Institutional Reform and Corporate Governance Effect of Family Control. Yung-Chih Lien National Taiwan University Taiwan

Transcription

1 Institutional Reform and Corporate Governance Effect of Family Control Yung-Chih Lien National Taiwan University Taiwan Shaomin Li Old Dominion University USA Chia-Chen Teng Chung Yuan Christian University Taiwan 0

2 Institutional Reform and Corporate Governance Effect of Family Control Abstract According to institutional theory, the performance of corporate governance is influenced by the institutional environment in which firms operate. Using panel data on 357 publicly listed firms in Taiwan (1996 to 2009), this study examines how firms with the corporate governance system of family control adapt to institutional reforms. The results of the analyses indicate that institutional reforms reduce a firm s dependence on family control in performing corporate governance and eliminate the negative performance effect of a pyramidal ownership structure by the controlling family. Moreover, our examination reveals that institutional reforms foster external corporate governance from firms domestic institutional investors. Keywords: Family Control; Corporate Governance; Institutional Reform; Pyramidal Ownership; Institutional investors 1

3 INTRODUCTION Corporate governance research suggests that institutional systems play a critical role in protecting investors interests from managerial expropriation (Shleifer & Vishny, 1997; La Porta, Lopez-de-Silanes, Shleifer and Vishny, 1998; 2002; Peng and Jiang, 2010). However, countries have distinct institutional systems and differ significantly in the effectiveness of their investors rights protection (La Porta, Lopez-de-Silanes, Shleifer & Vishny, 2000). These differences have motivated research adopting an institutional-based view on corporate governance, which suggests that corporate governance efficiency is contingent upon the attributes of an organization s institutional context (Aguilera, Filatotchev, Gospel & Jackson, 2008). However, in most emerging economies, the institutional context is not static but instead is undergoing transformation (Peng, 2002). From an institutional perspective, institutional transformation in emerging economies affects local companies management structure (Peng, 2003) and thus requires companies to significantly modify and adapt their corporate governance practices (Hoskisson, Eden, Lau & Wright, 2000; Luo & Chung, 2005). This presents an opportunity for us to study the question as to how corporate governance systems evolve and adapt as a result of institutional transformation. On the basis of institutional theory, this study intends to ascertain whether and how institutional transitions and reforms affect the efficiency of corporate governance in emerging economies. In general, the legal systems in most emerging economies do not 2

4 efficiently protect investors rights. This insufficient investors rights protection consequently decreases the efficiency of external finance and causes local companies to have highly concentrated ownership structures in their controlling family (Claessens, Djankov & Lang, 2000; La Porta et al., 1998). In addition, when the market is inefficient, the growth of local companies heavily depends on a network-based strategy, making firm information less transparent (Peng & Heath, 1996). In most emerging economies, these particular institutional characteristics create a specific corporate governance framework in which local firms rely mainly on the controlling family to perform corporate governance (Young, Peng, Ahlstrom, Bruton & Jiang, 2008). However, in the last decade, numerous emerging economies have engaged in extensive corporate governance reforms that have required more transparency in firms operations. Drawing on institutional theory, we suggest that such institutional reforms alter the institutional context of these emerging economies, thereby changing the governance needs of local firms and affecting the efficiency of family control in corporate governance. Our theoretical arguments and related empirical examination provide a number of promising contributions to the literature on the institutional-based view of corporate governance: First, previous studies tend to compare static institutional differences in governance systems across nations and to identify the effects of institutional structures on corporate governance (e.g., Peng & Jiang, 2010). Based on a unique longitudinal dataset 3

5 from Taiwan, this study examines periodic variances in institutions within a single nation. This focus allows for a pioneering study exploring the dynamic impacts of institutional systems on corporate governance (Filatotchev, Toms & Wright, 2006). Second, under the specific corporate governance framework in emerging markets, the controlling family is a determinant of corporate governance outcomes (Filatotchev, Lien, & Piesse, 2005). However, related empirical findings in the literature are inconsistent (Peng & Jiang, 2010; Morck & Yeung, 2003). We argue that previous findings have been inconsistent because previous studies have neglected the institutional component of the firm when examining the governance effects of the controlling family. The empirical examination in this study shows how the governance effects of the controlling family change and respond to institutional transitions and thus reveals the governance effects of the controlling family from an institutional perspective. Third, many corporate governance studies focus on the Asian financial crisis. According to these analyses, local institutional systems lack of investors rights protection was one of the major reasons for the outbreak of the crisis (Lemmon & Lins, 2003; Mitton, 2002; Johnson, Boone, Breach & Friedman, 2000). Although more than a decade has now passed and although many Asian countries have since undergone institutional reforms, researchers have yet to examine how the resulting reforms have compensated for such earlier inefficiencies and have lessened the negative effects of weak 4

