Agency conflicts in co-regulation: Evidence from IPO application screening in China

We examine agency conflicts in co-regulation using the unique data on audit firms with partners serving on the Stock Issuance Examination and Verification Committee (SIEVC), referred to here as SIEVC-connected audit firms, in China. We find that audit firms' SIEVC connection helps enhance the likelihood of their client companies passing SIEVC's IPO screening. We further demonstrate that to trade off opportunistic gains against reputational and legal costs, SIEVC-connected audit firms tend to work with those IPO applicant companies with overall quality no worse than others. Finally, we show that to seek the greatest possible opportunistic gains and reduce reputational and legal costs, SIEVC-connected audit firms strategically choose to work with the IPO applicant companies with good observable quality and poor unobservable quality. Our findings imply that due to agency conflicts, private entities participating in co-regulation tend to seek their own benefits by helping their connected parties obtain resources. In addition, IPO applicant screening on unobservable quality aggravate agency conflicts and induce more opportunistic behavior on the part of private parties participating in co-regulation. While such opportunistic behavior weakens the fairness of resource allocation, it does not reduce the efficiency of resource allocation.     

The Effect of Financial Liberalization on the Capital Structure and Investment Decisions of Indonesian Manufacturing Establishments

This article analyzes the consequences of financial liberalization,using a large panel of Indonesian manufacturing establishments.It discusses whether financial reforms have had an impact oninvestment and on the allocation of credit and whether the effectsdiffer depending on the type of firms. The overall conclusionis that shifting from administrative toward market-based allocationof credit has increased borrowing costs, particularly for smallerfirms, but, at the same time, has benefited firms by givingthem widened access to finance.     

The conditional nature of the value of corporate governance

Agency theory suggests that governance matters more among firms with greater potential agency costs. Rational investors are unlikely to value safeguards against unlikely events. Yet, few studies of the relation between governance and firm value control for investor perceptions of the likelihood of agency conflicts. Shleifer and Vishny [Shleifer, A., Vishny, R.W., 1997. A survey of corporate governance. Journal of Finance 52, 737–783] identify investment-related agency conflicts as the more severe type of agency conflicts in the US. We measure the perceived likelihood of this type of agency conflict using free cash flow (Jensen, M.C., 1986. Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review 76, 323–329). We find that firm value is an increasing function of improved governance quality among firms with high free cash flow. In contrast, governance benefits are lower or insignificant among firms with low free cash flow. We show that not controlling for this conditional relation between governance and firm value could lead to erroneous conclusions that governance and firm value are unrelated.     

Capital Allocation in Financial Firms

This paper develops a theory of capital allocation in financial intermediaries where the cost of "risk capital" is a critical consideration. The implication for capital budgeting is that financial firms should use a modified NPV rule in which projects are valued by calculating the NPV of cash flows using marketdetermined discount rates and then subtracting a deadweight cost of capital that reflects the project's marginal contribution to firm-wide risk.
By taking account of deadweight costs—mainly monitoring and moral hazard costs associated with having too little equity capital as well as "free cash flow" agency costs and higher taxes associated with having too much—the capital allocation model predicts that financial firms will diversify across businesses with similar deadweight costs. Such diversification reduces the cost of risk capital for the individual businesses, thereby creating more profitable investment opportunities at the margin and enabling the businesses to operate on a larger scale. The authors note that their model has similarities to but also important differences from the standard applications of RAROC models.     

Lease Financing and Corporate Governance

Lease financing is a well‐recognized mechanism for reducing the agency costs of debt. This study examines whether firms that attempt to control the agency costs of equity through strong governance structures, including Chief Executive Officer compensation alignment and board structure, are more likely to use an agency cost reducing debt structure, such as leasing. For a sample of large firms, we find that firms who use more incentive compensation and have more outside directors also tend to use more lease financing, suggesting these agency cost reducing measures are complements.     

Free Cash Flow,Shareholder Value,and the Undistributed Profits Tax of 1936 and 1937

In 1936, the Federal Government unexpectedly imposed a tax on undistributed corporate profits. Despite the direct costs of the tax, its announcement produced a positive revaluation of corporate equity, particularly among lower-payout firms. We interpret this as evidence of a divergence between managerial and shareholder preferences regarding dividend payout policies, consistent with the presence of agency costs. We also find that despite the incentives created by the tax, the actual growth in dividends during 1936 was lower among firms judged more likely to be subject to higher agency costs after controlling for liquidity, debt, and the growth in earnings.     

