Pledge of Stock and Firm Value: Evidence from the...
Transcript of Pledge of Stock and Firm Value: Evidence from the...
Proceedings of the Third Asia-Pacific Conference on Global Business, Economics, Finance
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Pledge of Stock and Firm Value: Evidence from the Amendment
of the Company Act of Taiwan
Yu-Chun Wang,
Department of Finance,
Ming Chuan University, Taiwan, ROC.
E-mail: [email protected]
___________________________________________________________
Abstract
This study investigates stock market reactions to the amendment of the 2011 Company Act of
Taiwan. Shares pledged for bank loans created by top management are regarded as having high
expropriation risk for outside investors. To improve minority shareholder protection, the
regulations were changed and the exercise of voting rights on pledged shares exceeding one half
of the shares held by a director upon election (excess pledged shares) became limited. Our
empirical evidence shows that firms with high pledge ratio experience positive abnormal stock
returns, and this situation is pronounced in firms with low shareholdings of the board and in
those with a chairman who pledges excess shares for bank loans. These findings are consistent
with the alignment hypothesis stating that firms that are less compliant with the new rule benefit
more from the legislation changes. Relations between pledged shares and firm value also
demonstrate how investors evaluate weakened corporate governance practices. The effect of
regulation changes on firm value has an important implication for law makers and
policymakers who could improve corporate governance by ameliorating the legal system.
_____________________________________________________________________
Keywords: pledge of stock, firm value, corporate governance, regulation
JEL classification: G14, G34, K22
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1. Introduction
The use of collateral in loan contracts is usually required to help lending banks mitigate the
risk of information asymmetry between banks and borrowers. When banks are uncertain on
whether borrowers would engage in moral hazard activities, the collateral would serve as an
insurance against such unfavorable conditions. Prior studies indicate that collateral is most
often associated with high-risk borrowers (Berger and Udell, 1990; Coco, 2000; Menkhoff et
al., 2006). Regarding the top management of a firm, their pledged shares for bank loans indicate
that they are high-risk borrowers and that their behavior may increase agency costs of outside
investors; thus, these pledges are referred to as the weak corporate governance practices in
Taiwan (Kao and Chiou, 2002; Lee and Yeh, 2004). However, limited evidence shows how
investors evaluate such poor corporate governance. This study addresses this issue by
examining the reaction of the Taiwan stock market to the Company Act amendment in 2011 on
regulating the pledge behavior of directors.
Beginning the passage of the Sarbanes–Oxley Act (SOX) of 2002 in the US, improving
corporate governance has been one of the most important challenges for all governments.
Taiwan is no exception. Until recently, pledged shares of directors for bank loans have become
a long-standing problem among corporate governance issues in this emerging market. To
improve the protection for minority shareholders, regulators advocated implementing
additional rules on the behavior of directors pledging stocks in 2011.1
Law makers argued that pledged shares for bank loans reflect the degree to which firm
directors increase leverage, specifically in using less personal funds, to fight for control rights.
When operating concessions are expected to change because of potential variation in the
ownership structure, incumbent directors could apply high leverage to increase share holdings
and defend operating concessions.2 Thus, pledged shares resemble a tool by which directors
could entrench positions. In addition, when directors create a pledge on shareholdings for bank
loans, they are subject to a required maintenance margin similar to mortgage loans. If the
market value of pledged stocks falls below the maintenance requirement, directors will be
informed through a margin call. If the required margin is not met, banks can sell the pledged
stocks. Thus, regulators also argue that directors who pledge shares when the stock price is high
may engage in riskier operations for higher returns to boost security price (the value of the
collateral), and further magnify the volatility of firm value. The most severe situation is when
1 Note that the “first reading” of this law amendment was on December 31, 2010, but the first publication
of the discussion in an official Committee in newspapers was on June 8, 2011. 2 See Stulz (1988) for discussions about managerial entrenchment through stock holdings. He suggests
that management can change the fraction of the votes they control by capital structure changes. See
Shleifer and Vishny (1989) for a model that describes how managers can reduce the probability of being
replaced and obtain more latitude in determining corporate strategy by making manager-specific
investments.
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directors who intend to tunnel3 the companies do not pay back the loan and leave “a shell
company” along with a decreasing stock price.4 Minority stockholders consequently suffer
from this expropriation of directors. Thus, the exercise of voting rights of excess pledged shares
(pledged shares that exceed one half of the shares held by a director upon election) is suggested
to be limited.5
However, the dissentient view of the limitation argues that a pledged share differs from a
transfer of property rights to lending banks. Voting rights, therefore, should not be restricted
until the pledged shares are settled. After a five-month debate, as the voice of strengthening
capital market and improving corporate governance outweighs that of opponents, the
Legislative Yuan (the Taiwanese Congress equivalent) passed the amendment of Article 197–1
of the Company Act on October 25, 2011. This amendment aims to limit the voting rights of
excess pledged shares. The goal of this study is to investigate the relationship between pledges
of shares and firm value by examining the stock market reaction to this event.
Although previous research argues that the pledge of shares of the management deteriorates
corporate governance, our knowledge on whether such behavior affects shareholder wealth is
limited. Recent regulatory changes have led to an exogenous shock to the behavior of the top
management. Thus, the stock market reaction to recent regulation is a novel research
opportunity to examine the relation between corporate governance and firm value that is less of
a concern of endogeneity. If existing behaviors of pledging stock are, on the average,
characterized by poor corporate governance, we expect regulatory changes to increase the value
of shareholders.