6 investors rights protection on corporate governance outcomes. The results of the empirical examination in this study help to fill this gap in the literature. Finally, our empirical examination is based on panel data on publicly listed firms in Taiwan. Taiwan is an emerging economy in East Asia (Hoskisson et al., 2000; Johnson et al., 2000), and its local corporate governance structures show a significant ownership concentration and a great degree of family control (Jiang and Peng, 2011), as in most emerging economies (Claessens et al., 2000; Johnson et al., 2000). Numerous previous corporate governance studies have used data on Taiwanese firms to identify the corporate governance attributes of family control in emerging economies (see Filatotchev et al., 2005; Liu, Ahlstrom & Yeh, 2006; Liu, Wang, Zhao & Ahlstrom, 2013). Extending these studies, our research utilizes a large empirical panel data analysis spanning 14 years ( ) to investigate changes in the effects of corporate governance across a period of institutional reform. The related findings should be empirically relevant to the corporate governance literature, particularly regarding the effect of the controlling family in firms in emerging economies. THEORETICAL BACKGROUND AND HYPOTHESES Institutional-based View of Corporate Governance Institutional theory suggests that in addition to industry- and firm-level conditions, a firm also needs to take into account the institutional framework as a critical factor when 5

7 crafting and implementing strategies to maximize its value (Oliver, 1997; Peng & Heath, 1996). Based on institutional theory, considerable research in the literature has examined the impact of the institutional environment on corporate governance and thus promoted the institutional-based view of corporate governance (Peng & Jiang, 2010). According to this view, the characteristics of corporate governance are interdependent on the diversity and fluctuations in the institutional environment; thus, universalistic context-free propositions are rejected within this research stream (Aguilera et al., 2008). The institutional-based view essentially argues that external and internal corporate governance mechanisms can be substitutive in solving agency problems (Peng & Jiang, 2010). For example, majority of the publicly listed firms in emerging markets are owned and controlled by their founding families (Claessens et al., 2000; La Porta, Lopez-de-Silanes & Shleifer, 1999). If the founding family has effective control of the firm s ownership and board structure, mitigating conflicts between the firm s controlling family and the minority shareholders is difficult with conventional internal governance mechanisms; therefore, external governance mechanisms should play a more important role in corporate governance (Fan & Wong, 2005). In essence, an effective legal system ensures an active and efficient market, which is vital to maintain the efficiency of external corporate governance (La Porta et al., 2000). However, emerging economies often have inefficient legal systems and mostly underdeveloped local markets for corporate control (La Porta et al., 6

8 2002; 2000; La Porta, Lopez-de-Silanes & Shleifer, 1999). External governance in such an institutional environment is therefore inhibited, leading to specific agency problems arising within firms with family control (Young et al., 2008; Johnson, Boone, Breach & Friedman, 2000). Controlling Family Domination From an institutional perspective, the institutional systems in most emerging economies are inefficient in protecting investors rights (Peng & Jiang, 2010; Li, 2009; 2005); thus, the control family must impose extensive control over firms in such economies in order to safeguard its interests from managerial expropriation (Young et al., 2008). Under the effective family control, the controlling family is responsible for the firm s performance outcomes (Filatotchev et al., 2005). However, the private interests of the controlling family are not always aligned with the firm s interest in maximizing its value. Specifically, a controlling family can derive benefits from a controlled firm in two ways: through the appropriation of the firm s interests for private gains and through the appreciation of the family equity holdings when the market value of the firm increases (Johnson et al., 2000). However, the sources of these two benefits are contradictory, as increased appropriation will diminish the firm s value and therefore diminish the family s interest from capital investments (Jensen & Meckling, 1976). In this regard, maintaining a significant proportion of corporate shares will prevent the controlling family from 7

