Aalborg University. From the SelectedWorks of Omar Farooq

Aalborg University From the SelectedWorks of Omar Farooq 2012 Effect of Corporate Governance Mechanisms on the Relationship between Legal Origins and Cost of Debt: Evidence from the Middle East and North Africa (MENA) Region Omar Farooq Mohamed Derrabi Available at: https://works.bepress.com/omar_farooq/13/

Effect of corporate governance mechanisms on the relationship between legal origins and cost of debt: Evidence from the MENA region Omar Farooq * Department of Business and Management, Aalborg University, Aalborg, Denmark Mohamed Derrabi UIR Business School, International University of Rabat, Rabat, Morocco / ESC-Rennes, France * Correspondence Address: Department of Business and Management, Aalborg University, Fibigerstræde 4, Aalborg 9220, Denmark. Telephone: +45 6134 1113 Email address: omar.farooq.awan@gmail.com

Effect of corporate governance mechanisms on the relationship between legal origins and cost of debt: Evidence from the MENA region Abstract How do differences in country-level governance and enforcement mechanisms affect firms? Using a large dataset from the MENA region, we document that differences in legal traditions translate into differences in cost of debt. Our results show that firms headquartered in the common law countries have lower cost of debt than firms headquartered in the civil law countries. Our results also show that bulk of the difference in cost of debt between firms headquartered across the two legal regimes can be explained by the corporate governance mechanisms. Our results have implication for firms in the civil law countries in a way that they highlight that higher cost of debt in the civil law countries can be offset by improving firm-level corporate governance mechanisms. JEL classification: G34; G32 Keywords: Corporate Governance; Cost of Debt; Emerging Markets; Choice of Auditors; Ownership Concentration.

1. Introduction How do legal traditions of a country effect firms? The answer to this question has formed the basis for plentiful of previous research. La Porta et al. (2002), for example, show that corporate valuations in the common law countries are significantly higher than corporate valuations in the civil law countries. While, Gugler et al. (2003) show that firms from countries with common law outperform firms from countries with Scandinavian, German or French laws. This strand of literature is, more or less, unanimous about the fact that firms thrive in countries with common laws. The common law countries provide better investor protection, more stringent enforcement mechanisms, and stronger property rights. Therefore, common law is considered to be synonymous to positive impact on firms relative to the civil law. An important question that arises from this above literature is that whether firms stuck in the civil law countries have any power to offset the adverse implications of the legal traditions of their countries? Or, do they have to be content with relatively unfavorable laws and regulations that civil law traditions offer and always be at a disadvantage relative to firms from the common law countries? The answer to these questions will highlight the power that firms have to safeguard themselves against any weaknesses of external governance mechanisms. This paper aims to answer some of the above questions by using the data from Morocco, Egypt, Saudi Arabia, United Arab Emirates, Jordan, Kuwait, Qatar, and Bahrain, i.e. the Middle East and North Africa (MENA) region. Using a large dataset covering the period between 2005 and 2009, we document lower cost of debt for firms headquartered in the common law countries relative to firms headquartered in the civil law countries. Our results show that cost of debt for firms headquartered in the common law countries is 5.01 basis points less than cost of debt for firms headquartered in the civil law countries. Our results are consistent with previous literature that documents lower information asymmetries in the common law countries (La Porta et al., 1999). We argue that higher information asymmetries exacerbate agency problems between insiders and outsiders in the civil law countries. Insiders have access to more timely information in these countries than outsiders and thus can exercise this information to their advantage. Outsiders, being aware of information disadvantage, tend to shy away from firms with higher information asymmetries. Our arguments are consistent with the assumption that better corporate governance mechanisms in the common law countries lower the risk faced by creditors (Blom