This study examines the response of investors to the prohibition of voting of excess pledged
shares of directors by the following aspects. First, we assess whether stock price reactions to the
new rule differ with levels of expropriation. Prior studies suggest that regulation benefits firms
that are less compliant with provisions of rules (Chhaochharia and Grinstein, 2007; Berkman et
al., 2010; Cai and Walkling, 2011). Thus, we hypothesize that firms experience positive
abnormal returns if they have higher levels of pledged shareholdings of directors than others.
To address this issue, we employ both firm- and director-level data on pledged shares to analyze
the extent of agency costs of minority shareholders. While director-level pledged share
3 Prior studies (e.g., Johnson et al., 2000b) use the term “tunneling” to describe the transfer of assets and
profits from firms for the benefit of those who control them. In an emerging market such as Taiwan,
which features family-controlled firms and directors participating in management, dominant insiders are
more likely to take risks in entities where their cash flow rights are low and then siphon out proceeds to
entities where their cash flow rights are high. 4 See the study of Lee and Yeh (2004), which indicates that stock pledge is one of the key characteristics
of financially distressed firms in Taiwan. 5 For example, if a director held 10,000 shares of a firm when he (or she) was elected and pledged 6,000
shares for bank loans, the new rule would limit the voting rights to 1,000 (6,000 minus 10,000/2) shares.
In this paper, we use the term “excess pledged shares” to describe the situation when pledged shares
exceed half of the shares held by a director upon election to the position.
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holdings are the most direct measure to investigate the level of directors having “a slap in his
face”, we expect that firms with a high number of directors having excess pledged shares would
have positive abnormal returns. Meanwhile, firm-level pledged share holdings, which are
disclosed by month, are the most accessible information for investors. Accordingly, we expect
that firms with their board having a high percentage of pledged share holdings over the actual
board holdings (the pledge ratio) will experience positive abnormal returns.
Agency conflicts of management boards may subsequently be associated with the
ownership structure (Jensen and Meckling, 1976; Leland and Pyle, 1977; Jensen, 1993). If the
board only holds a few shares of a firm (i.e., the participation they can obtain from the firm’s
profits is low), but pledges a large proportion of their share holdings, they are more likely to
engage in activities of entrenchment. Thus, the hypothesis also predicts that firms with
directors who hold low share holdings and pledge their stocks for bank loans would benefit
more from the newly passed regulation.
Third, we examine whether firms with excess pledged shares created by the chairman of the
board of directors experience positive abnormal returns. In contrast to the role of a chairman in
U.S. firms, under the Company Act in Taiwan, a chairman is the legal representative of a
company. The chairman is also the highest authority in a firm and is responsible for overall
operations. If a chairman pledges shares, investors may perceive this action as a severe conflict
of interest compared with the pledges of other directors. Thus, we hypothesize that positive
abnormal returns are more pronounced in firms with a chairman who makes excess pledged
shares.
This study contributes to the literature on firm value and corporate governance, specifically
on stock market reactions to corporation governance regulations (Chow, 1983; Johnson et al.,
2000a; Bushee and Leuz, 2005; Greenstone et al., 2006; Carvalhal da Silva and
Subrahmanyam, 2007; Chhaochharia and Grinstein, 2007; Wintoki, 2007; Zhang, 2007;
Hochberg et al., 2009; Berkman et al., 2010; Iliev, 2010; Cai and Walkling, 2011; Larcker et al.,
2011; among others). The alignment hypothesis suggests that regulations can reduce rent
extraction of the management from minority shareholders, hence increasing shareholder value
(Chhaochharia and Grinstein, 2007; Berkman et al., 2010; Cai and Walkling, 2011, Black et al.,
2015). Some studies find that governance provisions do not improve firm value because the
observed governance practices have been the results of value maximization (e.g. Iliev, 2010;
Larcker et al., 2011). Mixed conclusions and countervailing effects of regulations provided in
previous studies emphasize the importance of such an empirical issue that we will address in
the current study.
The remainder of this paper is organized as follows. Section 2 reviews the related literature
and presents the empirical hypotheses. Section 3 describes the research design, empirical
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model, and data. Section 4 reports the empirical results, and then Section 5 states the
conclusion.
2. Literature Review and Hypotheses Development
2.1 Literature on Pledge for Loans
Without considering collateral, if a bank agrees on a higher loan rate when facing
asymmetric information, the expected return would decrease (Leland and Pyle, 1977) because
borrowers would take ex post high-risk projects (Stiglitz and Weiss, 1981). Thus, to avoid such
adverse selection effect, lending banks prefer rationing credit to opaque borrowers rather than
increasing loan rate because they do not have enough information to ensure payback from
borrowers. A collateral resolves credit rationing and assists borrowers in asking for a reduction
in loan rate (when loan size is held constant) or an increase in loan size (when loan rate is held
constant). When borrowers are not trusted by banks, they can use the collateral to ease financial
constraints (Boot et al., 1991; Inderst and Mueller, 2007).
When a director of a firm is required to pledge shares from banks for personal loans, such
activity signals the assessment of the bank that the director has higher tendency to engage in
high-risk investment projects. This situation also indicates the agency problem between
directors and outside shareholders (Jensen and Meckling, 1976). To mitigate information
asymmetry for outside investors on personally pledged borrowings of insiders, Taiwan’s
competent authority requires, under the Article 197–1 of the Company Act (see Appendix A),
listed companies to fully disclose the amount of pledged shares in a firm. Although this
regulation improves the transparency of pledged borrowing of insiders, the risk of managerial
rent extraction remains.
In Taiwan, loan contracts with pledged stocks include terms of collateral maintenance ratio.