9 appropriating firm assets, as it strengthens the connections between the interests of the controlling family and firm performance and thus improves firm s performance (e.g., Carney & Gedajlovic, 2003; Chang, 2003). In addition to affecting the ownership structure of firms, controlling families in emerging economies also are dominant on the boards of local companies (Claessens et al., 2000; Johnson et al., 2000). Driven by family altruism (Chrisman, Chua, & Sharma, 2005), the controlling family will seek to preserve firm value for the next generation (Schulze, Lubatkin, Dino & Buchholtz, 2001). The company will thus show a significant long-term perspective in strategic decision making (Strange, Filatotchev, Lien & Piesse, 2009; Filatotchev, Strange, Piesse & Lien, 2007) when its board is under effective family control. In addition, family domination on the board increases the controlling family s resource commitment to the firm and hence enhances market performance (Aldrich & Cliff, 2003). In particular, emerging economies weak institutions usually lead to restricted and dysfunctional markets (La Porta et al., 1997, 1999) and thus make the controlling family s private resources more important in the development of local firms. From the institutional-based view of corporate governance, the governance effects of family control may vary based on the institutional environment (Peng & Jiang, 2010; Aguilera, 2005). Typically, the popularity of family controlled firms in emerging economies results from inadequate investors rights protection by local institutions. However, once 8

10 local institutions undergo reform and provide better investors rights protection, the advantages of family control in terms of fostering firm value may vanish (Zattoni et al., 2009; Luo & Chung, 2005), leading to a substitution of the effects between external governance and the internal governance of family control (Filatotchev & Nakajima, 2010; Ward et al., 2009). Moreover, it has been argued that the governance effects of family control may become less important after a firm reaches maturity or when a firm is operating in a more stable environment (Filatotchev et al., 2006; Gedajlovic et al. 2004). Thus, the stability and maturity of the institutional environment may diminish the governance effects of family control in fostering firm value. During the last decade, particularly after the Asian financial crisis in 1997 to 1998, corporate governance institutions in many emerging economies have undergone reforms (Lemmon & Lins, 2003; Mitton, 2002). These institutional reforms aimed to enhance legal accountability, to provide greater transparency over firm operations, and thus to contribute to the establishment of a well-functioning system of external corporate governance. From the institutional-based perspective of corporate governance, these institutional reforms may substitute for the advantages of family control in corporate governance and alleviate the dependence of local firms on family governance. Thus, we propose the following hypotheses: Hypothesis 1a. The positive performance effects of family domination in a firm s ownership 9

11 structure will be diminished after the implementation of institutional reforms in emerging economies. Hypothesis 1b. The positive performance effects of family domination on the board of directors will be diminished after the implementation of institutional reforms in emerging economies. Pyramidal Ownership of the Controlling Family Although family control may help to address the problem of managerial expropriation in emerging economy firms, it has also been demonstrated that these controlling families usually implement a pyramidal ownership structure to secure their domination (Lemmon & Lins, 2003). In such a structure, the equity holdings of the controlling family in the firm are made through their investments in other firms (Levy, 2009), resulting in an indirect ownership relationship between the family and the company under its control. When many of these relationships exist, the structure will reduce the interest bounding of the controlling family to its controlled firm while simultaneously protecting controlling rights in the firm from non-family investors because such a complicated ownership structure will, in most cases, lead any takeover attempts to fail (Claessens & Fan, 2002; Claessens et al., 2000). From an agency perspective, a pyramidal ownership structure will separate the ownership and control of a firm and thus cause conflicts of interest between the controlling family and the other shareholders, thereby weakening the corporate governance effect of family control 10

12 and diminishing firm performance (Young et al., 2008). Unlike the corporate governance literature, the strategic research literature suggests that a pyramidal structure may establish an informal governance mechanism among the various firms in the pyramid (Stafsudd, 2009) and accordingly establish business affiliations that ensure the integration of the resources of the affiliated companies in pursuit of a commonly shared goal (see Lamin, 2013; Chang & Hong, 2000). Such business affiliations contribute in fostering a firm s competitive advantage, especially in an emerging economy where resources for local firms are scarce and the market mechanism is largely underdeveloped (Chang, Chung & Mahmood, 2006). In fact, in addition to providing tangible resources, business affiliations via a pyramidal structure can cultivate a firm s collective reputation and the social capital (Ma, Yao & Xi, 2006). In particular, business transactions in most emerging economies are essentially determined by business networks (Li, 2009) and a pyramidal structure will thus allow a firm to acquire a more advantageous position in the social network (Chang & Hong, 2002; Mursitama, 2006) and result in a positive effect on firm performance (Zattoni et al., 2009). Given the agency costs and also the strategic advantages of the pyramidal ownership by the controlling family, the performance effect would be contingent on the efficiency of corporate governance institutions (Chung & Luo, 2008; Luo & Chung, 2005). Specifically, in an environment with less-developed institutions, firms rely on the internal governance of 11