and Schauten, 2006). Relatively better corporate governance mechanisms reduce information asymmetry between firms and other agents in the capital markets and therefore reduce the risk. Lower risk should, eventually, translates into lower cost of debt. We also show that our results are persistent in the sub-sample of large and small firms. We show that cost of debt for large firms headquartered in the common law countries is 3.27 basis points less than cost of debt for large firms headquartered in the civil law countries. This difference increases to 5.70 basis points in the sub-sample of small firms. Persistence of our results indicates that legal traditions may be considered as important determinant of cost of debt in the MENA region. Furthermore, we also show that the difference between cost of debt for firms headquartered in the common law countries and cost of debt for firms headquartered in the civil law countries can be significantly explained by the corporate governance mechanisms. We show that controlling for firm-level governance mechanisms results in making the difference between the two groups go down significantly. Our results, for example, show that controlling for corporate governance mechanisms (choice of auditors and ownership concentration) reduces the difference in cost of debt between firms headquartered across the two legal regimes by almost 63%. Our results indicate that firms headquartered in civil law can lower their cost of debt by improving corporate governance mechanisms. For example, our results show that reducing ownership concentration can lower cost of debt by improving information environment. Improving governance and information environment can induce creditors to lower their risk perception for a firm and lower their cost of debt. We also show that our results are robust across different sub-samples. Our results show that controlling for corporate governance mechanisms significantly reduce the difference in cost of debt between firms headquartered across the two legal regimes for sub-samples of large and small firms. Reduction is coefficient highlight the power that corporate governance has in explaining the difference in cost of debt for firms headquartered across the common and civil law countries in the MENA region. Improvement of governance mechanisms can offset some of the problems associated with the civil law regimes. The remainder of the paper is structured as follows: Section 2 briefly discusses motivation and background, while Section 3 describes corporate governance mechanisms used in this study. Section 4 summarizes the data and Section 5 presents assessment of our hypothesis. The paper ends with Section 6 where we present conclusions.

2. Motivation and background The Middle and North Africa (MENA) region, home to world s largest oil reserves, is politically and economically one of the most important regions of the world. 1 Prior literature, usually, assumes that the regional countries share important commonalities such as the absence of democracy and similarities in culture, religion, and language. 2 However, in spite of these commonalities, the regional countries also have important dissimilarities. One such dissimilarity is the legal traditions of the countries. Bahrain, Saudi Arabia, and United Arab Emirates, for example, follow English common law, while Egypt, Jordan, Kuwait, Morocco, and Qatar follow French civil law (La Porta et al., 1999). Extant literature suggests that differences in legal traditions translate into differences in corporate governance mechanisms. This strand of literature argues that countries with common law traditions provide stronger protection to outside investors. La Porta et al. (1999) examine 49 countries and find that the common law countries generally have the strongest and the civil law countries have the weakest legal protections for investors. Siems (2006) argues that stronger investor protection in the common law countries can be traced down to how common and civil law traditions came into being in the twelfth and thirteenth centuries in England and France respectively. He mentions that both of these countries faced the problem of protecting their law enforcers from intimidation by complainants during twelfth and thirteenth centuries. However, the crucial difference between the two countries was that France was relatively less peaceful than England. In France, there was a greater need for protection and control of law enforcers by the state. Therefore, French legislators drafted laws that would not provide opportunity to judges to re-interpret or change laws. In England, on the other hand, independent judiciary and a system of decentralized law-making was put in place where judges had broad powers to interpret and change laws. As a result, civil law puts more emphasis on codes rather than judicial discretion, while common law relies on judge-made laws rather than strict codes. Consequently, spirit of the law is very important in the common law 1 Given its importance, the region has always attracted significant interest from analysts and investors. This interest resulted in significant growth and development of regional stock markets. For example, the Casablanca Stock Exchange gained almost 300% during the five years preceding to the recent financial crisis, while the Cairo Stock Exchange gained whopping 1000% during the same time period. 2 There are a number of refereed journals that concentrate primarily on this region. Some of the important ones are Review of Middle East Economics and Finance, Middle East Development Journal, and International Journal of Islamic and Middle Eastern Finance and Management.