For example, if a director borrows 1 million New Taiwan Dollars (NTD) with pledged stocks
valued at NTD 2 million, then the collateral maintenance ratio is 200% (2/1*100%). If the
maintenance ratio drops below 140% (i.e., the stock price falls 30%) for three successive
trading days, the bank will deliver a notice of margin call, and the director should post a margin
to raise the maintenance ratio to 170%. If the borrower does not meet this requirement, the bank
can terminate the loan contract and sell the pledged stocks as part of the recovery. Therefore, to
increase the collateral value, directors have incentives to engage in high-risk investment
projects for higher returns, which results in high volatility in firm value. In this context, a
conflict of interest between directors and outside investors exists when directors pledge on
shareholdings.
Prior research has investigated the role of pledged shares in agency problems and presented
evidence consistent with the authority’s consideration that pledged shares are indicative of
agency problem. For example, Kao and Chiou (2002) find the correlation between earning
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information and stock price decreases when the pledged shareholdings of the board increases.
This situation indicates that the pledged shareholdings of boards induces earning management,
reduces information quality, and worsens the problem of information asymmetry between
management executives and minority stockholders. Lee and Yeh (2004) examine the
determinants of financial distress and find that pledge ratio is an essential attribute of firm-level
governance to increase the probability of financial distress or even boost bankruptcy cost. Chen
and Kao (2011) indicate in their study that directors who have financing need and hold high
turnover stocks prefer to pledge their stocks at private banks for loans. In sum, the literature
shows that the behavior of the board to pledge on their shareholdings lowers the common
interest between the management group and outside investors. Such a weak governance
mechanism would be harmful for firm value (Mitton, 2002; Gompers et al., 2003; Lemmon and
Lins, 2003; Cremers and Nair, 2005).
2.2 Hypotheses Development
A growing body of literature assesses the effects of regulations on firm-level governance
attributes (Atanasov et al., 2010; Bruno and Claessens, 2010) and on shareholder wealth (e.g.,
Greenstone et al., 2006; Chhaochharia and Grinstein, 2007; Berkman et al., 2010; Cai and
Walkling, 2011). Evidence suggests that rules aimed at improving governance mechanisms to
protect outside investors from expropriation are likely to create firm value. For example,
Chhaochharia and Grinstein (2007) examine the effect of the 2002 U.S. new governance rules
on firm value. During the announcement period of one year, portfolios of firms with insider
trading, related party transactions, and restated financial statements earned positive abnormal
returns compared with portfolios of firms that were more compliant with the rules. Cai and
Walkling (2011) investigate the announcement effect of Say-on-Pay Bill of 2007 on
shareholder wealth and find that stocks of firms with positive abnormal CEO pay and low CEO
pay-for-performance sensitivity reacted positively to the passage of the bill. In the Chinese
security market, Berkman et al. (2010) study three regulatory changes in 2000 and find firms
with minority shareholders facing greater expropriation benefit from new regulations,
especially for private firms rather than state-owned enterprises. In sum, these findings are
consistent with the notion that laws can eliminate the severity of expropriation from managers
and lead to higher maximization of shareholder value.
If investors perceive that the 2011 Company Act amendment would benefit firms with
high levels of pledged shareholdings of boards, these firms would have positive abnormal
returns upon the passage of the amendment.6
6 In Taiwan, information about pledged shareholdings is required to be disclosed publicly, and thus is
relatively transparent. The eased expropriation from insiders may be accompanied by legal convergence
(La Porta et al., 2000; Glaeser et al., 2001), and investors are likely to have rare doubts whether the rule
will be enforced effectively. From the view of cost–benefit analysis, given that extra auditing or filing
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H1a: Firms with high pledged shareholdings of boards exhibit positive abnormal returns upon
the passage of the Company Act amendment.
H1b: Firms with high pledged shareholdings of boards exhibit negative abnormal returns upon
the passage of the Company Act amendment.
In addition, when the board of directors controls a firm using a low fraction of
shareholdings, agency problems exacerbate because of inconsistent interests between the
management group and minority shareholders (Jensen and Meckling, 1976; Leland and Pyle,
1977; Jensen, 1993). Thus, firms with directors who hold low shareholdings and pledge their
shares for bank loan are expected to suffer from severe agency problems. These directors are
more likely to engage in rent-seeking activities, relationship-based transactions, and risky
investment projects, given that the costs of expropriation are low. Firms with such directors are
particularly benefited upon the amendment of the Company Act.
H2a: Firms with directors who hold low shareholdings and pledge their shares for bank loans
lead to positive abnormal returns upon the passage of the Company Act amendment.
H2b: Firms with directors who hold low shareholdings and pledge their shares for bank loans
have negative abnormal returns at the passage of the Company Act amendment.
Risk incentive of top managers affects equity prices (Yermack, 1997; Malmendier and
Tate, 2008; Wei and Yermack, 2011). Accordingly, we expect that the effects of legislation are
stronger for firms with top managers pledging their shares than for those without such top
managers. In Taiwan, the chairman of a firm is its legal representative under the Company Act,
and he (she) is also the highest authority in a firm and is responsible for overall operations.
Thus, the hypothesis predicts that positive abnormal returns are more pronounced in firms with
a chairman who makes excess pledged shares.
H3a: Positive abnormal returns at the passage of the Company Act amendment are stronger for
firms with a chairman who pledges excess shares.
H3b: Positive abnormal returns at the passage of the Company Act amendment are weaker for
firms with a chairman who makes excess pledged shares.
3. Research Design and Data
3.1 Research Design and Models
When assessing the link between corporate governance and firm value, researchers often
encounter problems of endogeneity, as corporate issues can be jointly determined. We use the
standard event–study methodology of portfolio time-series regression by Sefcik and Thompson
(1986), Campbell et al. (1997), Chhaochharia and Grinstein (2007), Berkman et al. (2010), and
Cai and Walkling (2011). The methodology aims to reduce potential shortcomings of clustering
costs are not generated when the board reduces their shared pledges, less compliant firms will benefit
from legislation improvement, as evidenced in this study.