13 family control to safeguard their value. However, a pyramidal ownership structure separates the private interests of the controlling family from the firm s interest in maximizing its value, thus diminishing the efficiency of family control in corporate governance as well as any positive strategic effects. In contrast, with more advanced institutions, the governance mechanism of family control may be less important, as external governance can substitute to protect firm value (Randøy & Jenssen, 2004; La Porta et al., 2002). This will reinforce the strategic advantages of a pyramidal ownership structure and ensure its positive effects in fostering firm performance. Therefore, we propose the following hypothesis: Hypothesis 2. After an institutional reform, the negative effects of a pyramidal ownership structure on the performance of firms in emerging economies will become positive. Ownership by Domestic Institutional Investors Despite the controlling family, firm s external institutional investors will also play a significant role in corporate governance after the firm is listed publicly (Filatotchev et al., 2006; Gedajlovic et al. 2004); thus, their governance effects can be relevant to firm performance (Lien, Piesse, Strange & Filatotchev, 2005; Young, Peng, Ahlstrom & Bruton, 2002). From the institutional-based view of corporate governance, we argue that the way in which institutional investors perform corporate governance will depend on the way in which their interests are connected with the firm within the specific institutional context (Webb, Beck & McKinnon, 2003) and that any changes in the institutional system therefore may 12

14 influence the governance effects on firm performance outcomes. Among the institutional investors, domestic institutional investors can be particularly influenced by the institutions of emerging economies. Specifically, relation-based networks are one of the most important institutional characteristics in emerging economies (Hoskisson et al., 2000; Li & Filer, 2007). Within these relational networks, domestic institutional investors play a critical role as intermediaries between the holders of surplus capital and firms in need of financial resources, causing their interests to be deeply embedded in the stability of the network structure. Thus, a mutually dependent relationship exists between the domestic institutions and their invested firms. Consequently, domestic institutions tend to support the strategic management of their invested firms, and they thus act as passive participants in the corporate governance of these firms (Tihanyi et al., 2003). Furthermore, domestic financial institutions not only hold significant equity in the invested firms but also usually lend the firms a substantial amount of capital (Shleifer & Vishny, 1997). However, owing to the lack of standards in banking fundamentals, e.g., in terms of credit checking, in emerging markets (Yeyati, Peria & Schmukler, 2004), financial institutions lack the necessary information to assume their debts when the borrowing companies violate their contracts. Collaborating with the controlling family helps domestic institutional investors protect their lending assets. However, institutional reforms will enhance legal accountability and provide greater 13

15 transparency over firm operations; thus, external governance may substitute for the effect of family control in corporate governance. Within the reformed institutional setting, domestic institutional investors should be more equipped to protect their investments in the firm and thereby have less motivation to collaborate with the controlling family. Furthermore, when the founding family has significant ownership within the firm, domestic institutional investor can perform an important role of external governance to counteract the agency problems associated with controlling family domination and thus promote the performance of their invested firms. Therefore, we propose the following hypothesis: Hypothesis 3. After institutional reform, domestic institutional investors will have a positive effect on the performance of their invested firms in emerging economies. METHOD Empirical Setting The empirical examination in this study is based on panel data on publicly listed firms in Taiwan spanning 14 years from 1996 to During this period, the Asian financial crisis (1997) occurred, which motivated the Taiwanese government to undertake significant financial system reforms in the early 2000s. The rapid institutional changes resulting from the reforms provide an ideal setting for us to test our hypothesis. Despite its successful economic development, until the late 1990s, the Taiwanese market was still characterized by inefficient corporate governance (Luo & Chung, 2005). 14

