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Corporate governance in publicly traded small firms: A study of Canadian venture exchange companies
Business Horizons (2012) 55, 583—591
Available online at www.sciencedirect.com
www.elsevier.com/locate/bushor
Corporate governance in publicly traded small firms: A study of Canadian venture exchange companies Irene M. Gordon *, Karel Hrazdil, Daniel Shapiro Beedie School of Business, Simon Fraser University, 8888 University Drive, Burnaby, BC V5A 1S6, Canada
KEYWORDS Corporate governance; Earnings quality; Venture exchange; Firm performance; Canadian small business
Abstract Most evidence regarding the determinants and effects of corporate governance practices is based on large firms. Herein, we explore these issues in the context of small publicly traded Canadian companies. We exploit the fact that such firms were not subject to corporate governance guidelines prior to 2005 and thus analyze the determinants of voluntary governance practice choices, as well as the effects of those practices on firm performance. Using a unique data set, we construct a corporate governance index for each firm. We measure performance by two variables: quality of accounting earnings and financial performance. The results indicate that corporate governance does matter for smaller traded Canadian firms. We find that both accounting and financial performance are positively related to corporate governance; however, their underlying mechanisms may differ somewhat. Given this result, it would be natural to expect all firms to choose higher levels of governance. However, our results also suggest small firms face resource constraints that limit their choices. We conclude that good governance is an important driver of small firm performance that cannot be neglected by the owners and managers of these firms. # 2012 Kelley School of Business, Indiana University. Published by Elsevier Inc. All rights reserved.
1. Why study small firms in Canada? Corporate governance, the system by which companies are directed and controlled, has been subject to much discussion by practitioners, academics, and regulators. There is now some consensus regarding
* Corresponding author E-mail addresses: [email protected] (I.M. Gordon), [email protected] (K. Hrazdil), [email protected] (D. Shapiro)
what constitutes good governance (OECD, 2004) and the various policy measures to ensure firms adopt effective practices. In Canada, firms listed on the Toronto Stock Exchange (TSX) must adhere to corporate governance guidelines or explain why they do not (Klein, Shapiro, & Young, 2005). Not surprisingly, a majority of listed firms now–—more or less–—stick to these guidelines. This is the case for most firms listed on major stock markets in the developed world. While it is true that most large firms operating in developed capital markets generally conform
0007-6813/$ — see front matter # 2012 Kelley School of Business, Indiana University. Published by Elsevier Inc. All rights reserved. http://dx.doi.org/10.1016/j.bushor.2012.07.005
584 to good governance practices, there is no overwhelming evidence to suggest that firm performance is enhanced by better corporate governance. In a Canadian setting, there is limited evidence regarding whether governance matters, and what does exist correlates to larger listed companies (Klein et al., 2005; MacAulay, Shantanu, Oxner, & Hynes, 2009; Niu, 2006). The absence of strong evidence for the positive impact of corporate governance on firm performance may, in fact, be a result of the successful diffusion of good governance practices. In the mid1990s, the TSX issued 14 corporate governance best practice guidelines that Canadian companies listed on the exchange were encouraged to follow. Although implementing the guidelines is voluntary on an individual firm basis, TSX-listed companies are required to annually disclose and compare their corporate governance practices to the 14 best practices. As such, there are strong incentives for large firms to adopt common governance practices, thereby resulting in lower variation in such practices across listed firms. This convergence of best practices across firms is heightened because large firms also have the resources to implement the guidelines. In addition, many TSX firms are cross-listed on the U.S. exchanges, and are thus affected by U.S. mandatory governance practices (Charitou, Louca, & Panaydies, 2007). All of these factors tend to make measured governance practices relatively similar across the TSX firms. In turn, this makes it difficult to find a robust statistical relationship between corporate governance and firm performance. For example, MacAulay et al. (2009) investigated how the introduction of the TSX governance regulations affected compliance and firm performance for all Canadian companies listed on the TSX. The authors found that while compliance with corporate governance regulations increased during the period, the relationship between corporate governance and firm performance weakened. In this article, we focus on the smaller companies listed on the TSX Venture Exchange before 2005 because prior to that date, both adoption and disclosure were left to individual companies’ management. That is, TSX Venture Exchange firms were not subject to the TSX governance guidelines. Given the TSX Venture Exchange companies’ size and limited resources to enhance governance, voluntary adoption and disclosure should vary across firms. This variation allows us to better evaluate the effectiveness of voluntary governance practices. Our contribution to the understanding of the importance of corporate governance arises from our analysis of the unique context of small publicly traded TSX Venture Exchange companies prior to
I.M. Gordon et al. 2005. We develop a new database (described later) that permits us to construct an index of corporate governance for each firm in our sample and to measure its performance. We find that more effective corporate governance practices are related to firm characteristics, including the size of their boards, the ownership structure of the company, leverage, market value of equity, and the nature of the auditor. Further, we provide evidence that earnings quality and financial performance are both positively related to effective corporate governance. These results suggest that small firms with resource constraints are less likely to choose effective governance structures even though doing so will improve performance. Thus, managers and owners must pay careful attention to the costs and benefits of improved governance.
2. Does corporate governance matter? Three research questions Herein, we address three fundamental research questions related to the determinants and effects of corporate governance practices for small firms: 1. What kinds of firms will choose effective governance in a non-regulated environment, and in particular, do resource constraints limit the adoption of good corporate governance? 2. Does effective corporate governance contribute to accounting performance–—measured by earnings quality–—and if so, what elements of governance are most important? 3. Are more effective corporate governance practices positively reflected in a firm’s value by the market, and if so, what elements are most important? The first question addresses the issue of choice. Given the absence of regulatory requirements, to what extent will small firms voluntarily choose to adopt best practice governance? If they do not choose to adopt these practices voluntarily, to what extent do resource constraints limit their choices? In addressing this latter question, we draw on the limited extant literature regarding small firm governance to inform our analysis (Eisenberg, Sundgren, & Wells, 1998; Lin, 2011; Malin & Ow-Yong, 1998; Switzer, 2007). This literature does point to the importance of resource constraints in limiting the adoption of best practice governance. However, it does not address the question of governance choice when that choice is voluntary.