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in the specification of cross-sectional regression analysis and to avoid endogeneity of firm
value and corporate governance in static analysis. This method diversifies from the
cross-sectional correlation among sampling stocks arising from the shared event window. We
investigate whether the amendment of the Company Act creates value for firms with high
pledge ratios by using the following portfolio time-series regressions.
(1) H
0 1 2RET_PLEG D_Event RET_MKTt t t
(2) L
0 1 2RET_PLEG D_Event RET_MKTt t t
(3) H L
0 1 2RET_PLEG - RET_PLEG D_Event RET_MKTt t t t
Where, HRET_PLEGt
and LRET_PLEGt
denote the equal-weighted portfolio returns of
firms with high and low levels of board pledge variables. In this study, we determine the high
and low levels of pledge-related variables by terciles, such that variables are nearest to zero.
H LRET_PLEG RET_PLEGt t denotes the return of a portfolio that had a long position in
high pledge-related firms and a short position in low pledge-related firms. D_Event is a dummy
variable of event time that takes a value of 1/n in the event window of length n, and zero
otherwise. The coefficient of D_Event β1 is the estimated CARs (cumulative abnormal returns,
Equations 1 and 2) of the concerned portfolio or the difference in CARs (Equation 3 between
the concerned portfolios during the event window). RET_MKTt denotes equal-weighted
market portfolio returns of sample firms listed in the Taiwan Stock Exchange (TWSE) at time t.
Following Cai and Walkling (2011), we set a three-day event window as (-1, +1) that centers on
the day of the passage of the new law. The coefficient of D_Event, β1, is the CARs of the stock
market during the event window. We perform the model with a sample period of a 250 trading
days that started from October 28, 2010.
3.2 Sample and Data
Our sample firms are listed companies in the TWSE. The initial sample contains 727 listed
firms at the time of the 2011 Company Act amendment. The exclusion of one foreign firm and
34 financial firms (regulated industry) results in our final sample of 692 firms. We collect the
data of pledged shares of the board from two sources. The Company Act requires listed
companies to disclose monthly the creation or cancelation of pledges of stocks held by board
members. Thus, we can obtain the data of firm-level board pledge ratios in September 2011 (the
first month prior to the amendment passage) from the database of the Taiwan Economic Journal
(TEJ). TEJ is the most comprehensive financial data vendor of Taiwanese financial market
because it gathers information from the TWSE filings of public companies. In addition, the
laws require listed firms to disclose detailed ownership structure (including pledged shares of
board members) in the annual financial reports. We also collect director-level data of pledged
shares at the end of 2010 from the TEJ database. With such information, we can identify
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whether the chairman of a firm made excess pledges on his (or her) shareholdings. Data on
stock prices and other firm characteristics also come from the TEJ database.7
4. Empirical Results
4.1 Descriptive Statistics
Table 1 presents the summary statistics of our sample. The average pledge ratio at the end of
September 2011 is about 10.3% with a median of 0, indicating that not more than half of firms
have a board with members pledging their stocks for bank loans. For director-level data,
approximately 6.6% of the directors in the firms made excess pledged shareholdings. About 9%
of the firms have chairmen who made excess pledged shares for bank loans, and 16.2% of the
firms have at least one director, who is not the chairman, making excess pledged shares. About
a quarter (9% + 16.2%) of the firms has at least one director pledging over half of his shares for
bank loans. The average shareholding ratio of the board is 18.7%.
4.2 Empirical Results for Hypothesis Testing
To examine whether firm-level compliance with the new rule affects market valuation, we
examine Equations 1 to 3 based on the high and low terciles of pledge ratio. Table 2 presents the
estimation results of portfolio CARs over the window (-1, +1). With almost 40% of the firms
having a positive pledge ratio, Panel A of Table 2 compares the CARs of groups of firms with
the highest third and highest fourth of pledge ratios with those without pledged shares of the
board. The CAR of portfolio consisting of firms with highest fourth of pledge ratios, whose
pledge ratio is greater than 12.65% with a mean of 38%, is 0.37% and is statistically significant
at 1% level. This portfolio outperforms that containing firms without pledged shares of the
board, whose CAR is -0.23%, by 0.6% at 1% statistical significance. The portfolios of firms
with the highest third of pledge ratio and firms with positive pledge ratio exhibit a similar
pattern. Their CARs are significantly positive and greater than the CAR of the portfolio of firms
without pledged shares of the board. Thus, the results support H1a.
Panel B of Table 2 presents the CARs when the 2011 Company Act amendment was passed
for groups based on board shareholding and then pledge ratio. For both groups with high and
low board shareholdings, the portfolios of firms with a positive pledge ratio have positive
CARs. However, for the low-board shareholding group only, the portfolio of firms with a
positive pledge ratio significantly outperforms that of firms without pledged shares of the
board. The difference in CARs at the onset of the new provision is 0.77%, which is statistically
significant at the 1% level. This outperformance is the largest among all portfolios based on
pledge ratio. This result indicates that minority shareholders of firms with low board
7 See Appendix B for the summary statistics of these variables. These firms have a median market
capitalization of NT$ 6.7 billion, an average book-to-market ratio of 0.68, and a one-year stock return of
14.9% on average prior to the legislation. The average leverage is 34.2% and the average return on assets
(ROA) is about 10%.