16 Particularly, the Asian financial crisis in 1998 and 1999 had a serious economic impact on many Asian countries, including Taiwan. Numerous studies have indicated that the inefficiencies of the local governance system in protecting investors rights were among the major reasons for the outbreak of the crisis (Lemmon & Lins, 2003; Mitton, 2002; Johnson et al., 2000). Against this backdrop, in 2001, the Taiwanese government embarked upon a series reforms to facilitate external corporate governance. Specifically, in 2001, the Taiwanese government amended the Company Law to require companies to disclose cross-holding information. In 2002, the TSE established an online system of information disclosure for all listed firms in Taiwan (the Market Observation Post System, at In 2003, Taiwanese regulators promulgated a set of new regulations aimed at improving the quality of information disclosure. In addition, in 2003, the TSE began annual reviews and evaluations of the quality of firm information disclosures, and the results were published online as a reference for all investors. To ensure the independence of boards of directors, since 2003, the TSE has also required that newly listed firms reserve at least two seats for independent directors. More direct evidence of the transition in corporate governance institutions in Taiwan can be found in the shareholder protection index (SPI) in the survey by Chu (2012). This survey is based on Siems et al. (2009), and is comparable to surveys in other markets that 15

17 follow the same approach (e.g., Armour, Deakin, Sarkar, Siems & Singh, 2009; Siems, 2008). The SPI Index consists of ten variables to measure various aspects of corporate governance efficiency with respect to protection of shareholder rights. In Table 1, we list and define the ten variables. Insert Table 1 in here In Table 2, we report the SPI scores for Taiwan for the period from 1995 to In comparison to the initial situation in 1995, over time, the institutional system provided stricter protection of shareholders rights, including giving shareholders agenda-setting power (from 0.5 to 1), allowing for independent board members (from 0 to 0.57), and requiring mandatory bids (from 0 to 0.5) and disclosure of major share ownership (from 0.5 to 0.75). Most of this progress took place between 2001 and 2002, as Taiwan was experiencing dramatic institutional reform and creating a more efficient institutional environment for corporate governance. Insert Table 2 in here Data and Sampling In this study, we used data from the Taiwan Economic Journal (TEJ) database for the empirical examination of our hypotheses. The TEJ is a well-established provider of data on companies throughout Asia. Information obtained from the TEJ has been widely used in previous studies to test the corporate-governance effects on Taiwanese firms (e.g., Chang et 16

18 al., 2006; Liu et al., 2006). In the sampling process, we focused on the publicly-listed firms in Taiwan, but excluded financial companies because of their unique institutional framework with regard to corporate governance (Filatotchev et al., 2005). In addition, we collected data for these companies across a 14-year period from 1996 to 2009, including 3,585 firm-year observations for 357 publicly-listed firms in Taiwan. Table 3 shows the annual distribution of the observations across the 14-year test period. Insert Table 3 in here Dependent Variables We used two financial indicators to gauge the performance effect of a firm s governance during the specific time period ( ) the firm s Return of Equity ratio and the Market-to-Book Value ratio. The Return of Equity is a common firm performance measure in corporate governance studies that focus on the emerging markets (e.g., Peng, 2004), calculated as the firm s net income divided by the average of the owners equity during a given year. The Market-to-Book Value ratio has also been widely used in corporate governance studies (e.g., Baker & Wurgler, 2004). As in other studies, the ratio in this paper represents the market value of the firm (book-asset value minus book equity value plus market equity value) divided by the book-asset value at the end of a given year. Independent Variables Five independent variables were used for our empirical testing. The first two variables 17

19 (Family Ownership / Family Member on Board) represent the extent of family domination on the firm s ownership structure and on the composition of the board of directors. The third variable (Family Pyramid) is a dummy, representing whether the controlling family owns its shares indirectly through other controlled institutions under its control. The fourth variable (Domestic Institutions Ownership) is the percentage of corporate shares owned by domestic institutional investors, including domestic banks, mutual funds, and insurance companies. In addition to these four corporate governance variables, we use Taiwan s Shareholder Protection Index from Chu (2012) (see Table 2) to represent the change of efficiency for the Taiwan institutions in implementing corporate governance. Control Variables As in the testing models in previous studies (e.g., Peng & Jiang, 2010), further variables were included in our empirical analyses to control for other factors that are likely to affect the governance effect on firm performance. Specifically, we used the logarithm of each firm s book assets to account for the scale effect (Assets Scale), the logarithm of firm age to control for the historical effect (Firm Age), the ROA ratio of one year ago to control for the effect of previous performance (Past Performance), the capital Intensity Ratio (the logarithm of total assets divided by sales revenue) to control for the industrial effect, and the Debt-to-Assets Ratio (total debt divided by total assets) to control for the effect of the financial structure. Furthermore, sourced from the TEJ database, a dummy variable (Top 18