Corporate governance in publicly traded small firms: A study of Canadian venture exchange companies The second question addresses firms’ reporting practices, in this case as measured by the quality of reported earnings. There is limited evidence suggesting that stronger governance mechanisms reduce opportunistic management behavior, thus improving the quality and reliability of financial reporting (Morck, Shleifer, & Vishny, 1988; Niu, 2006). In principle, better corporate disclosure reduces information asymmetry between investors and managers, which in turn maintains and enhances investors’ confidence in the integrity of a firm’s financial information and hence its value (Cormier, Ledoux, Magnan, & Aerts, 2010; Welker, 1995). However, better disclosure is also costly, and may be relatively more so for smaller firms. Thus, small firms may choose to limit their investments in better disclosure. In sum, our second research question asks whether better governed small firms are more likely to adopt higher-quality reporting practices. Our third research question focuses on financial performance. Survey studies suggest there is, at best, mixed evidence in support of the hypothesis that better corporate governance results in better financial performance (Adams, Hermalin, & Weisbach, 2010; Daily, Dalton, & Cannella, 2003). Much of the evidence on this relationship comes from the U.S. market, in which corporate governance mechanisms and disclosures are highly regulated and large companies are often examined (Gompers, Ishii, & Metrick, 2003; Yermack, 1996). However, prior evidence regarding the relationship between corporate governance and firm performance in Canadian companies has been mixed (Bujaki & McConomy, 2002; Gupta, Kennedy, & Weaver, 2009; Klein et al., 2005). These studies generally utilize relatively small samples of large Canadian firms available from the investor service of the Globe and Mail, which publishes governance rankings annually for about 300 companies represented on the TSX. At this point, it is important to note that measuring best practice corporate governance is not straightforward. In fact, there are many dimensions to what constitutes best practice, and it is common to aggregate them to form a single governance index. We follow this practice in our study, but we also employ some of the sub-measures to determine whether any of them is more important individually. We employ this method for both accounting and financial performance.
3. Data and methodology Our initial sample consists of all companies listed on the TSX Venture Exchange in 2004. With revenues
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ranging up to C$39,000,000, these companies qualify as small businesses (Diez-Vial, 2009). Using proxy data collected by the Simon Fraser University, Beedie School of Business’ CIBC Centre for Corporate Governance and Risk Management, in association with the University of Toronto’s Capital Markets Institute, we recorded raw governance and other data for 1,617 firms traded on the TSX Venture Exchange in 2004. We also collected additional financial data for the firms, as described below.
3.1. Data from proxy statements In measuring overall governance quality, some researchers use existing techniques, such as principal components analysis; some construct their own composite governance indices (Bujaki & McConomy, 2002; Gompers et al., 2003); and some rely on publicly available governance scores (Klein et al., 2005). In Canada, the most utilized comprehensive corporate governance index ranking available comes from the ‘Report on Business’ (ROB) section of the Globe and Mail. Although the Globe and Mail rankings capture an unusually wide variety of governance indicators–—related to board composition, shareholding and compensation policy, shareholder rights policy, and disclosure policy–—the weights attached to these variables are somewhat arbitrary. This issue of assigned variable weightings, coupled with the fact that the ROB rates only the large companies contained in the Canadian S&P/TSX Index, rules out the use of this index for TSX Venture Exchange small businesses. Using the proxy data collected for the TSX Venture Exchange companies, we follow Bujaki and McConomy (2002) and construct a measure for the extent of adoption of the 14 TSX corporate governance guidelines based on 22 key guideline dimensions. The overall corporate governance (CG) score is equal to the sum of scores across all 14 relevant TSX guidelines (defined in the Appendix). Following previous studies that rely on the Globe and Mail rankings, we further subdivide the CG score into two sub-indices. The first, composition, is defined as the sum of scores across several dimensions related to board composition: the majority of the board is independent of management; the audit committee consists entirely of independent directors; the compensation committee consists entirely of independent directors; the nominating committee consists entirely of independent directors; the board chair is separate from the chief executive officer (CEO); the board has a lead director; there is a process for assessing the performance of the board, its committees, and members; the directors are able to meet independently of management; the
586 board chair is an independent director; the company has a nominating committee; the company has a compensation committee; and the company has a corporate governance committee. For each element coded as 1, these are summed to determine the composition score. Policies, the second sub-index, is defined as the CG score minus the composition score. The elements of this sub-index are policies regarding: strategic position; broad orientation and education programs; code of conduct/ethics; engagement of external advisors by board members; and assessments of board effectiveness, or the score related to the firm’s disclosure policy. We also measure ownership structure from the proxy disclosures. Proxy circulars must disclose all individuals and groups holding more than 10% of the voting rights (block) and the number of people on the board related to an entity with voting rights greater than 10% (BD block). We focus on these block holders as we expect that a significant number of minority investors will influence a firm’s choice to implement corporate governance standards voluntarily. Given the scarcity of resources in small start-up companies to compensate board members, we examine the impact of board size–—the number of board directors–—on the magnitude of the governance score (Coles, Daniel, & Naveen, 2008).
3.2. Financial and performance variables We hand-collected relevant financial data from companies’ financial statements available on the System for Electronic Document Analysis and Retrieval (SEDAR) (www.sedar.com) and market-based information (e.g., share prices) from Yahoo finance (http://ca.finance.yahoo.com). Malin and Ow-Yong (1998) suggest that governance choices may depend on whether the firm will require access to capital markets. Therefore, we measure a firm’s current capital by a dummy variable (debt issue) equal to 1 if the company issued long-term debt in 2004. These firms will want to ensure investors’ interests are protected and may convey this signal through a stronger commitment to stringent corporate governance. To control for a company’s access to financing, we include: leverage (i.e., book value of debt divided by market value of common equity); average sales growth, or DREV (i.e., a change in revenue scaled by average total assets); and size, measured by the logarithm of market value of equity (i.e., share price at the fiscal year end times the number of shares outstanding). Low levels of leverage indicate greater debt capacity. Therefore, larger growing firms financed heavily through debt are more likely to raise financing through equity and will be more willing
I.M. Gordon et al. to comply voluntarily with stricter governance standards. We measure the quality of reported earnings (i.e., accruals) and the consequent information asymmetry in two ways. First, we follow Srinidhi and Gul (2007) and measure accrual quality (AQ1) as the absolute value of the residuals from the regression relating current accruals to past, present, and future cash flows; change in revenue; and property, plant, and equipment. This accrual-quality measure deteriorates if the accruals are driven by opportunism but not when the accruals are motivated by the need to convey private information. As a second measure of earnings quality (AQ2), we follow Kothari et al. (2005) and use the absolute value of discretionary accruals from the Jones model adjusted for performance. Specifically, we match each firm’s discretionary accrual observation with that of another firm from the same industry group with the closest return on assets in 2004. For ease of interpretation, we multiply the AQ1 and AQ2 by -1.0 so that increasing values of AQ1 and AQ2 indicate increasing accrual quality. Consistent with prior literature (Klein et al., 2005), we measure firm performance as a relative market valuation measured by Tobin’s Q (defined as the book value of liabilities plus market value of common equity divided by the book value of assets). Based on previous findings revealing that companies audited by larger audit firms disclose more information (Wallace & Naser, 1995), we define auditor as a dummy variable equal to 1 if the company was audited by one of the Big 4 auditors. The expectation is that when a company has a Big 4 firm auditor, higher levels of additional disclosed information improves the company’s governance score and reduces the costs of extra monitoring for investors. Finally, we include a set of industry dummies as we expect companies may be under pressure from their peers to adopt the industry base level of corporate governance compliance.