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shareholding and high pledge ratio face higher entrenchment risk. Therefore, improvement of
legislation may help them overcome the previously mentioned disadvantage. This finding
supports H2a.
Table 3 presents the portfolio CARs based on the number of directors with excess pledged
shares in a firm. In Panel A, we compare the portfolio of firms that have the highest sixth and
the highest fourth of directors having excess pledged shares with that of firms without any
directors conducting pledges. The portfolio of firms whose number of directors with excess
pledged shares in a firm is greater than 16.6% (more than 1/6 of the board members) exhibits a
positive CAR of 0.3%, and the CAR is statistically significant at 1% level. This portfolio
outperforms that of firms without any directors having excess pledged shares by 0.35% at the
1% level.
In Panel B of Table 3, we focus on the firms with at least one director making excess pledged
shares. We further split this subsample into two groups based on whether the chairman makes
excess pledged shares or not. The CAR of the portfolio of firms whose chairman creates excess
pledged shares is 0.78%, which is statistically significant at 1% level. This portfolio
outperforms that of firms with at least one director, but not the chairman, having excess pledged
shares by 0.95%. The difference in CARs is the highest among all comparisons in this study.
The results indicate that whether the chairman of a firm makes excess pledged shares for bank
loans is important in determining the levels of agency conflicts between the board and outside
investors. Hence, the market perceives that the new regulation is an attempt to improve the
credibility of investor protection, and such firms would be affected mostly. Our H3b is
therefore largely supported by the evidence presented.
Overall, our results suggest that the stock market considered the new regulation to be
effective in improving investor protection of Taiwanese listed firms. We find that firms with a
high pledge ratio experience greater abnormal stock returns than those without pledged shares
for bank loans of the board. This relation is more profound in firms with low shareholdings of
the board. The director-level evidence indicates that, among firms with at least one board
member with excess pledged shares, those with a chairman pledging excess shares for bank
loans exhibit higher stock returns than others (chairmen without excess pledged shares). These
findings support the hypothesis that firms that are less compliant with the new rule will benefit
more from the legislation.
4.3 Robustness Tests
4.3.1 Multivariate Analysis of Stock Returns and Pledge of Stock
In addition to the standard event study methodologies, we perform regressions to test the
relationship between pledged shares and stock returns. While the stock returns may cause
cross-sectional correlation problems in a regression, which can bias the ordinary least squares
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standard errors, we estimate robust standard errors adjusted for industry clustering and then
calculate t-statistics based on these robust standard errors. Furthermore, we use a bootstrap
methodology similar to that performed by Chhaochharia and Grinstein (2007) and Cai and
Walkling (2011) to estimate the p-value of the regression coefficients. The p-value is obtained
by benchmarking our test results against those obtained on randomly selected non-event days.
Comparing the estimations between event and non-event days alleviates the possibility that the
statistical relations are a general phenomenon and not specific to the market’s reaction to the
regulatory change.
Table 4 presents the regression results of the relations between CARs by the time the new
rule was passed and the pledge ratio of firms. In Column 1, the coefficient of the pledge ratio is
0.14, which is statistically significant at the 5% level. The bootstrapped p-value confirms the
significance of the pledge ratio variable in this regression. Hence, a positive relation exists
between pledge ratio and abnormal returns, and this relation is unique to the concerned
regulatory event and not a general phenomenon.8
4.3.2 Effects of Other Corporate Governance Variables
While the new regulation aims to improve investor protection, one may suspect that, in
addition to firms with excess pledged shares, weakly governed firms would benefit from the
legislation. The market seems to consider that the new regulation will improve corporate
governance regardless of the governance attributes. In this context, the increment to the value
of firms examined with board pledges on stocks would not determine the relationship between
pledge of stock and firm value. Instead, this increment is an increase in value for all weakly
governed firms. We subsequently investigate the relations between abnormal stock returns and
seven corporate governance proxies by the regression analysis described in the previous
section. The attribute variables include excess control board (percentage of board seats
occupied by the controlling shareholders less the cash flow rights of the controlling
shareholders, see Young et al., 2008), cash flow rights (proportion of net profits that controlling
shareholders can claim through all their direct and indirect shareholdings, see La Porta et al.,
2002), deviation of cash flow rights from control rights (difference between control rights9 and
cash flow rights of controlling shareholders, see Claessens et al., 2000), institutional holdings
(shareholdings held by institutional investors, see Ferreira and Matos, 2008), foreign holdings
(shareholdings held by foreign investors, see Leuz et al., 2008), government holdings
(shareholdings held by the government, see Berkman et al., 2010), and CEO duality (a dummy
that takes a value of one if the CEO is also the chairman of a firm, and zero otherwise, see
8 In this regression analysis, the natural log of market capitalization, book-to-market ratio, and past year
stock return are significant. However, from the bootstrapped p-value, their significance appears as a
general phenomenon and not unique to the event being examined. 9 “Control rights” is the voting right that the controlling shareholders have through their direct and
indirect shareholdings.
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Donaldson and Davis, 1991).
Columns 2 to 8 of Table 4 report the regression results. The significance of pledge ratio
remains consistent across the regressions of CARs on other corporate governance variables.
However, we find no evidence suggesting that any of the seven governance variables is
important in explaining abnormal stock returns as a result of the new legislation. Although
institutional holdings seem to correlate positively with the CARs, the bootstrapped p-value
(:0.22) fails to reject the null hypothesis that the relationship between institutional holdings and
abnormal stock returns is a general phenomenon instead of a specific relation during the event.
Hence, among all the corporate governance variables we have examined, only the relations
between pledge ratio and abnormal stock returns are specific to the time when the Company
Act amendment was passed.