traditions. Contrary to the common law traditions, influential individuals can enact laws and regulations via which they could get away with their unscrupulous behavior. Differences in investor protection between common law and civil law countries have profound effect on corporate governance mechanisms. La Porta et al. (1999) argue that whenever investors finance firms, they want to be protected against any fraudulent behavior of management. Laws and regulations are important mechanisms that ensure investors the protection of their capital. Some of these laws require firms to decrease agency problems by improving their disclosure and accounting practices. Better disclosure and accounting practices allow shareholder to receive dividends, to vote for directors, to participate in shareholders meetings, to subscribe to new issues of securities on the same terms as the insiders, to sue directors or the majority for suspected expropriation, and to call extraordinary meetings. It is important to mention here that, in most of the countries, enforcement of laws and regulations prescribed during the process of raising capital cannot be taken for granted. The traditional mechanisms, such as enforcement by market participants or market regulators, to enforce private contracts between investors and firms may not work properly in most of the emerging markets. As a result, firms would not have enough incentive to repay investors. Therefore, courts and the judicial machinery have to play a crucial part in ensuring that laws and regulations are properly enforced. Inefficient courts are slow, subject to political pressures, and at times corrupt. These courts are often unable to invest resources necessary to ascertain the facts pertaining to private contracts between investors and firms. When the enforcement of private contracts is costly, other forms of protecting property rights, such as judicially-enforced laws or government-enforced regulations, may become more important. In such circumstances, it is better to have contracts restricted by laws and regulations that are enforced than unrestricted contracts that are not. This paper argues that common law countries enforce laws and regulations more efficiently than civil law countries. Prior literature documents that legal rules in the common law system are usually made by judges, based on precedents and inspired by general principles such as fiduciary duty or fairness. Judges are expected to rule on new situations by applying these general principles even when specific conduct has not yet been described or prohibited in the statutes (La Porta et al. 2000). Coffee (2000) argues that judges in common law countries try to make sure that any action even if it adheres to the letter of a law undertaken by firm is unfair to investors or not. He states that judges in common law countries tend to sniff out the intentions of management.

Bad intentions are penalized, even if they are within the statutes. La Porta et al. (2000) believe that expansion of legal precedents to additional violations of firm s fiduciary duty, and the fear of such expansion, limit the expropriation by the insiders in common law countries. However, contrary to common law, civil law remains within the statutes and does not require judges to penalize bad intentions. Therefore, management in civil law countries can go ahead with any action to expropriate no matter how harmful it is for investor as long as it is not forbidden in the statutes. 3 Consistent with prior research, we argue that better corporate governance mechanisms should translate into lower cost of debt for firms headquartered in the common law countries. Our arguments are consistent with prior literature that argues that good corporate governance mechanisms reduce information asymmetry between firms and other agents in the capital markets and therefore reduce the risk of a firm. Debt providers, being outsiders, minimize the information asymmetry by taking into consideration corporate governance mechanisms. Better governance mechanisms signal lower information asymmetries, therefore allow debt holders to require lower returns on their investments. Consistent with these arguments, Bhojraj and Senpgupta (2003) show a positive correlation between disclosure and bond ratings and a negative relation between disclosure and bond yields. Furthermore, La Porta et al. (1997, 1998) show that legal systems with common law origins offer better protection to creditors than civillaw origins. This, therefore, leads to lower risk for debt providers in common law countries and thus lower cost of debt. 3 An interesting example of when courts failed to go beyond the statute in civil law country is the case of SAICO against directors of SARL Peronnet (a French company controlled by the Peronnet family). SAICO was a minority shareholder of SARL Peronnet. It sued those directors of SARL Peronnet that were from the Peronnet family for expropriation. In the case, SAICO argued that the Peronnet family established a new company, SCI, solely owned by family its members. It presented evidence that SCI bought some land and took out a loan to build a warehouse. The warehouse was then rented to SARL Peronnet and the proceeds were used to repay the loan. After the loan was repaid, the warehouse was leased to SARL Peronnet, whose board voted to transfer the activities of the company to the new warehouse. SAICO argued that the Peronnet family expropriated the corporate opportunity of SARL Peronnet (namely to build a warehouse), and thereby benefited itself at the expense of minority shareholders. The court ruled against SAICO and held that the decision to build a warehouse through SCI was not taken with the sole intention of benefiting the majority shareholders (i.e., the Peronnet family), and had a legitimate business purpose. The court took no interest in the questions of whether the creation of SCI, and the prices it charged SARL Peronnet for the use of the warehouse, were fair to SAICO and other minority shareholders. In the common law countries, courts would be very suspicious of the conduct of the Peronnet family unless it could demonstrate that the transaction did not have unfair motives.