4. Empirical findings and discussion The CG scores and other board characteristics are available for all 1,617 companies traded on the TSX Venture Exchange. However, the absence of financial data reduced the effective sample to 702. The aggregate data (not presented) indicate that, on average, larger companies have higher CG scores than smaller companies and also tend to have larger boards. Table 1 provides summary data for the 702 companies for which we have financial data. It is noteworthy that the average board size is five directors, which is relatively small. In addition, 78% of the
Corporate governance in publicly traded small firms: A study of Canadian venture exchange companies Table 1. Summary statistics Mean Variable CG Score Composition Policies Board Size Block BD Block AQ1^ AQ2^ MVE($mil) * AT($mil) * Tobin’s Qz DREV^ Leveragez Debt Issue Auditor Mining BioTech Industrial R/E($mil) NI($mil) Sales($mil)
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Std. Deviation
Median
Minimum
Maximum
3.936 2.075 2.487 1.393 0.887 0.829 0.239 0.168 20.794 10.358 4.261 0.252 0.653 0.307 0.425 0.490 0.290 0.221 12.133 3.403 5.337
1.000 1.000 0.000 5.000 1.000 0.000 -0.148 -0.099 4.725 2.552 2.329 0.001 0.067 0.000 0.000 1.000 0.000 0.000 -5.222 -0.521 0.003
0.000 0.000 0.000 3.000 0.000 0.000 -1.000 -1.000 0.002 0.032 0.300 -1.000 0.000 0.000 0.000 0.000 0.000 0.000 -196.809 -81.389 0.000
19.000 11.000 9.000 12.000 5.000 5.000 -0.001 -0.001 241.131 138.200 17.500 1.000 2.536 1.000 1.000 1.000 1.000 1.000 47.906 8.793 39.084
3.223 1.959 1.265 4.818 0.786 0.621 -0.233 -0.159 10.918 5.559 3.989 0.026 0.354 0.105 0.236 0.600 0.093 0.051 -7.614 -0.921 1.625
* Variables are log transformed for the correlation and regression analysis; z variables are winsorized at the extreme 1%; ^ variables are winsorized to be no greater than 1 in absolute value.
companies have large blocks (10% or greater) of shares held by investors. The mean of Tobin’s Q is around 4.0, which indicates that most companies on the TSX Venture Exchange are growth firms. On average, these companies are not highly leveraged; in fact, only 10% issued debt in 2004. Table 2 provides evidence of the determinants of corporate governance. Since the correlation between composition and policies is more than 85%, the composition and policies components of the CG score are used individually in subsequent analyses. The CG score and its composition component are significantly and positively influenced by the
number of large block holders. However, the positive block-holder effect is reduced when there are a large number of board members who are related to the block holder. In other words, purely external block holders are likely to expect better corporate governance. This suggests that ‘internal’ block holders are less affected by information asymmetry and therefore do not demand measures to counter it. Corporate governance and its components are also positively related to larger board size, higher leverage, higher market value of equity, and auditor type. Larger boards are better able to provide the resources associated with better governance and
Table 2. Determinants of corporate governance (CG score) CG Score Variable
Composition
Policies -4.496 ** 0.244 -0.083 0.186 *** -0.227 0.239 0.001 0.288 *** 0.484 ** 0.239 0.637 * -0.502
Intercept Block Block*BD Block Board Size Debt Issue Leverage DREV Log(MVE) Auditor Mining BioTech Industrial
-9.885 *** 0.633 *** -0.264 ** 0.655 *** -0.111 0.494 * 0.066 0.586 *** 1.253 *** 0.237 1.934 *** -0.592
-5.390 *** 0.389 ** -0.182 *** 0.469 *** 0.116 0.254 * 0.066 0.298 *** 0.769 *** -0.002 1.297 *** -0.090
Adjusted R2
17.85%
28.17%
Note: N = 702; * if p < 0.05; ** if p < 0.01; *** if p < 0.001.
4.99%
588 Table 3.
I.M. Gordon et al. Determinants of accrual quality (AQ)
Variable Intercept CG Score Composition Policies Auditor Leverage Log(MVE) Mining BioTech Industrial Adjusted R 2
AQ1 -0.585 *** 0.004 *
AQ1 -0.602 ***
AQ1 -0.594 ***
AQ2 -0.417 *** 0.006 ***
0.003 0.019 0.040 *** 0.024 *** -0.016 -0.094 *** -0.096 *** 4.66%
0.021 0.040 *** 0.025 *** -0.016 -0.091 *** -0.097 ***
AQ2 -0.436 ***
AQ2 -0.431 ***
0.006 0.006 ** 0.021 0.040 *** 0.025 *** -0.017 -0.089 ** -0.095 ***
4.35%
4.78%
0.009 0.021 0.009 0.037 -0.113 *** -0.055 3.31%
0.013 0.023 0.012 0.038 * -0.107 *** -0.057 2.53%
0.012 *** 0.011 0.022 0.011 0.036 -0.106 *** -0.052 3.67%
Note: N = 702; * if p < 0.05; ** if p < 0.01; *** if p < 0.001.
may be associated with resource-rich companies. Companies with higher leverage may have credit requirements that necessitate effective governance practices and may also wish to provide a signal to credit markets. Similarly, companies with higher market value of equity are likely companies wishing to signal they are capable of effective governance in order to maintain access to equity markets. The results also suggest a Big 4 auditor may have the knowledge to encourage and even insist on better governance practices than a smaller auditor. Additionally, companies in the bio-technology industry are significantly more likely to voluntarily adopt the TSX governance guidelines than are companies in other industries. It is not immediately clear why this is the case, but it is possible that bio-technology firms tend to be growth firms in environments of considerable complexity and uncertainty where effective governance practices may be seen as important for minimizing risk. Table 3 provides evidence on whether better governance is related to earnings quality. For both
Table 4.