4.4 Additional Tests
4.4.1 Market Response
Before 2011, the Company Act of Taiwan required listed companies to disclose the amount
of pledged shareholdings. Notwithstanding, the management entrenchment by pledged shares
for bank loans was not eased. The Company Act amendment of 2011 further limited the voting
rights of directors on excess pledged shareholdings. If investors perceive this effect to improve
investor protection (La Porta et al., 2000; Glaeser et al., 2001; La Porta et al., 2002), the market
would positively respond to the new rule.
Based on the theory predicting a positive relation between investor protection and firm
value, we also premised that the stock market would positively respond to the regulation. We
study the stock market reactions to the Legislative Yuan’s passage of the new regulation aimed
at improving investor protection. The following regression model is employed to examine the
stock market response to the amendment of Company Act of 2001 of Taiwan.
(4) 0 1RET_MKT D_Eventt t
Where, the variables are as mentioned earlier in this paper.
Table 5 shows the estimation results of Equation 4 in an attempt to investigate the market
response to the passage of the 2011 amendment of the Company Act. The stock market
positively reacted to the new legislation, with a statistically significant abnormal return of
2.96% during the three-day event window. This finding reveals that stock market participators
regard the new law as beneficial for investor protection; thus, the stock market appreciated in
line with the argument of La Porta et al. (2000). For comparison, Column 2 of Table 5 presents
the estimation results during the discussion of the provision in June. The abnormal stock market
return during the (-1, +1) window is 0.25%, which is not statistically significant, implying that
the stock market may not have considered the discussion in the Committee of the Legislative
Yuan as contributory to the increased probability of the passage of the rule. Only until the
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Taiwanese Congress completed the legislation-making process did investors become convinced
of the eventual approval of the new rule. Thus, the stock market did not react strongly to the
committee discussion about this regulation.
4.4.2 Changes in Pledged Shares
Prior studies argue that the willingness of a firm to improve investor protection plays an
important role in determining whether shareholders benefit from the regulations. For example,
Berkman et al. (2010) find that state-owned enterprises, relative to private firms, are less likely
to comply with regulations of investor protection. Hence, minority shareholders of state-owned
enterprises are less benefited from new company rules. Cai and Walkling (2011) also point out
that worst-governed firms may be not willing to comply with new rules, and thus will not find
the provisions as beneficial. These findings suggest that the willingness to comply with
regulations is important in determining whether investors would benefit from new laws.
Based on such interpretation, one may expect that if the board of a firm responds to the
initiative of a Company Act amendment by reducing their pledged shares for bank loans, the
market will positively react to such compliance. When the board of a firm is willing to reduce
pledged shares, investors would consider the firm responsive to improve governance, and the
stock price would appreciate as a positive reaction. Thus, we examine whether firms with
directors who have decreased pledge ratio after the law amendment experience positive
abnormal returns. A decrease in pledge ratio is caused by either an increase in share holdings of
the board or a cancelation of pledged shares. Both movements tend to be more aligned with the
aim of the new regulation. In this part, we use the decrease in pledge ratio prior to the passage of
the Company Act as a proxy for a firm’s willingness to improve corporate governance.
Table 6 reports the CARs of groups based on changes in pledge ratio of firms between June
and September 2001 during the law-making process.10 While not more than 25% of the firms
had pledge ratios changing during the period, we focus on the groups of firms whose changes in
pledge ratios are in the top decile (> 0.3%) and those in the bottom decile (< 1.57%). The results
show that the portfolio of firms whose boards reduced pledged shares for bank loans exhibits a
positive and statistically significant CAR of 0.28%. However, this portfolio does not
outperform any other portfolios. Therefore, the evidence supporting the argument is weak.
5. Conclusions and Discussions
We show that pledged stocks of board members affect the wealth of investors based on the
evident positive reaction of the share prices of these firms to the passage of the 2011 Company
Act amendment that attempted to improve investor protection by restricting the exercise of
voting pledged shares of board members. However, the amendment does not benefit all
10 See Appendix B for the summary statistics of this variable. After the first discussion in the Committee
of Legislative Yuan in June 2011, the average change in pledge ratio until September 2011 was about
-0.02%.
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companies, but only concerned entities. Our evidence shows that firms that are less compliant
with the new provision (having higher excess pledged shares) experience a greater increase in
shareholder wealth than firms that are more accordant with the spirit of the rule (having less
excess pledged shares). This result is supportive of the alignment hypothesis, which suggests
that regulations can reduce the rent extraction of the management from minority shareholders
(Chhaochharia and Grinstein, 2007; Berkman et al., 2010; Cai and Walkling, 2011).
Our results are consistent with the notion that pledged shares of the board are harmful for
shareholder value. Possible explanations can be borrowed from prior research that suggests the
presence of the pledged shares associated with earning management, financial failure,
management entrenchment, and information asymmetry between the management and outside
investors. Such agency conflicts are more severe when the chairman of a firm, as the highest
authority and responsible for the overall operations in a Taiwanese firm, makes excess pledged
shares. While governments all over the world are making efforts to propose more investor
protection regulations, this study adds to the understanding of the importance of the legal
environment by showing the relations between governance regulation changes and firm value.
While our results support the alignment hypothesis, some previous studies report that
governance provisions do not improve firm value possibly because the observed governance
practices have been the results of value maximization (e.g. Iliev, 2010; Larcker et al., 2011).
Mixed conclusions in literature may be accounted for by certain governance practices
mandated by regulations that are not optimal contracts between the management and outside
investors (e.g., the number of block holders and the level of CEO compensation). Further, some
regulations are even costly to comply with (e.g., the requirement of management report for
small companies), whereas some would alleviate potential expropriation of self-dealing
managers (e.g., insider trading, excess compensation, excess pledges of shareholdings, and
relationship-based transactions). Thus, the effects of regulation change on shareholder wealth
are likely to depend on the effectiveness and efficiency of new rules that can be enforced to
increase investor protection.