20 Group) was used to indicate whether the firm was affiliated with one of the 100 major business groups in Taiwan. Detailed definitions of all the variables are listed in Table 4. Insert Table 4 in here Estimation In this study, we used panel-data analysis model to account for the performance effect of any firm-level factors, which may change over time. Greene (2000) asserts that a panel-data analysis that incorporates both time-series and cross-sectional approaches allows the researcher to account for variations across firms and over time. This approach can also increase the degree of freedom in the empirical model. To conduct the panel data analysis, either a fixed-effect model or a random-effect model can be considered (Greene, 2000). We adopted the random-effect model because it assumes each observation is drawn from a normal distribution that helps us to make inferences about the effect of total population by using the characteristics of the samples (Verbeek, 2000). On the other hand, endogeneity can be a problem in regressions of corporate governance data (Cho, 1998). Thus, we lagged the independent variables by one year to evaluate firm characteristics at a point at which endogeneity would not likely be an issue (see Peng and Jiang, 2010). Based on the random-effect approach, we conducted two-stage analyses. In the first stage, we used the full sample from 1996 to 2009 to examine how the corporate governance factors (i.e., family ownership, family member on board, family pyramid and domestic 19

21 institutions ownership) respond the institutional reforms and thus affect firm performance. In the second stage, we split our samples into two sub-periods and compared the corporate governance effects under different institutional contexts. Because institutional reform tends to be a part of a process rather than a one-time shock, we partitioned the 3,533 firm-year observations in this study into the pre-reform years ( ), the reform years ( ), and the post-reform years ( ). We focused on a comparison of the corporate governance effects between pre-reform and post-reform periods. RESULTS Table 5 shows the descriptive statistics for all of the variables in this study as well as the correlations among these variables. According to the table, on average the controlling family in Taiwan holds percent of ownership and 17 percent of the seats on the board in our sample firms. Furthermore, 44 percent of our sample firms are dominated by the controlling family through a pyramidal ownership structure. On average, domestic institutional investors hold percent of the equity stakes in these sample firms. Insert Table 5 in here Table 6 compares the means of the testing variables during the pre-reform and the post-reform years. As shown in the table, after implementation of the institutional reforms Family Ownership increased from percent to percent, while Family Member on Board decreased from percent to percent. The results reveal that the private 20

22 interest of controlling family is associated with firm value in greater extent after the institutional reform, meanwhile the firms show grater extent of board independence from the controlling family. However, the number of firms that were associated with Family Pyramidal ownership structure during the two sub-periods remained relatively unchanged (41.5 percent and 41.8 percent). Meanwhile, Domestic Institutions Ownership increased from percent to percent and the Institutional Reform Index increased from 5.25 to The results of this comparison suggest that there were significant improvement in corporate governance institution between the pre-reform and post-reform periods in Taiwan. Insert Table 6 in here Based on the institutional measure on Shareholder Protection Index, Table 7 reports the outcomes of our first-stage analysis based on the full samples from 1996 to As shown in the table, we respectively used the Return of Equity ratio (models 1 to 6) and Market-to-Book Value ratio (models 7 to 12) as the dependent variable in the test and both the results reveal similar corporate governance effects in supporting our hypotheses. Specifically, mode 1 and model 7 present the test results with only the controlling variables and both the modes reveal a positive performance effect of firm s Scale of Assets, validating the importance of corporate assets for firm performance in the resource-scarce environment of the emerging economies. In addition, we found a negative effect for Firm s Age, suggesting that older firms are difficult to adapt to the institutional change. Moreover, a 21

23 firm s Past Performance is positively associated with its subsequent performance, whereas Capital Intensity Ratio and the Debt-to-Assets Ratio have an adverse effect on performance. Insert Table 7 in here The corporate governance effects of our testing variable in model 8 reveal a positive effect for domination by the controlling family (Family Ownership and Family Member on Board) on firm performance, suggesting that corporate performance in the emerging economies is sustained by the governance effect of family control. However, our analyses reveal that the pyramidal ownership structure of the controlling family (Family Pyramid) has a significant negative effect on the firm s Return of Equity, suggesting that the pyramidal ownership will corrode the efficiency of corporate governance under the principal-principal framework. We also found that institutional reform is positively associated with firm performance, validating that institutional effect is also relevant in determining the corporate governance efficiency in emerging economies. In the remainder of Table 7, we present results of the analyses with respect to the way a firm s family-control governance mechanisms respond to the institutional reform in Taiwan. Consistent with Hypotheses 1a and 1b, we found that the institutional reform has a significant moderating effect to substitute for the positive performance effects of controlling family domination on the ownership structure of firm (Family Ownership x Shareholder Protection Index, model 3) and on the composition of the firm s board of directors (Family 22