H1: Better corporate governance mechanisms in the common law countries translate into lower cost of debt for firms headquartered in the common law countries relative to firms headquartered in the civil law countries An important implication of our arguments is that any difference in cost of debt between firms headquartered in the two legal regimes can be explained by corporate governance mechanisms. Corporate governance mechanisms are supposed to alleviate agency problems and thus lower the risk faced by creditors. Any effort on part of firms to reduce agency problems and information asymmetries should be rewarded by lower of cost of debt across both legal regimes. H2: Corporate governance mechanisms explain bulk of the difference in cost of debt between firms headquartered in the common law countries and firms headquartered in the civil law countries 3. Corporate governance mechanisms For the purpose of this paper, we consider ownership concentration and choice of auditors as proxies for corporate governance mechanisms. The following sub-sections explain the rationale behind using the above mentioned variable as proxies for corporate governance mechanisms in greater detail. 3.1 Ownership concentration Prior literature characterizes emerging markets with concentrated ownership structure. Farooq and Bennani (2009) report that an average Moroccan firm is owned by a single shareholder, while Farooq and Kacemi (2011) document that insiders own, on average, almost 50% of shares in firms listed at the MENA stock exchanges. 4 This strand of literature argues that state is not able to efficiently and effectively enforce property rights in emerging markets. As a 4 The East Asian crisis of 1997-98 brought into focus a number of governance problems that resulted from concentrated ownership structure. One such example was United Engineers Malaysia (UEM) who bought shares in its parent, Renong Berhad, for an artificially high price. The shares purchased were those held by family members of management of UEM and Renong Berhad (Source: Business Week June 8, 1998).

result, concentration of ownership becomes an important vehicle via which insiders can extract private benefits by expropriating resources out of firms. 5 McConnell and Servaes (1990) and Mikkelson and Partch (1989) not that entrenchment and incentives effects that result from concentrated ownership increase agency problems and thus provide incentives for insiders and controlling shareholder to expropriate. In addition, this strand of literature also argues that lack of diversification of controlling shareholder exposes him to firm s idiosyncratic risk (Maug, 1998). This risk decreases controlling shareholder s subjective value of investment and he may use an opportunity to collude with managers to shift wealth from minority shareholders to him. 6 Leuz et al. (2003) argue that increased incentives to expropriate allow insiders and controlling shareholders to evade effective disclosure of information. Poor information disclosure exacerbates information asymmetries between insiders and outsiders and result in agency problems. 3.2 Choice of auditors Prior literature considers appointment of one of the big-four auditors as an external auditor to be associated with lower agency problems. This strand of literature argues that bigfour auditors have more motivation to be careful and prudent in their examinations of client firms. McKinley et al. (1985), for example, document that financial statements audited by bigfour auditors are less likely to contain undetected fraud as compared to those audited by other auditors. One of the reasons for more reliability of big-four auditors is their more independence relative to other auditors. Pearson (1980) documents that lesser reliance of big-four auditors on any of their client firms makes them more independent than other auditors who may have to rely exclusively on their client firms for their financial sustainability. As a result, non-big-four auditors experience more difficulty in resisting pressures from their client firms in situations of 5 There is also a plentiful of literature that argues otherwise, i.e. concentrated ownership can result in better governance mechanisms. This strand of literature argues that concentrated ownership is usually characterized by trust, commitment, and altruism and these three factors translate into lower governance problems (Davis, 1983; Chami, 1999). 6 Prior literature suggests that expropriation of minority shareholders translates into a negative relationship between ownership concentration and firm performance. Mitton (2002), for example, shows that firms where incentives to expropriate are high (i.e. concentrated ownership firms), firm performance is lower. He used the data from Indonesia, Malaysia, Thailand, South Korea and Philippines and found negative relationship between firm performance and concentrated ownership.

conflict (Pearson, 1980). Furthermore, big-four auditors have superior technology and more talented employees than small auditors, and thus have higher incentives to behave independently (McLennan and Park, 2003). As a consequence, the information content of audit reports produced by big-four auditors is considered to be more credible than those of other auditors. An important implication of the above arguments is that appointment of one of the big-four auditors should be associated with better information disclosure. Better information disclosure lowers the information asymmetries. 4. Data The aim of this paper is to document the differences in cost of debt between firms headquartered in the common law and firms headquartered in the civil law countries in the MENA region. For the purpose of this paper, we select Morocco, Egypt, Saudi Arabia, United Arab Emirates, Jordan, Kuwait, Qatar, and Bahrain as the representative stock markets of the MENA region. Our sample period consists of the time period between 2005 and 2009. The following sub-sections explain the data in greater detail. 4.1 Corporate governance mechanisms This paper uses ownership concentration and choice of auditors as proxies for corporate governance mechanisms. For the purpose of this study, we define ownership concentration as the proportion of shares held by insiders, while choice of auditors is defined by a firm s decision to appoint one of the big-four auditors as its external auditor. Our definition of big-four auditors consists of KPMG, Ernst & Young, PriceWaterhouseCoopers, and Deloitte & Touche. The data for these variables was obtained from Worldscope and Infinancials. 7 Table 1 documents descriptive statistics for corporate governance mechanisms in the common law countries and in the civil law countries during our sample period. The results in Table 1, Panel A, show that common law countries have, on average, less ownership concentration than civil law countries in every industrial sector. The only exception is Oil and Gas sector and Utilities sector where ownership concentration is higher in common law countries. Concentration of ownership in the 7 Infinancials is the provider of auditable fundamental data and analytics on worldwide listed firms.