Appendix A: Article 197-1 of Company Act
Article 197-1: Upon creation or cancellation of a pledge on the company's shares held by a
shareholder, a notice of such action shall be given to the company, and the company shall, in
turn and within 15 days after such pledge creation/ cancellation date, have the change of pledge
over such shares reported to the competent authority and declared in a public notice; unless
otherwise provided for in any rules or regulations separately prescribed by the authority in
charge of securities affairs.
In case a director of a company whose shares are issued to the public that has created pledge
on the company’s shares for more than one half of the shares being held by him/her at the time
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he/she is elected, the portion of excessive voting power shall not be exercised, nor counted in
the number of votes of shareholders present at the meeting.
Appendix B: Summary statistics of the robustness tests
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Table 1: Summary statistics of the main variables
Variable Mean Median Std 25th 75th
Pledge ratio (%) 10.33 0.00 19.63 0.00 12.65
% of directors with excess pledged
shares
6.64 0.00 14.32 0.00 5.32
Board shareholding (%) 18.67 14.50 12.84 9.60 23.94
Dummy=1 if the chairman makes
excess pledges
0.0896 0.0000 0.2858 0.0000 0.0000
Dummy=1 if any non-chairman
director makes excess pledges
0.1618 0.0000 0.3686 0.0000 0.0000
Change in pledge ratio between
June and September 2011 (%)
-0.0178 0.0000 8.6932 0.0000 0.0000
Firm characteristics
Market capitalization (in millions
of NT$)
29,204 6,673 111,363 3,070 16,348
Book-to-market ratio 0.6832 0.6329 0.3040 0.4717 0.8584
Past year stock return (%) 14.91 5.49 46.86 -12.78 31.10
Leverage (%) 34.21 32.82 15.66 21.84 45.03
Return on assets (ROA) (%) 10.03 9.08 8.27 5.63 14.29
Note: This table presents the summary statistics of the main variables used in this study. The sample
contains 692 listed firms in TWSE in 2011. Pledge ratio is the percentage of pledged shares over total
shareholdings held by board members. Board shareholding is the shares held by the board divided by
total outstanding shares. Financial characteristics are figures at the year end of 2010.
Table 2: Cumulative abnormal returns (CARs) of portfolios by level of pledge ratio
Panel A. CARs sorted by pledge ratio
Portfolio CAR t-statistics
Difference
in CARs
with Low
t-statistics
(Diff.) N
Mean of pledge
ratio (%)
Highest Fourth
(pledge ratio > 12.65%)
0.37*** 6.86 0.60*** 4.09 172 38.0
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Highest Third
(pledge ratio > 5.23%)
0.42** 2.50 0.65** 2.38 228 30.9
High
(pledge ratio > 0)
0.35** 2.17 0.58** 2.18 273 26.2
Low
(pledge ratio = 0)
-0.23** -2.17 419 0
Panel B. CARs sorted by board shareholding and pledge ratio
Portfolio CAR t-statistics N
Mean of pledge
ratio (%)
High board shareholding
High pledge
(pledge ratio > 0)
0.55* 1.75 120 23.5
Low pledge
(pledge ratio = 0)
0.07 0.87 226 0
Difference (High-Low) 0.48 1.22
Low board shareholding
High pledge
(pledge ratio > 0)
0.19*** 2.82 153 28.3
Low pledge
(pledge ratio = 0)
-0.58*** -4.19 193 0
Difference (High-Low) 0.77*** 4.06
Note: This table presents the portfolio CARs based on the levels of pledge ratios, as the 2011 Company
Act amendment was passed. The portfolio CARs are estimated using Equations (1) or (2), and the
difference in the portfolio CARs are estimated using Equation (3). Standard errors in OLS regressions are
calculated based on heteroskedasticity-consistent covariance matrix. *, **, and *** denote significance
at the 0.1, 0.05, and 0.01 levels, respectively.
Table 3: Cumulative abnormal returns (CARs) of portfolios by the excess pledged shares of
directors
Panel A. CARs by the excess pledged shares of directors
Portfolio CAR t-statistics
Difference
in CARs
with Low t-statistics N
Mean of pledge
ratio (%)
Highest Sixth
(# of directors with excess
pledged shares
> 16.6%)
0.30*** 3.52 0.35*** 3.60 116 37.0
Highest Fourth
(# of directors with excess
pledged shares
> 0)
0.16** 2.27 0.22** 2.27 174 30.0
Low
(# of directors with excess
pledged shares
= 0)
-0.06** -2.27
518 3.72
Panel B. CARs of portfolios of firms with at least one director having excess pledged shares
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Portfolio CAR t-statistics N
Mean of
pledge ratio
(%)
# of directors with excess pledged
shares> 0
and chairman with excess pledge
shares
0.78*** 6.77 62 40.32
# of directors with excess pledged
shares > 0
and chairman without excess
pledged shares
-0.17* -1.70 112 24.26
Difference 0.95*** 5.84
Note: This table presents the portfolio CARs based on whether any directors made excess pledged shares
(Panel A) and whether the chairman made excess pledged shares (Panel B), as the 2011 Company Act
amendment was passed. The # of directors with excess pledged shares is the number of directors creating
excess pledged shares divided by the number of board members. The portfolio CARs are estimated using
Equations (1) or (2), and the difference in the portfolio CARs are estimated using Equation (3). Standard
errors in OLS regressions are calculated based on heteroskedasticity-consistent covariance matrix. *, **,
and *** denote significance at the 0.1, 0.05, and 0.01 levels, respectively.