proxies of accrual quality (AQ1 and AQ2), we find that companies that adopt and disclose effective governance practices also report high earnings quality. Perhaps surprisingly, it is the policies component of the CG score that is both statistically and economically more significant than the composition component. Thus, earnings quality is apparently more dependent on aspects of governance related to the adoption of codes of ethics and the ability to access external consultants than it is to more highly publicized elements like board and committee composition. Consistent with prior literature, we further find that larger companies with higher leverage have higher earnings quality. Finally, Table 4 provides evidence regarding whether more effective corporate governance practices affect firms’ financial performance. Our results confirm that, the more effective a firm’s corporate governance–—especially the higher the composition component–—the greater the firm’s value, or Tobin’s Q. Thus, in the case of firms’ financial performance in Canada, we find that
Determinants of financial performance
Variable Intercept CG Rank Composition Policies Auditor DREV Leverage Log(AT) Mining BioTech Industrial
Tobin’s Q 29.720 *** 0.087 ***
Tobin’s Q 29.868 ***
Tobin’s Q 29.172 ***
0.950 *** -0.652 -0.870 *** -1.740 *** -0.716 ** 0.447 0.132
0.853 *** -0.666 -0.872 *** -1.760 *** -0.697 ** 0.257 0.074
0.053 1.042 *** -0.653 -0.884 *** -1.691 *** -0.703 ** 0.635 0.135
Adjusted R 2
33.78%
34.33%
33.32%
0.237 ***
Note: N = 702; * if p < 0.05; ** if p < 0.01; *** if p < 0.001.
Corporate governance in publicly traded small firms: A study of Canadian venture exchange companies corporate governance matters, and what is most important is the set of variables related to board and committee structure. For the most part, the financial control variables are statistically significant. Consistent with prior literature (Klein et al., 2005), firm size is consistently negatively related to performance, as is firm leverage. Performance is also significantly related to whether the company has a Big 4 auditor.
5. Implications for small firms and public policy In this article, we examine the determinants and effects of corporate governance practices by small Canadian firms, exploiting the unique voluntary disclosure environment existing on the Toronto Venture Exchange prior to 2005. We use hand-collected governance and financial data for all companies listed on the TSX Venture Exchange in 2004 to analyze the governance practices in these smaller businesses. We find that good governance is indeed an important driver of small firm performance, a factor that owners and managers should not neglect. However, we also find that small firms are likely limited in their ability to select good governance because of resource constraints. These results raise an important question: If corporate governance best practices contribute to firm performance, particularly stock market performance, then why would firms not voluntarily choose to adopt them? One reason could be that while the costs of achieving good governance (i.e., bigger boards, more committees, more expensive auditors) are easily measured and understood, the benefits are not, so firms may weigh the costs more heavily. Our results suggest that this could be a mistake. A second possible explanation is that firms do understand the relevant costs and benefits, and for some firms, the costs simply outweigh the benefits. Additionally, our results suggest that the costs are higher for smaller firms. Thus, even among these smaller firms, size matters. We find that the larger companies in our sample have significantly better corporate governance practices than the smaller companies. On average, the larger companies also have larger board sizes. These differences suggest that smaller firms with smaller boards may not have the resources to comply with best practices in corporate governance. In addition, larger companies are likely to be able to recruit higher-quality board members. These differences may also be driven by the larger companies’ internal plans to move from the TSX Venture Exchange to the TSX, where better
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corporate governance performance would be expected. The costs and benefits of adopting governance best practices may also depend on firms’ ownership structures. We find that larger numbers of block holders are associated with better governance, but the effect is reduced when there are board members related to block holders. Thus, there may be private benefits of control that cause closely held firms to adopt different governance practices. For owners and managers of small firms, our results clearly suggest that close attention should be paid to the benefits of adopting good governance practices. If adoption is costly, then firms should consider ways to reduce costs by focusing on particular aspects of governance. For example, investors tend to more highly value the composition component of corporate governance. Small firms could usefully focus on this component, rather than the policies component. For investors, our results suggest that good corporate governance is a useful metric to consider when building portfolios. We also note that where there is evidence of private benefits of control (i.e., concentrated ownership and weak governance), investors should be cautious. For public policy makers, our results suggest that a one-size-fits-all policy is likely to place substantial costs on smaller firms. Thus, flexible regulatory mechanisms may be preferable. Indeed, the Canadian system of voluntary compliance with mandatory disclosure seems appropriate. This is the system required of TSX Venture Exchange firms as of 2005, when it was recognized that some governance practices may not be appropriate for all firms. Finally, for researchers, our study raises several questions begging future investigation. What will become of these firms as they become subject to TSX guidelines? What will happen to firms that move from the Venture Exchange to the TSX? Why are the determinants of earnings quality not more similar to those of financial performance? The scholarly environment is ripe for additional exploration.
Acknowledgment We acknowledge helpful comments from M. Parent and the participants at the 2011 Global Finance Association conference, the 2011 European Accounting Association conference, and the 2011 Canadian Academic Accounting Association conference. Hrazdil acknowledges financial support from the Social Sciences and Humanities Research Council of Canada and Gordon acknowledges the support of the Certified General Accountants Association of British Columbia.