hands of insiders in the civil law countries provides means and incentives to controlling shareholders to expropriate minority shareholders. Similar results are reported for the choice of auditors. The results in Table 1, Panel A, show that firms in the common law countries hire more reputable auditors than firms in the civil law countries in every industrial sector. It indicates more reliable information disclosure in the common law countries. Similar to Table 1, Panel A, our results in Table 1, Panel B, indicate less ownership concentration in common law countries across all years. An important observation from Table 1, Panel B, is considerable drop in ownership concentration in common law countries after the recent financial crisis of 2008. Similar results are reported for choice of auditors across all years. We show that firms in the common law countries are more inclined than firms in the civil law countries to hire one of the big-four auditors across all years. Our results of this table are an indication of better corporate governance mechanisms and lower information asymmetry in the common law countries. [Insert Table 1 here] 4.2 Legal origins The MENA region follows a mixed legal system, where the body of law is a combination of several legal traditions blended into one. 8 For the purpose of this paper, we follow La Porta et al. (1999) and divide the commercial laws of our sample countries into two major categories: (1) English common-law and (2) French civil-law. La Porta et al. (1999) classify Bahrain, Saudi Arabia, and United Arab Emirates as common law countries, and Egypt, Jordan, Kuwait, Morocco, and Qatar as civil law countries. 4.3 Cost of debt Cost of debt is calculated as the interest expense for the financial year divided by total debt during the same year. The preliminary statistics indicate that the outcome provides abnormal values, and thus may introduce noise in the measurement of the effective cost of debt 8 The four major sources of law in the region are: the Islamic Sharia, Ottoman law, French civil codes, and English common law.

for a firm. Therefore, following Pittman and Fortin (2004), we trim the data to address extreme observations, and winsorised the allowed spread at the 5th and 95 th percentiles of the initial pooled distribution. The data for interest expense and total financial debt are obtained from Worldscope. Table 2 documents descriptive statistics for cost of debt in common law and civil law countries during our sample period. The results Table 2, Panel A, show that cost of debt in the common law countries is lower than cost of debt in the civil law countries across all industries. Similar results are reported in Table 2, Panel B, where we report lower cost of debt in the common law countries across all years relative to cost of debt in the civil law countries. [Insert Table 2 here] 5. Methodology The purpose of this paper is two folds: (1) To identify whether there exist a difference in cost of debt between firms headquartered in the common law countries and firms headquartered in the civil law countries and (2) To document whether corporate governance mechanisms explain the differences in cost of debt between firms headquartered across the two legal regimes. 5.1 Legal origins and cost of debt The first step in our analysis is to document the relationship between legal traditions prevailing in the country and cost of debt incurred by firms headquartered in these countries. The civil law countries, usually, have lower investor protection, lower enforcement mechanisms, and lower stock market development. All of these factors lead to relatively more agency problems in the civil law countries. We expect higher agency problems to translate into higher cost of debt for firms headquartered in the civil law countries relative to firms headquartered in the common law countries. In order to test this hypothesis, we estimate a regression with cost of debt (CoD) as a dependent variable and a dummy variable representing whether a firm is headquartered in the common law countries or not (COMMON) as an independent variable. The COMMON takes the value of 1 if firm is headquartered in a country with common law traditions and 0 otherwise. The CoD is defined as the ratio of total interest expense to total debt. For the purpose of