24 Member on Board x Shareholder Protection Index, model 10). We also found that institutional reform positively moderates the performance effect of the pyramidal ownership of the controlling family (Family Pyramid x Shareholder Protection Index, model 5), supporting our Hypothesis 2. Finally, the analysis results reveal that domestic institutional ownership will have stronger corporate-governance effect in support of firm performance (model 12). This provides strong support for Hypothesis 3. Table 8 presents the results of our second-stage analysis, in which we compare the performance effects of these family-control corporate governance factors during the pre-reform ( ) and the post-reform periods ( ). As shown in the Table, we found that the positive effects of controlling family domination on firm performance (Family Ownership and Family Member on Board) were weakened after the institutional reforms. This finding is consistent with Hypothesis 1. In addition, the results reveal that the performance effect of Family Pyramid changed from negative to positive in the post-reform period, lending support to Hypothesis 2. We also found that the performance effect of Domestic Institutions Ownership was influenced by the institutional reforms and changed from insignificant in the pre-reform period to significantly positive in the post-reform period, thus supporting Hypothesis 3. All of the above findings in the second-stage analyses are consistent with our first-stage analyses based on the full sample and the corporate governance institutional index of this study. 23

25 Insert Table 8 in here DISCUSSION Theoretical Contributions In this study, we explored how institutional reforms aimed at corporate governance reshape the corporate governance effects of family control in emerging economies. Most emerging economies institutional systems are deficient in protecting shareholders rights; thus, local firms tend to rely on the governance effects of family control in preventing managerial expropriation, leading to a high prevalence of controlling family domination in most of emerging economies (Claessens et al., 2000). Based on the principal-principal corporate governance framework (Young et al., 2008), most studies on emerging economies focus on issues arising from the conflicting interest between the firm s controlling family and the firm s other shareholders (see Filatotchev et al., 2005; Liu et al., 2006; Liu et al., 2013). However, from the perspective of institutional theory, these studies tend to neglect the contingent of institutional reforms that would enhance the efficiency of external governance to the firms and thereby transform the corporate governance effect of family control in emerging economies (Aguilera et al., 2008). Based on data from publicly listed firms in Taiwan, this empirical research detects the corporate governance effect that is similar to that in most other emerging economies. Prior to the institutional reforms, institutions in Taiwan were inefficient in terms of protecting 24

26 shareholder rights (Luo & Chung, 2005). However, as shown in Table 1, the Taiwanese government engaged in extensive institutional reforms in the early 2000s and thereby fostered the external governance of firms operations. In the context of the institution reforms, our empirical findings support the institutional-based view of corporate governance (Aguilera et al., 2008) by showing that institutional reform alters the essence of corporate governance and substitutes for the governance effect of family control (Filatotchev & Nakajima, 2010). Specifically, according to our examination, the institutional reforms substitute for and invalidate the positive performance effect of controlling family domination. Numerous studies indicate that family control fosters firm performance in emerging economies (Carney & Gedajlovic, 2003; Chang, 2003). According to institutional theory, this positive performance effect is rooted in the specific institutional environments of emerging economies, where the corporate governance effects of family control compensate for the inefficiency of external corporate governance (Peng & Jiang, 2010). In addition, the family control of the firm facilitates the resource commitment of the controlling family and thus enhances the competitive advantage of the firm in the resource-scarce environment of an emerging economy (Young et al., 2008). However, we found that after institutional reforms have been implemented, the advantages of family control are diminished, demonstrating the substitution of external corporate governance for family control as a mechanism of 25