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Appendix. TSX guidelines on and scoring of the corporate governance disclosures for the TSX Venture Exchange companies Relevant TSX guideline
Scoring*
1. The board of directors of every corporation should explicitly assume responsibility for stewardship, specifically for the following: Adopting a strategic planning process Identifying risk and risk-management systems Developing succession planning Formulating a communications policy Maintaining the integrity of internal control and management information systems
Coded 1 if the disclosures explicitly state the following: - The board assumes responsibility for stewardship - The board has established a strategic planning process - The board assumes responsibility for identifying risk - The board has a clear succession policy
2. The board of directors should constitute a majority of individuals who qualify as unrelated directors
Coded 1 if disclosures state the following: - The majority of the board is independent of management - The board reviews the status of a director with respect to significant shareholders
3. The circumstances of each individual director should be examined in determining their relationship; firms should disclose annually whether a majority of directors are unrelated
Coded 1 if disclosures indicate for each director who is independent
Coded 1 if disclosures indicate the following: 4. Firms should have a committee of directors for nominating new directors and assessing directors on an - The company has a nominating committee ongoing basis; members of this committee should be non- - The nominating committee is composed management completely of independent directors 5. Firms should implement a process for assessing the effectiveness of the board, its committees, and individual directors
Coded 1 if disclosures indicate that there is a process for assessing the performance of the board, its committees, and its members
Max Score
4
2
1
2
1
6. An orientation and education program should be provided Coded 1 if disclosures indicate that the to new board members company has a formal orientation program
1
7. The board should consider its size and the potential for No TSX Venture Exchange company provided reduction this information
0
8. The board should review the adequacy and form of directors’ compensation
1
Coded 1 if disclosures indicate that the company has a compensation committee
9. Committees of the board of directors should generally be Coded 1 if disclosures indicate that all composed of outside directors, a majority of whom are committees described are composed unrelated directors completely of independent directors
1
10. Firms should have a committee with responsibility for Coded 1 if disclosures indicate that the governance issues company has a corporate governance committee
1
11. Together with the CEO, the board of directors should Coded 1 if disclosures indicate the following: develop position descriptions for the board and for the - The company has a code of business CEO involving the definition of the limits to conduct/ethics - The company has a written charter management’s responsibilities
2
12. Firms should have structures and procedures so the board can function independently of management
Coded 1 if disclosures explicitly state the following: - The board chair is separate from the CEO - The company has a lead director - The board chair is an independent director - Directors are able to meet independently of management
4
13. The audit committee should be composed only of outside Coded 1 if disclosures explicitly indicate that directors, have its roles and responsibilities specifically the audit committee consists entirely of defined, have direct communication channels with independent directors internal and external auditors, and have oversight responsibility for management reporting on internal control
1
Corporate governance in publicly traded small firms: A study of Canadian venture exchange companies
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Appendix (Continued )
Relevant TSX guideline 14. The board of directors should implement a system that enables an individual director to engage an outside adviser at the expense of the corporation in appropriate circumstances
Scoring* Coded 1 if disclosures indicate that there is a formal process for allowing directors to engage outside advisors at the company’s expense
Max Score 1
Note: 0 = no or not mentioned; 1 = yes (explicitly stated or, if the answer is yes, can be determined from the information disclosed).
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Lin, C. (2011). An examination of board and firm performance: Evidence from Taiwan. International Journal of Business and Finance Research, 5(4), 17—34. MacAulay, K., Shantanu, D., Oxner, M., & Hynes, T. (2009). The impact of a change in corporate governance regulations on firms in Canada. Quarterly Journal of Finance and Accounting, 48(4), 29—52. Malin, C., & Ow-Yong, K. (1998). Corporate governance in small companies — The alternative investment market. Corporate Governance: An International Review, 6(4), 224—232. Morck, R., Shleifer, A., & Vishny, R. (1988). Management ownership and market valuation: An empirical analysis. Journal of Financial Economics, 20(1), 293—315. Niu, F. (2006). Corporate governance and the quality of accounting earnings: A Canadian perspective. International Journal of Managerial Finance, 2(4), 302—327. OECD. (2004). OECD principles of corporate governance. Paris: Organisation for Economic Co-operation and Development. Srinidhi, B., & Gul, F. (2007). The differential effects of auditors’ nonaudit and audit fees on accrual quality. Contemporary Accounting Research, 24(2), 595—629. Switzer, L. (2007). Corporate governance, Sarbanes-Oxley, and small-cap firm performance. Quarterly Review of Economics and Finance, 47(5), 651—666. Wallace, R., & Naser, K. (1995). Firm-specific determinants of the comprehensiveness of mandatory disclosure in the corporate annual reports of firms listed on the stock exchange of Hong Kong. Journal of Accounting and Public Policy, 14(4), 311—368. Welker, M. (1995). Disclosure policy, information asymmetry, and liquidity in equity markets. Contemporary Accounting Research, 11(2), 801—827. Yermack, D. (1996). Higher market valuation of companies with a small board of directors. Journal of Financial Economics, 40(2), 185—211.
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Corporate governance in publicly traded small firms: A study of Canadian venture exchange companies Irene M. Gordon *, Karel Hrazdil, Daniel Shapiro Beedie School of Business, Simon Fraser University, 8888 University Drive, Burnaby, BC V5A 1S6, Canada
KEYWORDS Corporate governance; Earnings quality; Venture exchange; Firm performance; Canadian small business
Abstract Most evidence regarding the determinants and effects of corporate governance practices is based on large firms. Herein, we explore these issues in the context of small publicly traded Canadian companies. We exploit the fact that such firms were not subject to corporate governance guidelines prior to 2005 and thus analyze the determinants of voluntary governance practice choices, as well as the effects of those practices on firm performance. Using a unique data set, we construct a corporate governance index for each firm. We measure performance by two variables: quality of accounting earnings and financial performance. The results indicate that corporate governance does matter for smaller traded Canadian firms. We find that both accounting and financial performance are positively related to corporate governance; however, their underlying mechanisms may differ somewhat. Given this result, it would be natural to expect all firms to choose higher levels of governance. However, our results also suggest small firms face resource constraints that limit their choices. We conclude that good governance is an important driver of small firm performance that cannot be neglected by the owners and managers of these firms. # 2012 Kelley School of Business, Indiana University. Published by Elsevier Inc. All rights reserved.