completeness, we also include industry dummies (IDUM) and year dummies (YDUM) in our regression equation. 9 Our basic regression is as follows. 10 CoD = α + 1 + Year β Year β ( COMMON ) Ind ( YDUM ) + β ( IDUM ) + ε Ind Furthermore, we also introduce a number of firm-specific variables in our regression equation to control for the effect of various firm-specific characteristics on cost of debt. For example, big firms draw more interest from investors and analysts and therefore have lower information asymmetry. Therefore, one can expect to have lower cost of debt for large firms. Therefore, we add log of firm s total assets (SIZE) to overcome the concerns related to size on cost of debt. In addition, we add total debt to total asset ratio (LEVERAGE) in our regression equation to control for the effect of leverage on cost of debt. Firms with higher debt are exposed to more financial risk and thus should have higher cost of debt. We also add earnings per share (EPS) as a proxy for firm s profitability. More profitable firms should have more access to capital, and therefore should have lower cost of debt. Our modified regression equation takes the following form. CoD + β + 2 Year = α + β1( COMMON ) ( SIZE) + β 3( LEVERAGE) + β 4 ( EPS ) Year Ind β ( YDUM ) + β ( IDUM ) + ε Ind The results of the above set of regression are reported in Table 3. Our results show that firms headquartered in the common law countries have lower cost of debt relative to headquartered in the civil law countries. We report significantly negative coefficient estimate of COMMON for both equations. The results from Equation (4) show that firms in the common law countries have lower cost of debt than firms in civil law countries by 5.01 basis points. We argue that better corporate governance mechanisms, as was shown in Table 3, increase the transparency of firms and thus lower the risk faced by creditors. Lower risk, eventually, translates into lower cost of debt. Our arguments are consistent with prior literature that 9 We do not include country dummies in our regression equation because of high collinearity of some of the country dummies with COMMON dummy. Furthermore, we believe that the most important country-specific characteristic that can effect ownership concentration is the legal traditions followed in a country. Therefore, there is not enough need and motivation to include country dummies in our regression equation. 10 We used robust regression in STATA for all of the regression estimations done in this paper. Robust regression produces those coefficients that are consistent with OLS assumptions. Robust regression produces White corrected robust variance estimates. (1) (2)

documents negative relationship between better governance and cost of debt (Bhojraj and Senpgupta, 2003; Blom and Schauten, 2006). This strand of literature argues that good corporate governance mechanisms reduce information asymmetry between firms and other agents in the capital markets and therefore reduce the risk of the firm. [Insert Table 3 here] There may be concerns that the differences in cost of debt uncovered in the previous regression equations are confined to certain stocks. For example, it may be the case that the differences in cost of debt between firms headquartered across the two legal regimes are restricted to small firms. To address these concerns, we split our sample into two groups, one group with size higher than the median size and the other with size lower than the median size. Smaller firms are considered to be associated with higher agency problems. As a result, we expect the difference in cost of debt to be magnified in the sample of small firms. We re-estimate equation (3) for both sub-samples. The results are reported in Table 4. The results confirm our previous findings of significant difference in cost of debt between firms headquartered in the common law countries and firms headquartered in the civil law countries. Our results show significantly negative coefficient of COMMON for both sub samples. The coefficient of COMMON is larger in magnitude for the firms with smaller size, 5.70 for small firms versus 3.27 for large firms. It indicates that small firms have more agency problems and thus exhibit higher difference in cost of debt across the two legal regimes. [Insert Table 4 here] 5.2 Corporate governance mechanisms and the relationship between legal origins and cost of debt We argued in Section 2 that common law offers stronger investor protection and therefore leads to superior corporate governance mechanisms. One of the implications of superior corporate governance mechanisms in common law countries is lower agency problems in these countries. If our arguments regarding agency problems and common law are true, we

should expect corporate governance variables to explain considerable amount of difference in cost of debt between firms headquartered in the civil law countries and firms headquartered in the common law countries. In order to test this hypothesis, we estimate the following equations. In the following equations, AUDITOR is a dummy variable that takes the value of 1 if a firm is audited by one of the big-four auditors and 0 otherwise, while OWNERSHIP is the percentage of shares held by insiders. CoD + β + 2 Year And CoD + β + β + 2 4 Year = α + β1( COMMON ) ( AUDITOR) + β3 ( OWNERSHIP) Year Ind β ( YDUM ) + β ( IDUM ) + ε Ind = α + β1( COMMON ) ( AUDITOR) + β 3( OWNERSHIP) ( SIZE) + β 5 ( LEVERAGE) + β 6 ( EPS ) Year Ind β ( YDUM ) + β ( IDUM ) + ε Ind The results of the above analysis are reported in Table 5. Our results show that inclusion of governance variables AUDITOR and OWNERSHIP significantly reduce the difference in cost of debt between firms headquartered across the two legal regimes. For example, comparison of Equation (2) with Equation (4) show that the coefficient estimate of COMMON decreases from -5.01 to -1.88. Our result signifies that corporate governance variables explain almost 63% of the difference in cost of debt between firms headquartered in the civil law countries and firms headquartered in the common law countries. An important observation for this analysis is the negative relationship between cost of debt and choice of auditors and positive relationship between ownership concentration and cost of debt. Our results indicate that firms can lower their cost of debt by either appointing one of the big-four auditors as their external auditors or decreasing ownership of the insiders. (3) (4) [Insert Table 5 here] As was done before, we re-estimate Equation (4) for sub-samples of large and small firms constructed earlier. Our results show a significant reduction in the difference in cost of debt

