien & Hsu 2010; Gordon et al. 2007, p.81). A criticism of using this metric is the obvious involvement of the former top tier public accounting firm, Arthur Andersen & Co. s implication in the Enron scandal of 2001 (Rahmat 2013, p.76). This reinforces the notion that a firm with shady RP transactions might seek to legitimise those same transactions by having them signed off 12

22 by a reputable auditing firm (Gordon et al. 2007, p.93; Wahab et al. 2011, p.143). At the same time, having a strong and independent external monitor, outside of the board of directors, can be an effective mechanism in countering the negative effects of RP transactions (Rahmat 2013, p.76; Gordon et al. 2007, p.93). Leverage can also act as a corporate governance mechanism (Jensen & Meckling 1976, p.40). External creditors are concerned with the ability of the firm to repay borrowings, and will therefore ensure management or controlling shareholders do not expropriate firm resources. They have the necessary incentives to monitor firms and their management to ensure sufficient funds for debt repayment (Gordon et al. 2004b, p.36). 2.3 Related Party Transactions and Theoretical Framework RP Transactions: Efficient Transactions or Conflict of Interest? Related party transactions are transactions between the firm and a party that is related either as a subsidiary, associate, principal owners, officers or directors (Gordon et al. 2007, p.83). There are two primary views on RP transactions in the extant literature which result in either positive or negative effects on investors and minority shareholders. Gordon et al. (2004a, 2004b) and Kohlbeck and Mayhew (2004) were among the earliest to identify these two opposing perspectives on RP transactions. Prior to this it had been perceived that RP transactions would only constitute conflicts of interest that were detrimental to shareholders. However, based on rational economic arguments, it was hypothesized that it was possible to view RP transactions in two contrasting ways. One view is that RP transactions are conflicts of interest and are negative for firm performance and valuation, and the other view is that RP transactions are efficient transactions that benefit firm performance and valuation. These two views are also known as the conflict of interest hypothesis, and the efficient transactions hypothesis. Under the conflict of interest hypothesis, RP transactions were a breach of the agent s responsibility. This responsibility could take the form of management s duties to shareholders, or the monitoring function of the board of directors (Gordon et al. 2004a, p.4, 2004b, p.11). The alternative efficient transactions hypothesis states that RP transactions are the most economically efficient method for the company to carry out certain dealings. In the next section, we examine the detailed theoretical frameworks underpinning these two contrasting views on RP transactions Agency Theory and Conflict of Interest Related party transactions have emerged as a form of self-dealing with the potential for a multitude of negative consequences. The basis of determining the negative impact of RP transactions has its roots in agency theory (Gordon et al. 2004a, p.4; Kohlbeck & Mayhew 2004, p.3; Cheung et al. 2006, p.346). 13

23 The modern firm is characterized by separation of ownership and management. Agency theory explains the nature of the separation of ownership and management in a firm. This has been developed by Berle and Means (1932), and further refined for the modern corporation by Jensen & Meckling (1976). Subsequent work in this area led to development of contracting theories of the firm (Fama 1980; Fama & Jensen 1983). However much of this development was done in Western or Anglo-American economies where there is a high dispersion of ownership. In emerging economies such as Malaysia, concentrated ownership is the norm. Research in a Malaysian context, with concentrated ownership, is limited. The majority of research in corporate governance is based on agency theory. Principal-agent conflict arises between shareholders (principal) and management (agents). Management is assumed to have different objectives from shareholders, many of which are to benefit themselves. Mechanisms such as the board of directors are governance measures put in place to ensure that management acts in the interest of shareholders. These measures represent agency contracting costs, which are put into place at the expense of the shareholders, to align management s objectives to that of shareholders. The Great Depression-era book The Modern Corporation and Private Property was among the earliest works on the basis of agency theory and modern corporate governance. Published in 1932, it examined the evolution of the corporation that had resulted in the separation of ownership and management. It also looked at the implications for the corporation and its shareholders. Written by Adolf Berle and Gardiner Means, the key idea was this: once an investment had been made in a corporation by shareholders, they were distanced legally from the property (investment) they had put into the corporation. Legal title now rested with the corporation. It is noted that the shareholders own the corporation; in fact in many instances now and in the past, they were also the management. However, through the changing roles and delegation of power in a corporation, management in a modern corporation is often surrendered to a controlling group other than the shareholders (Berle & Means 1932, p. 334). Berle and Means (1932 p. 336) state that All powers granted to management and control are powers in trust, but the question arises as to how to ensure that those powers are not abused. Courts and corporation law have in the past laid down the rules by which the statement above is enforced (La Porta et al. 1996, p. 12). In the working paper entitled Law and Finance, the authors study the legal rights attached to shares (La Porta et al. 1996). These legal rights are the means by which shareholders ensure their investment is protected and a return can be obtained from it. Shareholder rights such as voting rights, calling for general meetings, obtaining relevant information and protection of minority shareholders are all meant to protect the investments of shareholders. As seen in the previous section on the Malaysian Companies Act, there has been an 14

24 effort to regulate RP transactions in Malaysia through various amendments to the Act. This is an overall theme of whether there is sufficient legislation and regulation to protect shareholders, investors and the general public from fraud in RP transactions in Malaysia. Another issue to consider is the type of abuse that may occur. The most obvious is outright expropriation. As Adam Smith (1904 p. 439) writes in his book entitled The Wealth of Nations, managers of companies in which the capital is not their own will not have the same anxious vigilance of a company managed by the capital providers. Consequently, a significant amount of early corporation law development was focused on preventing outright theft by the controlling group of management. This was evident in the 18th to 19th centuries in Britain as well as Europe (Shleifer & Vishny 1997, p. 742). However, mere legal protection for investors is insufficient. Rigid rules do not put the interests of the investors, the management or the corporation in good stead. Due to the endless variety in the nature of business that could be carried out by a corporation, it is not practical for the courts to determine the commercial merits of transactions carried out by a corporation. Take for example the United States, which is the most litigious society in the world (Rubin 2010). Even in this country, courts refuse to engage in meddling with the day-to-day affairs of a corporation, quoting the now universal business judgement rule (Shleifer & Vishny 1997, p. 741). It is also not in commercial interests to have shareholders running the corporation through voting on every transaction (OECD 1999, p.12). In Malaysia, the development of regulation is an ongoing process to bring it in line with global best practices (Chan 2010, p.3). This needs to be balanced with effective enforcement, which has been lacking in the past (La Porta et al. 1996, p.6). A study on the impact of RP transactions and factors associated with it will aid both the development of regulation and effectiveness of enforcement in Malaysia. Jensen and Meckling (1976, p.58), in their paper on the theory of the firm, developed the formalized view of the agency problem using financial economics. Contracting within the agency relationship is between the shareholders (principal) and management (agent). Due to the separation of ownership and control, the problem of ensuring that funds or capital are not wasted, and that a return is assured, arises as a concern for shareholders. Related party transactions can be seen as a conflict of interest between the agents and principals in the agency relationship within a corporation. The incentive to expropriate varies with cash flow rights (Jensen & Meckling 1976, p.64). Cash flow rights refer to ownership via shareholding. In a widely held corporation, this indicates that management s self-dealing is a maximization of their own utility at the expense of the other shareholders. Jensen & Meckling (1976, p.58) further expound that there will be differences in the decisions made by the agent relative to the best interests of the principal. The key assumption here is that both the principal and agent are utility 15