1. Why study small firms in Canada? Corporate governance, the system by which companies are directed and controlled, has been subject to much discussion by practitioners, academics, and regulators. There is now some consensus regarding
* Corresponding author E-mail addresses: [email protected] (I.M. Gordon), [email protected] (K. Hrazdil), [email protected] (D. Shapiro)
what constitutes good governance (OECD, 2004) and the various policy measures to ensure firms adopt effective practices. In Canada, firms listed on the Toronto Stock Exchange (TSX) must adhere to corporate governance guidelines or explain why they do not (Klein, Shapiro, & Young, 2005). Not surprisingly, a majority of listed firms now–—more or less–—stick to these guidelines. This is the case for most firms listed on major stock markets in the developed world. While it is true that most large firms operating in developed capital markets generally conform
0007-6813/$ — see front matter # 2012 Kelley School of Business, Indiana University. Published by Elsevier Inc. All rights reserved. http://dx.doi.org/10.1016/j.bushor.2012.07.005
584 to good governance practices, there is no overwhelming evidence to suggest that firm performance is enhanced by better corporate governance. In a Canadian setting, there is limited evidence regarding whether governance matters, and what does exist correlates to larger listed companies (Klein et al., 2005; MacAulay, Shantanu, Oxner, & Hynes, 2009; Niu, 2006). The absence of strong evidence for the positive impact of corporate governance on firm performance may, in fact, be a result of the successful diffusion of good governance practices. In the mid1990s, the TSX issued 14 corporate governance best practice guidelines that Canadian companies listed on the exchange were encouraged to follow. Although implementing the guidelines is voluntary on an individual firm basis, TSX-listed companies are required to annually disclose and compare their corporate governance practices to the 14 best practices. As such, there are strong incentives for large firms to adopt common governance practices, thereby resulting in lower variation in such practices across listed firms. This convergence of best practices across firms is heightened because large firms also have the resources to implement the guidelines. In addition, many TSX firms are cross-listed on the U.S. exchanges, and are thus affected by U.S. mandatory governance practices (Charitou, Louca, & Panaydies, 2007). All of these factors tend to make measured governance practices relatively similar across the TSX firms. In turn, this makes it difficult to find a robust statistical relationship between corporate governance and firm performance. For example, MacAulay et al. (2009) investigated how the introduction of the TSX governance regulations affected compliance and firm performance for all Canadian companies listed on the TSX. The authors found that while compliance with corporate governance regulations increased during the period, the relationship between corporate governance and firm performance weakened. In this article, we focus on the smaller companies listed on the TSX Venture Exchange before 2005 because prior to that date, both adoption and disclosure were left to individual companies’ management. That is, TSX Venture Exchange firms were not subject to the TSX governance guidelines. Given the TSX Venture Exchange companies’ size and limited resources to enhance governance, voluntary adoption and disclosure should vary across firms. This variation allows us to better evaluate the effectiveness of voluntary governance practices. Our contribution to the understanding of the importance of corporate governance arises from our analysis of the unique context of small publicly traded TSX Venture Exchange companies prior to
I.M. Gordon et al. 2005. We develop a new database (described later) that permits us to construct an index of corporate governance for each firm in our sample and to measure its performance. We find that more effective corporate governance practices are related to firm characteristics, including the size of their boards, the ownership structure of the company, leverage, market value of equity, and the nature of the auditor. Further, we provide evidence that earnings quality and financial performance are both positively related to effective corporate governance. These results suggest that small firms with resource constraints are less likely to choose effective governance structures even though doing so will improve performance. Thus, managers and owners must pay careful attention to the costs and benefits of improved governance.
2. Does corporate governance matter? Three research questions Herein, we address three fundamental research questions related to the determinants and effects of corporate governance practices for small firms: 1. What kinds of firms will choose effective governance in a non-regulated environment, and in particular, do resource constraints limit the adoption of good corporate governance? 2. Does effective corporate governance contribute to accounting performance–—measured by earnings quality–—and if so, what elements of governance are most important? 3. Are more effective corporate governance practices positively reflected in a firm’s value by the market, and if so, what elements are most important? The first question addresses the issue of choice. Given the absence of regulatory requirements, to what extent will small firms voluntarily choose to adopt best practice governance? If they do not choose to adopt these practices voluntarily, to what extent do resource constraints limit their choices? In addressing this latter question, we draw on the limited extant literature regarding small firm governance to inform our analysis (Eisenberg, Sundgren, & Wells, 1998; Lin, 2011; Malin & Ow-Yong, 1998; Switzer, 2007). This literature does point to the importance of resource constraints in limiting the adoption of best practice governance. However, it does not address the question of governance choice when that choice is voluntary.
Corporate governance in publicly traded small firms: A study of Canadian venture exchange companies The second question addresses firms’ reporting practices, in this case as measured by the quality of reported earnings. There is limited evidence suggesting that stronger governance mechanisms reduce opportunistic management behavior, thus improving the quality and reliability of financial reporting (Morck, Shleifer, & Vishny, 1988; Niu, 2006). In principle, better corporate disclosure reduces information asymmetry between investors and managers, which in turn maintains and enhances investors’ confidence in the integrity of a firm’s financial information and hence its value (Cormier, Ledoux, Magnan, & Aerts, 2010; Welker, 1995). However, better disclosure is also costly, and may be relatively more so for smaller firms. Thus, small firms may choose to limit their investments in better disclosure. In sum, our second research question asks whether better governed small firms are more likely to adopt higher-quality reporting practices. Our third research question focuses on financial performance. Survey studies suggest there is, at best, mixed evidence in support of the hypothesis that better corporate governance results in better financial performance (Adams, Hermalin, & Weisbach, 2010; Daily, Dalton, & Cannella, 2003). Much of the evidence on this relationship comes from the U.S. market, in which corporate governance mechanisms and disclosures are highly regulated and large companies are often examined (Gompers, Ishii, & Metrick, 2003; Yermack, 1996). However, prior evidence regarding the relationship between corporate governance and firm performance in Canadian companies has been mixed (Bujaki & McConomy, 2002; Gupta, Kennedy, & Weaver, 2009; Klein et al., 2005). These studies generally utilize relatively small samples of large Canadian firms available from the investor service of the Globe and Mail, which publishes governance rankings annually for about 300 companies represented on the TSX. At this point, it is important to note that measuring best practice corporate governance is not straightforward. In fact, there are many dimensions to what constitutes best practice, and it is common to aggregate them to form a single governance index. We follow this practice in our study, but we also employ some of the sub-measures to determine whether any of them is more important individually. We employ this method for both accounting and financial performance.
3. Data and methodology Our initial sample consists of all companies listed on the TSX Venture Exchange in 2004. With revenues
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ranging up to C$39,000,000, these companies qualify as small businesses (Diez-Vial, 2009). Using proxy data collected by the Simon Fraser University, Beedie School of Business’ CIBC Centre for Corporate Governance and Risk Management, in association with the University of Toronto’s Capital Markets Institute, we recorded raw governance and other data for 1,617 firms traded on the TSX Venture Exchange in 2004. We also collected additional financial data for the firms, as described below.