between firms headquartered across the two legal regimes for both sub-samples. The magnitude of coefficient of COMMON reduces from 5.70 to 1.79 in a sub-sample of small firms, while the magnitude of coefficient of COMMON reduces from 3.27 to 1.39 for a sub-sample of large firms. Reduction is coefficient indicate the power that corporate governance have in explaining the difference in cost of debt for firms headquartered across the common and civil law countries. [Insert Table 6 here] 6. Conclusion This paper documents lower cost of debt for firms headquartered in the common law countries relative to firms headquartered in the civil law countries in the MENA region (Morocco, Egypt, Saudi Arabia, United Arab Emirates, Jordan, Kuwait, Qatar, and Bahrain) during the period between 2005 and 2009. Consistent with prior literature, we argue that common law countries have better investor protection, stronger governance mechanisms, and lower agency problems. As a result, creditors are exposed to lower risk in the common law countries. Lower risk, eventually, translates into lower cost of debt. In addition, our results also show that bulk of the difference between cost of debt for firm headquartered in the common law countries and cost of debt for firms headquartered in the civil law countries can be explained by corporate governance mechanisms. Our results have implication for firms in the civil law countries in a way that we show that higher difference in cost of debt in civil law countries can be offset by improving firm-level corporate governance mechanisms. Reference Bhojraj, S. and Senpgupta, P., (2003). Effect of corporate governance on bond ratings and yields: The role of institutional investors and outside directors. Journal of Business, 76, pp.455-476. Blom, J. and Schauten, M. B. J., (2006). Corporate governance and cost of debt. Erasmus University Rotterdam, Working paper.

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Table 1: Descriptive statistics for corporate governance mechanisms The following table documents the descriptive statistics for the corporate governance in the MENA region, i.e. Morocco, Egypt, Saudi Arabia, United Arab Emirates, Jordan, Kuwait, Qatar, and Bahrain. For the purpose of this paper, we identify ownership concentration and choice of auditors as proxies for corporate governance mechanisms. The sample period is from 2005 to 2009. Panel A documents descriptive statistics for each industry across the two legal regimes and Panel B, documents similar statistics for each year. Panel A: Corporate governance mechanisms within each industry Industry Common Law Civil Law Ownership Big-four Auditors Ownership Big-four Auditors Concentration Concentration Oil and Gas 56.24% 75.00% 51.55% 54.55% Basic Materials 27.92% 76.92% 69.84% 70.59% Industrials 29.91% 69.23% 67.71% 66.04% Consumer Goods 36.74% 68.42% 56.06% 44.00% Healthcare 22.63% 100.00% 46.63% 40.00% Consumer Services 52.78% 82.35% 68.85% 66.67% Telecommunication 59.11% 83.33% 83.41% 75.00% Utilities 81.24% 100.00% 27.20% 50.00% Financials 43.76% 89.77% 54.96% 75.33% Technology - - 35.77% 50.00% Panel B: Corporate governance mechanisms within each year Year Common Law Civil Law Ownership Big-four Auditors Ownership Big-four Auditors Concentration Concentration 2005 57.35% 81.43% 58.77% 68.77% 2006 49.51% 80.05% 56.69% 67.29% 2007 45.47% 78.34% 62.78% 68.68% 2008 40.67% 81.03% 61.50% 67.52% 2009 34.18% 83.24% 66.08% 68.76%