Table 4: Multivariate regressions
Variable [1] [2] [3] [4] [5] [6] [7] [8]
Ln(1+pledge ratio) 0.14** 0.14** 0.15** 0.15** 0.15** 0.14** 0.15** 0.14**
2.27 2.35 2.43 2.36 2.44 2.31 2.41 2.24
0.06 0.05 0.08 0.06 0.06 0.07 0.07 0.08
Excess control board 0.00
-0.70
0.30
Cash flow rights 0.01
1.57
0.22
Deviation of cash flow
rights from control rights
0.01
0.39
0.30
Institutional holdings 0.01**
2.11
0.22
Foreign holdings 0.00
0.41
0.38
Government holdings 0.03
0.92
0.14
CEO duality 0.42
1.18
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0.09
Ln market capitalization 0.20** 0.22** 0.24** 0.19** 0.09 0.17 0.18* 0.21**
1.96 2.07 2.31 1.99 0.71 1.11 1.78 2.20
0.22 0.20 0.18 0.26 0.40 0.25 0.28 0.21
Book-to-market ratio -0.97** -0.90** -0.96** -0.98** -0.95** -0.98** -0.96** -0.97**
-2.13 -1.91 -2.14 -2.12 -2.15 -2.21 -2.10 -2.12
0.16 0.17 0.16 0.15 0.18 0.16 0.17 0.18
Past year stock return 0.01** 0.01** 0.01* 0.01** 0.01** 0.01** 0.01** 0.01**
2.15 2.14 1.93 2.15 2.09 2.15 2.11 2.13
0.14 0.09 0.12 0.13 0.13 0.14 0.14 0.11
Leverage 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
0.09 0.09 0.15 0.08 0.04 0.07 0.13 0.14
0.46 0.45 0.44 0.49 0.48 0.49 0.48 0.44
ROA -0.01 -0.01 -0.01 -0.01 -0.01 -0.01 -0.01 -0.01
-0.60 -0.62 -0.57 -0.59 -0.75 -0.65 -0.60 -0.56
0.36 0.33 0.35 0.34 0.32 0.33 0.38 0.38
Intercept -2.69* -2.94* -3.64** -2.56* -1.41 -2.23 -2.49 -3.05**
-1.75 -1.81 -2.05 -1.71 -0.80 -1.06 -1.59 -2.02
0.28 0.27 0.20 0.29 0.36 0.29 0.32 0.26
Overall R2 0.05 0.06 0.06 0.06 0.06 0.05 0.06 0.06
N 692 692 692 692 692 692 692 692
Note: This table presents the regression results with the CARs as the dependent variable, as the 2011
Company Act amendment was passed. “Excess control board” is the percentage of board seats occupied
by the controlling shareholders less the controlling shareholders’ cash flow rights. “Cash flow rights” is
the proportion of a firm’s net profits that the controlling shareholders can claim through their direct and
indirect shareholdings. “Deviation of cash flow rights from control rights” is the difference between the
control rights and cash flow rights of controlling shareholders. “Control rights” is the voting right that the
controlling shareholders hold through their direct and indirect shareholdings. “Institutional holdings” is
the shareholdings held by institutions. “Foreign holdings” is the shareholdings held by foreign investors.
“Government holdings” is the shareholdings held by the government. “CEO duality” is a dummy that
takes a value of one if the CEO is also the chairman of a firm, and zero otherwise. The coefficient
estimate, t-statistics, and bootstrapped p-value are provided in each cell of the table. t-statistics are
calculated based on standard errors adjusted for industry clustering. P-values are estimated by bootstrap
method with 1,000 replications. *, **, and *** denote significance at the 0.1, 0.05, and 0.01 levels,
respectively. The bold type denotes the significance for p-value at least at the 10% level.
Table 5: Stock market returns when the 2011 Company Act amendment was passed
Variable
[1]
Passage
October 25 2011
(-1, +1)
[2]
First Discussion
June 8 2011
(-1, +1)
Intercept -0.07 -0.06
(-0.89) (-0.75)
D_Event 2.96** 0.25
(2.29) (0.66)
Note: This table reports the market-wide cumulative abnormal returns (CARs) as the amendment in the
2011 Company Act of Taiwan was passed. CARs are estimated using Equation (4) with an
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equal-weighted portfolio consisting of all 692 sample firms. The first column presents the results for the
event window of the amendment passage, and the second column presents the results for the event
window of the first discussion on the amendment in the Committee of Legislative Yuan. ** denotes
significance at the 0.05 level.
Table 6: Cumulative abnormal returns (CARs) of portfolios by changes in pledge ratio between
June and September 2001
Portfolio CAR t-statistics N
Mean of
pledge ratio
(%)
Highest Decile
(change in pledge ratio > 0.3%)
0.43 0.82 69 37.8
Mid
(-1.57% <= change in pledge ratio <= 0.3%)
-0.09 -1.38 554 5.10
Lowest Decile
(change in pledge ratio < -1.57%)
0.28* 1.66 69 24.8
Difference (Highest-Lowest) 0.15 0.26
Note: This table presents the portfolio CARs based on the changes in pledge ratio between June and
September 2011, as the 2011 Company Act amendment was passed. The portfolio CARs are estimated
using Equations (1) or (2), and the difference in the portfolio CARs are estimated using Equation (3).
Standard errors in OLS regressions are calculated based on heteroskedasticity-consistent covariance
matrix. *, **, and *** denote significance at the 0.1, 0.05, and 0.01 levels, respectively.