Geographic diversification and agency costs of debt of multinational firms

This paper examines the agency conflicts between shareholders and bondholders of multinational and non-multinational firms and provides an explanation for the puzzle that multinational firms use less long-term debt, but more short-term debt than domestic firms. Using a sample of 6951 firm–year observations for multinational and domestic firms over the 1988–1994 period, we find that alternative measures of agency costs have statistically significant negative effects on the firm's long-term leverage. The results, however, also show that the negative effects of agency costs of debt on long-term leverage are significantly greater for multinational than non-multinational firms. It is documented that the effect of the agency costs of debt on leverage are increased by the firm's degree of foreign involvement. The evidence shows that firm's increasing foreign involvement exacerbates agency costs of debt leading to lower (greater) use of long-term (short-term) debt financing. This result is also confirmed using alternative measures of foreign involvement. The evidence is consistent with the view that multinational corporations (MNCs) are susceptible to higher agency costs of debt than domestic corporations because geographic diversity renders active monitoring more difficult and expensive in comparison to domestic firms. The results fail to support the view that MNCs' lower long-term debt ratios are due to the advantages of the internal capital markets.     

Managerial risk incentives and investment related agency costs

We assess the impact of compensation based incentives together with monitoring mechanisms on investment related agency costs. The results indicate that well structured compensation based incentives significantly reduce agency costs. Managerial firm based wealth delta has a significant, negative effect on agency costs for firms in all size categories. The significance of managerial firm based wealth vega in reducing agency costs is concentrated in small firms, suggesting that vega exposure is more effective where risk is higher. The significance of cash compensation in reducing agency costs is concentrated in the large firms. This result implies that higher cash compensation reduces agency costs by allowing risk-averse managers the opportunity to diversify outside the firm.     

Agency costs,taxes and debt: The UK evidence

This paper provides an empirical examination of the impact of the corporation tax and agency costs on firms' capital structure decisions. Our evidence suggests that the agency costs are the main determinants of corporate borrowing. Consistent with the agency theory, we find that firms that have fewer growth options have more debt in their capital structure. Moreover, our results show that debt mitigates the free cash flow problem and that firms that are more likely to be diversified and less prone to bankruptcy are highly geared. the negative effect of insider shareholding on leverage disappears, however; when all the agency mechanisms are accounted for. In addition, we find that, in the long run, companies that are tax exhausted exhibit significantly lower debt ratios than tax-paying firms. However, in the short run, firms' capital structure decisions are not affected by taxation.     

Women on boards of directors and corporate philanthropic disaster response

In this study we conduct firm-level analysis of the impact of women in the boardroom on corporate philanthropic disaster response (CPDR). We propose that CPDR contains agency costs and that female directors are more likely to restrain the associated agency costs of CPDR. We predict a negative relationship between the ratio of women on boards of directors (WoBs) and philanthropic contribution, which is weaker in firms with political connections and stronger in firms with better-developed institutional environments. Data was collected from the philanthropic responses to the Wenchuan earthquake on May 12, 2008 of privately-owned listed Chinese firms. The results support the hypothesized negative relationship, which is found to be weaker in firms with political connections. However, marketization-related factors do not significantly moderate this relationship. These results indicate that CPDR contains agency costs and that female directors do not facilitate the corporate donation process, but rather evaluate the benefits and restrain the associated agency costs.     

Agency costs of free cash flow and conditional conservatism

This study investigates whether agency costs of free cash flow (FCF) are associated with conditional conservatism. Prior research documents that conditional conservatism improves ex ante efficient investment decisions and facilitates ex post monitoring of managers’ investment decisions. As conditional conservatism can provide protection from possible managerial expropriation, the demand for conditional conservatism should increase with the agency costs of FCF. Using excess cash as a proxy for the agency costs of FCF, I provide evidence that firms with higher agency costs of FCF incorporate losses in a timelier manner relative to gains compared to their counterparts. Additionally, the association between excess cash and conditional conservatism predictably varies with the presence of alternative monitoring mechanisms that mitigate FCF problems, such as debt or dividend payouts or repurchases. Further investigation suggests that greater conservatism is associated with a lower likelihood of overinvestment among firms bearing high agency costs of FCF, demonstrating the ability of conservatism to reduce agency costs of FCF.     

Agency Cost,Dividend Policy and Growth: The Special Case of REITs

Dividend distribution enhances information transmission, and mitigates agency conflicts by restricting managers’ access to free cash flow, and exposing firms to the scrutiny and monitoring by market participants when raising external capital. The reduction in agency costs and improvement in information dissemination reduce the cost of funds, and investment at more competitive cost of capital enhances firm value. For REITs, because of the mandated high dividend distribution, growth depends on the availability of external capital at competitive rates, such that mitigation of agency costs is critical to sustain growth. We examine the relation between dividends and growth with a sample of U.S. equity REITs. Our data reveal a significantly positive relation between externally financed growth and dividend payments. The relation is stronger among REITs with more growth opportunities, and REITs that issue new equity and debt. We interpret this evidence as consistent with the notion that by reducing agency costs and facilitating capital raising, dividends enhance growth.     

Annual report readability and corporate agency costs

Annual reports are the main sources of information for outside investors’ investment decisions and enable shareholders to supervise the management. Difficulties with the readability of these reports may therefore have serious consequences. Using 19,221 firm-year observations of Chinese A-share listed firms from 2001 to 2015, we investigate the association between annual report readability and corporate agency costs, where readability is proxied by report file length and/or file size. We find that firms with better annual report readability experience lower agency costs, and the negative association between readability and agency costs is more pronounced in firms with higher external audit quality, internal control quality or analyst coverage. These results hold after several robustness checks. The positive effect of annual report readability is stronger in private firms than in state-owned enterprises, and becomes stronger after the implementation of new accounting standards in 2007. Readable annual reports can help in monitoring corporate insiders’ opportunistic behavior and thus reduce agency costs.     