3.1. Data from proxy statements In measuring overall governance quality, some researchers use existing techniques, such as principal components analysis; some construct their own composite governance indices (Bujaki & McConomy, 2002; Gompers et al., 2003); and some rely on publicly available governance scores (Klein et al., 2005). In Canada, the most utilized comprehensive corporate governance index ranking available comes from the ‘Report on Business’ (ROB) section of the Globe and Mail. Although the Globe and Mail rankings capture an unusually wide variety of governance indicators–—related to board composition, shareholding and compensation policy, shareholder rights policy, and disclosure policy–—the weights attached to these variables are somewhat arbitrary. This issue of assigned variable weightings, coupled with the fact that the ROB rates only the large companies contained in the Canadian S&P/TSX Index, rules out the use of this index for TSX Venture Exchange small businesses. Using the proxy data collected for the TSX Venture Exchange companies, we follow Bujaki and McConomy (2002) and construct a measure for the extent of adoption of the 14 TSX corporate governance guidelines based on 22 key guideline dimensions. The overall corporate governance (CG) score is equal to the sum of scores across all 14 relevant TSX guidelines (defined in the Appendix). Following previous studies that rely on the Globe and Mail rankings, we further subdivide the CG score into two sub-indices. The first, composition, is defined as the sum of scores across several dimensions related to board composition: the majority of the board is independent of management; the audit committee consists entirely of independent directors; the compensation committee consists entirely of independent directors; the nominating committee consists entirely of independent directors; the board chair is separate from the chief executive officer (CEO); the board has a lead director; there is a process for assessing the performance of the board, its committees, and members; the directors are able to meet independently of management; the
586 board chair is an independent director; the company has a nominating committee; the company has a compensation committee; and the company has a corporate governance committee. For each element coded as 1, these are summed to determine the composition score. Policies, the second sub-index, is defined as the CG score minus the composition score. The elements of this sub-index are policies regarding: strategic position; broad orientation and education programs; code of conduct/ethics; engagement of external advisors by board members; and assessments of board effectiveness, or the score related to the firm’s disclosure policy. We also measure ownership structure from the proxy disclosures. Proxy circulars must disclose all individuals and groups holding more than 10% of the voting rights (block) and the number of people on the board related to an entity with voting rights greater than 10% (BD block). We focus on these block holders as we expect that a significant number of minority investors will influence a firm’s choice to implement corporate governance standards voluntarily. Given the scarcity of resources in small start-up companies to compensate board members, we examine the impact of board size–—the number of board directors–—on the magnitude of the governance score (Coles, Daniel, & Naveen, 2008).
3.2. Financial and performance variables We hand-collected relevant financial data from companies’ financial statements available on the System for Electronic Document Analysis and Retrieval (SEDAR) (www.sedar.com) and market-based information (e.g., share prices) from Yahoo finance (http://ca.finance.yahoo.com). Malin and Ow-Yong (1998) suggest that governance choices may depend on whether the firm will require access to capital markets. Therefore, we measure a firm’s current capital by a dummy variable (debt issue) equal to 1 if the company issued long-term debt in 2004. These firms will want to ensure investors’ interests are protected and may convey this signal through a stronger commitment to stringent corporate governance. To control for a company’s access to financing, we include: leverage (i.e., book value of debt divided by market value of common equity); average sales growth, or DREV (i.e., a change in revenue scaled by average total assets); and size, measured by the logarithm of market value of equity (i.e., share price at the fiscal year end times the number of shares outstanding). Low levels of leverage indicate greater debt capacity. Therefore, larger growing firms financed heavily through debt are more likely to raise financing through equity and will be more willing
I.M. Gordon et al. to comply voluntarily with stricter governance standards. We measure the quality of reported earnings (i.e., accruals) and the consequent information asymmetry in two ways. First, we follow Srinidhi and Gul (2007) and measure accrual quality (AQ1) as the absolute value of the residuals from the regression relating current accruals to past, present, and future cash flows; change in revenue; and property, plant, and equipment. This accrual-quality measure deteriorates if the accruals are driven by opportunism but not when the accruals are motivated by the need to convey private information. As a second measure of earnings quality (AQ2), we follow Kothari et al. (2005) and use the absolute value of discretionary accruals from the Jones model adjusted for performance. Specifically, we match each firm’s discretionary accrual observation with that of another firm from the same industry group with the closest return on assets in 2004. For ease of interpretation, we multiply the AQ1 and AQ2 by -1.0 so that increasing values of AQ1 and AQ2 indicate increasing accrual quality. Consistent with prior literature (Klein et al., 2005), we measure firm performance as a relative market valuation measured by Tobin’s Q (defined as the book value of liabilities plus market value of common equity divided by the book value of assets). Based on previous findings revealing that companies audited by larger audit firms disclose more information (Wallace & Naser, 1995), we define auditor as a dummy variable equal to 1 if the company was audited by one of the Big 4 auditors. The expectation is that when a company has a Big 4 firm auditor, higher levels of additional disclosed information improves the company’s governance score and reduces the costs of extra monitoring for investors. Finally, we include a set of industry dummies as we expect companies may be under pressure from their peers to adopt the industry base level of corporate governance compliance.
4. Empirical findings and discussion The CG scores and other board characteristics are available for all 1,617 companies traded on the TSX Venture Exchange. However, the absence of financial data reduced the effective sample to 702. The aggregate data (not presented) indicate that, on average, larger companies have higher CG scores than smaller companies and also tend to have larger boards. Table 1 provides summary data for the 702 companies for which we have financial data. It is noteworthy that the average board size is five directors, which is relatively small. In addition, 78% of the
Corporate governance in publicly traded small firms: A study of Canadian venture exchange companies Table 1. Summary statistics Mean Variable CG Score Composition Policies Board Size Block BD Block AQ1^ AQ2^ MVE($mil) * AT($mil) * Tobin’s Qz DREV^ Leveragez Debt Issue Auditor Mining BioTech Industrial R/E($mil) NI($mil) Sales($mil)
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Std. Deviation
Median
Minimum
Maximum
3.936 2.075 2.487 1.393 0.887 0.829 0.239 0.168 20.794 10.358 4.261 0.252 0.653 0.307 0.425 0.490 0.290 0.221 12.133 3.403 5.337
1.000 1.000 0.000 5.000 1.000 0.000 -0.148 -0.099 4.725 2.552 2.329 0.001 0.067 0.000 0.000 1.000 0.000 0.000 -5.222 -0.521 0.003
0.000 0.000 0.000 3.000 0.000 0.000 -1.000 -1.000 0.002 0.032 0.300 -1.000 0.000 0.000 0.000 0.000 0.000 0.000 -196.809 -81.389 0.000
19.000 11.000 9.000 12.000 5.000 5.000 -0.001 -0.001 241.131 138.200 17.500 1.000 2.536 1.000 1.000 1.000 1.000 1.000 47.906 8.793 39.084
3.223 1.959 1.265 4.818 0.786 0.621 -0.233 -0.159 10.918 5.559 3.989 0.026 0.354 0.105 0.236 0.600 0.093 0.051 -7.614 -0.921 1.625
* Variables are log transformed for the correlation and regression analysis; z variables are winsorized at the extreme 1%; ^ variables are winsorized to be no greater than 1 in absolute value.