27 corporate governance (Filatotchev & Nakajima, 2010; Ward et al., 2009). According to these findings, a firm s governance system (i.e., family control) changes not only with the evolution of the firm s life cycle (Gedajlovic et al. 2004; Zahra & Filatotchev, 2004) but also with the transformation the institutional environment. Our findings indicate that a pyramidal ownership structure by the controlling family will enhance firm performance owing to the more efficient external corporate governance achieved by the institutional reforms. According to the literature, pyramidal ownership by the controlling family has a dual effect on firm value. From the agency perspective, a pyramidal ownership structure reduces the interest bounding of the controlling family to the firm and thus has a negative corporate governance effect under the principal-principal framework (Claessens & Fan, 2002; Claessens et al., 2000). However, from the strategic point of view, the pyramidal ownership structure creates business affiliations among various firms (Stafsudd, 2009) and thus integrates their resources and operations in pursuit of a shared goal. These business affiliations will thus enhance the firm s competitive advantage in the market (Ma et al., 2006). On the basis of institutional theory, our empirical findings suggest that the net impact of a pyramidal ownership structure by the controlling family on the performance of corporate governance is contingent upon the institutional context. The costs of pyramidal ownership structure will be constrained by external governance mechanisms when the firms operate in a more efficient institutional environment, and thus, 26

28 the pyramidal ownership by the controlling family will have a positive effect on firm value. According to our findings, the corporate governance effect of domestic institutional investors on firm performance significantly improved after the institutional reforms, suggesting the governance effect was significantly affected by the institutional environment. In the context of the relation-based society in most emerging economies, a number of studies have indicated that the interests of domestic institutional investors are dependent on the stability of the social network (Li & Filer, 2007; Hoskisson et al., 2000), resulting in a significant propensity among the domestic institutional investors to support the management agenda of the controlling family and thus to act as passive participants in corporate governance (Tihanyi et al., 2003). From the perspective of institutional theory, our analyses suggest that institutional reforms can have a significant impact on the business context and thus alter the interest expectations and risk preferences of domestic institutional investors with respect to their invested firms. Such institutional reforms will, in turn, relieve the dependence of domestic institutional investors on social networks and will encourage them to play a more active role in corporate governance. In addition, as intermediaries providing access to financial capital (Engwall & Johanson, 1990), institutional investors are sensitive to the transition of local institutions and thus will rapidly adjust to enhance their legitimacy within the new institutional setting. Based on these empirical findings, our study provides support for the institution-based view of corporate governance (Peng & Jiang, 2010). 27

29 Practical Implications The findings in this article have significant practical implications for management and policy making. First, after an institutional transition, controlling family domination may become an obstacle to firm performance, indicating that the corporate governance based on the principal-principal framework will gradually become unsuitable to the institutional context of emerging economies. Second, subsequent to institutional reform, firms in emerging economies will encounter extreme market-based competition. These companies should therefore cultivate their relationships with institutional investors, as these investors not only provide critical resources to firms but also play an active role in monitoring firms management teams. Finally, institutional reform in emerging economies is relevant to the efficiency of corporate governance in local companies. However, institutional reform can restricts the private benefits of the controlling family and creates significant costs for firms to adapt to the new institutional environment. When formulating and implementing reforms, policymakers in emerging economies should anticipate resistance from controlling families. Future Research This study has several limitations that may provide avenues for future research. Among emerging economies, Taiwan is relatively advanced in terms of its economic development. Moreover, it is relatively politically stable. These characteristics have facilitated institutional reform and strengthened its effects. Future studies should attempt to 28

30 ascertain the effects of institutional transitions on corporate governance in other contexts with different economic and political conditions. In addition, our study focuses on institutional reforms in legal and regulatory systems. However, researchers might also consider other environmental factors that affect firm governance. Future research may thus strengthen the findings from this study by examining how other contextual factors, i.e., increased foreign competition, political upheavals, technologic changes, and economic downturns, might affect the effectiveness of various corporate governance mechanisms. CONCLUSION In this study, we investigate whether and how institutional transitions and reforms affect the corporate governance efficiency of family control in emerging economies. Based on institutional theory, we argue that the efficiency of the corporate governance system (i.e., family control) will vary according to the institutional context. We further assert that as emerging markets continue to evolve toward more accountability and transparency, these institutional changes will reinforce the external monitoring and discipline of firms that will undermine the effect of original corporate governance system basing on the family control. The results of our empirical examination validate the above arguments. Specifically, our research provides evidence that institutional reforms not only reduce a firm s dependence on family control in performing corporate governance but also positively moderate the impact of a pyramidal ownership structure by the controlling family on firm performance. The 29

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