Does insider trading regulation deter private information trading? International evidence

Using a sample of 2189 firms from 21 countries we find that, on average, stricter insider trading regulations reduce private information trading. However, for firms with high agency costs, insider trading restrictions are less effective in deterring private information trading. We suggest that controlling shareholders who are banned from trading may resort to covert expropriation of firm resources thereby reducing transparency and increasing the returns to private information trading. Consistent with this, we find that firms with higher agency costs located in countries with stricter insider trading laws have more opaque earnings and are valued lower.     

The substitution hypothesis of agency conflicts: Evidence on Shariah compliant equities

According to the substitution hypothesis and recent evidence, firms that are better governed carry less debt and experience fewer agency problems. This may also imply that firms with lower debt are better governed and experience lower agency costs. We test this hypothesis by comparing the agency costs of Shariah compliant (SC, and therefore low debt) and Shariah noncompliant (SNC) firms, using a proprietary dataset comprising constituents of the Dow Jones Islamic index for the period 2006–2015. The findings support the hypothesis but are contingent on the firm's idiosyncratic risk; SC firms with low idiosyncratic risk have higher agency costs.     

Can the agency costs of debt and equity explain the changes in executive compensation during the 1990s?

Contracting theory predicts that greater equity-related compensation will decrease the agency problems of equity but may exacerbate the agency problems of debt. We present evidence that the agency costs of debt may have declined during the 1990s. Specifically, changes in the financial characteristics of our sample firms suggest that underinvestment, asset substitution, and financial distress became less likely. Furthermore, agency costs of equity increased during the 1990s, primarily because firms became more difficult to monitor. Together, the findings provide an explanation for why more firms used option-based compensation in the latter 1990s, and why the proportion of options in compensation structure increased throughout the decade of the 1990s.     

Segment Disclosure Transparency and Internal Capital Market Efficiency: Evidence from SFAS No. 131

Using the adoption of SFAS 131, I examine the effect of segment disclosure transparency on internal capital market efficiency. SFAS 131 requires firms to define segments as internally viewed by managers, thereby improving the transparency of managerial actions in internal capital allocation. I find that diversified firms that improved segment disclosure transparency by changing segment definitions upon adoption of SFAS 131 experienced an improvement in capital allocation efficiency in internal capital markets after the adoption of SFAS 131. In addition, I find that the improvement in internal capital market efficiency was greater for firms that suffered more severe agency problems before the adoption of SFAS 131 and also for firms whose managers faced stronger incentives to improve efficiency after the adoption of SFAS 131. My results suggest that more transparent segment information can help resolve agency conflicts in the internal capital markets of diversified firms, thus improving investment efficiency.     

Financial hedging and corporate investment

Building on the well-documented relationship between corporate financial hedging and firms' borrowing costs, this study examines the impact of utilizing financial derivative instruments on corporate investment. We document that engaging in financial hedging enables firms to pursue more inorganic growth opportunities in the form of M&As. Acquiring firms with financial hedging programs have a lower borrowing cost and are more likely to pay for their deals with cash and use external borrowing. While financial hedging serves as a vehicle for firms to bring their inorganic investment plans to fruition by facilitating their financing, it also leads to inferior investment choices when conflicts of interest among managers and shareholders are more likely to arise. Our study shows for the first time that the financial flexibility emanating from corporate financial hedging can give rise to agency costs by instigating entrenched managers to overinvest.     

CAPITAL STRUCTURE,SHAREHOLDER RIGHTS,AND CORPORATE GOVERNANCE

We show how capital structure is influenced by the strength of shareholder rights. Our empirical evidence shows an inverse relation between leverage and shareholder rights, suggesting that firms adopt higher debt ratios where shareholder rights are more restricted. This is consistent with agency theory, which predicts that leverage helps alleviate agency problems. This negative relation, however, is not found in regulated firms (i.e., utilities). We contend that this is because regulation already helps alleviate agency conflicts and, hence, mitigates the role of leverage in controlling agency costs.     

Investment and financing decisions of private and public firms

We examine differences in the allocation of cash flow between Western European private and public firms. Public firms have a higher investment‐cash flow sensitivity than comparable private firms. This difference is not attributable to more severe financing constraints of public firms. Instead, because differences in investment‐cash flow sensitivities are only observed for the unexpected portion of firms’ cash flow, the empirical evidence supports an agency‐based explanation. Similar patterns are observable for the expected and unexpected portion of firms’ shareholder distributions. Our results are driven by firms from countries with low ownership concentration and more liquid stock markets, where shareholders have lower incentives to monitor. The results are also more pronounced for public firms with low industry Tobin's q and high free cash flow, which are more prone to suffer from agency problems.