Table 2: Descriptive statistics for cost of debt The following table documents the descriptive statistics for cost of debt in the MENA region, i.e. Morocco, Egypt, Saudi Arabia, United Arab Emirates, Jordan, Kuwait, Qatar, and Bahrain. For the purpose of this paper, we calculate Cost of debt as the ratio of interest expense for the financial year to total debt during the same year. The sample period is from 2005 to 2009. Panel A documents descriptive statistics for each industry across the two legal regimes and Panel B, documents similar statistics for each year. Panel A: Cost of debt within each industry Industry Common Law Civil Law Oil and Gas 0.94% 4.87% Basic Materials 2.85% 7.31% Industrials 5.09% 8.35% Consumer Goods 4.70% 15.99% Healthcare 2.62% 2.66% Consumer Services 3.31% 4.82% Telecommunication 2.57% 6.94% Utilities 3.03% 4.15% Financials 2.26% 5.14% Technology - 4.20% Panel B: Cost of debt within each year Industry Common Law Civil Law 2005 3.88% 5.86% 2006 3.51% 7.03% 2007 2.85% 8.37% 2008 2.75% 6.53% 2009 3.13% 5.47%

Table 3: Relationship between legal origins and cost of debt The following table documents the relationship between cost of debt and legal origins of the country using equation (1) and equation (2). The sample comprise of firms from Morocco, Egypt, Saudi Arabia, United Arab Emirates, Jordan, Kuwait, Qatar, and Bahrain. The sample period is from 2005 to 2009. The coefficient that are significant at 10% are followed by *, those at 5% and 1% by ** and *** respectively. Equation (1) Equation (2) COMMON -3.5856*** -5.0137*** SIZE 0.5299*** LEVERAGE -0.0846*** EPS 0.0605 Industry Dummies Yes Yes Year Dummies Yes Yes No. of Observations 2455 2113 Adjusted-R² 0.023 0.035 F-value 3.78 5.16

Table 4: Relationship between legal origins and cost of debt The following table documents the relationship between cost of debt and legal origins of the country using equation (2) for a sub-sample of small and large firms. The sample comprise of firms from Morocco, Egypt, Saudi Arabia, United Arab Emirates, Jordan, Kuwait, Qatar, and Bahrain. The sample period is from 2005 to 2009. The coefficient that are significant at 10% are followed by *, those at 5% and 1% by ** and *** respectively. Small Firm Big Firms COMMON -5.7025*** -3.2747*** SIZE 1.0023** -0.3358 LEVERAGE -0.0349-0.1606*** EPS -0.0052 0.1079 Industry Dummies Yes Yes Year Dummies Yes Yes No. of Observations 1057 1056 Adjusted-R² 0.024 0.050 F-value 11.51 3.66

Table 5: Relationship between legal origin, cost of debt, and governance mechanisms The following table documents the implications of differences in corporate governance mechanisms across the two legal regimes for the cost of debt using equation (3) and equation (4). The sample comprise of firms from Morocco, Egypt, Saudi Arabia, United Arab Emirates, Jordan, Kuwait, Qatar, and Bahrain. The sample period is from 2005 to 2009. The coefficient that are significant at 10% are followed by *, those at 5% and 1% by ** and *** respectively. Equation (3) Equation (4) COMMON -2.4174** -1.8883** AUDITOR -2.1561-2.4711 OWNERSHIP 0.0515** 0.0316* SIZE -0.2998** LEVERAGE -0.0235 EPS 0.0873 Industry Dummies Yes Yes Year Dummies Yes Yes No. of Observations 347 332 Adjusted-R² 0.033 0.066 F-value 3.63 5.34

Table 6: Relationship between legal origins and cost of debt The following table documents the implications of differences in corporate governance mechanisms across the two legal regimes for the cost of debt using equation (4) for a sub-sample of small and large firms. The sample comprise of firms from Morocco, Egypt, Saudi Arabia, United Arab Emirates, Jordan, Kuwait, Qatar, and Bahrain. The sample period is from 2005 to 2009. The coefficient that are significant at 10% are followed by *, those at 5% and 1% by ** and *** respectively. Small Firm Big Firms COMMON -1.7918* -1.3937* AUDITOR -1.2889-3.8187 OWNERSHIP -1.1772 0.0566** SIZE -0.9227* -0.4576 LEVERAGE 0.0660*** -0.0802 EPS 0.1435*** 0.0701 Industry Dummies Yes Yes Year Dummies Yes Yes No. of Observations 117 215 Adjusted-R² 0.175 0.086 F-value 6.38 4.45