companies have large blocks (10% or greater) of shares held by investors. The mean of Tobin’s Q is around 4.0, which indicates that most companies on the TSX Venture Exchange are growth firms. On average, these companies are not highly leveraged; in fact, only 10% issued debt in 2004. Table 2 provides evidence of the determinants of corporate governance. Since the correlation between composition and policies is more than 85%, the composition and policies components of the CG score are used individually in subsequent analyses. The CG score and its composition component are significantly and positively influenced by the
number of large block holders. However, the positive block-holder effect is reduced when there are a large number of board members who are related to the block holder. In other words, purely external block holders are likely to expect better corporate governance. This suggests that ‘internal’ block holders are less affected by information asymmetry and therefore do not demand measures to counter it. Corporate governance and its components are also positively related to larger board size, higher leverage, higher market value of equity, and auditor type. Larger boards are better able to provide the resources associated with better governance and
Table 2. Determinants of corporate governance (CG score) CG Score Variable
Composition
Policies -4.496 ** 0.244 -0.083 0.186 *** -0.227 0.239 0.001 0.288 *** 0.484 ** 0.239 0.637 * -0.502
Intercept Block Block*BD Block Board Size Debt Issue Leverage DREV Log(MVE) Auditor Mining BioTech Industrial
-9.885 *** 0.633 *** -0.264 ** 0.655 *** -0.111 0.494 * 0.066 0.586 *** 1.253 *** 0.237 1.934 *** -0.592
-5.390 *** 0.389 ** -0.182 *** 0.469 *** 0.116 0.254 * 0.066 0.298 *** 0.769 *** -0.002 1.297 *** -0.090
Adjusted R2
17.85%
28.17%
Note: N = 702; * if p < 0.05; ** if p < 0.01; *** if p < 0.001.
4.99%
588 Table 3.
I.M. Gordon et al. Determinants of accrual quality (AQ)
Variable Intercept CG Score Composition Policies Auditor Leverage Log(MVE) Mining BioTech Industrial Adjusted R 2
AQ1 -0.585 *** 0.004 *
AQ1 -0.602 ***
AQ1 -0.594 ***
AQ2 -0.417 *** 0.006 ***
0.003 0.019 0.040 *** 0.024 *** -0.016 -0.094 *** -0.096 *** 4.66%
0.021 0.040 *** 0.025 *** -0.016 -0.091 *** -0.097 ***
AQ2 -0.436 ***
AQ2 -0.431 ***
0.006 0.006 ** 0.021 0.040 *** 0.025 *** -0.017 -0.089 ** -0.095 ***
4.35%
4.78%
0.009 0.021 0.009 0.037 -0.113 *** -0.055 3.31%
0.013 0.023 0.012 0.038 * -0.107 *** -0.057 2.53%
0.012 *** 0.011 0.022 0.011 0.036 -0.106 *** -0.052 3.67%
Note: N = 702; * if p < 0.05; ** if p < 0.01; *** if p < 0.001.
may be associated with resource-rich companies. Companies with higher leverage may have credit requirements that necessitate effective governance practices and may also wish to provide a signal to credit markets. Similarly, companies with higher market value of equity are likely companies wishing to signal they are capable of effective governance in order to maintain access to equity markets. The results also suggest a Big 4 auditor may have the knowledge to encourage and even insist on better governance practices than a smaller auditor. Additionally, companies in the bio-technology industry are significantly more likely to voluntarily adopt the TSX governance guidelines than are companies in other industries. It is not immediately clear why this is the case, but it is possible that bio-technology firms tend to be growth firms in environments of considerable complexity and uncertainty where effective governance practices may be seen as important for minimizing risk. Table 3 provides evidence on whether better governance is related to earnings quality. For both
Table 4.
proxies of accrual quality (AQ1 and AQ2), we find that companies that adopt and disclose effective governance practices also report high earnings quality. Perhaps surprisingly, it is the policies component of the CG score that is both statistically and economically more significant than the composition component. Thus, earnings quality is apparently more dependent on aspects of governance related to the adoption of codes of ethics and the ability to access external consultants than it is to more highly publicized elements like board and committee composition. Consistent with prior literature, we further find that larger companies with higher leverage have higher earnings quality. Finally, Table 4 provides evidence regarding whether more effective corporate governance practices affect firms’ financial performance. Our results confirm that, the more effective a firm’s corporate governance–—especially the higher the composition component–—the greater the firm’s value, or Tobin’s Q. Thus, in the case of firms’ financial performance in Canada, we find that
Determinants of financial performance
Variable Intercept CG Rank Composition Policies Auditor DREV Leverage Log(AT) Mining BioTech Industrial
Tobin’s Q 29.720 *** 0.087 ***
Tobin’s Q 29.868 ***
Tobin’s Q 29.172 ***
0.950 *** -0.652 -0.870 *** -1.740 *** -0.716 ** 0.447 0.132
0.853 *** -0.666 -0.872 *** -1.760 *** -0.697 ** 0.257 0.074
0.053 1.042 *** -0.653 -0.884 *** -1.691 *** -0.703 ** 0.635 0.135
Adjusted R 2
33.78%
34.33%
33.32%
0.237 ***
Note: N = 702; * if p < 0.05; ** if p < 0.01; *** if p < 0.001.
Corporate governance in publicly traded small firms: A study of Canadian venture exchange companies corporate governance matters, and what is most important is the set of variables related to board and committee structure. For the most part, the financial control variables are statistically significant. Consistent with prior literature (Klein et al., 2005), firm size is consistently negatively related to performance, as is firm leverage. Performance is also significantly related to whether the company has a Big 4 auditor.
5. Implications for small firms and public policy In this article, we examine the determinants and effects of corporate governance practices by small Canadian firms, exploiting the unique voluntary disclosure environment existing on the Toronto Venture Exchange prior to 2005. We use hand-collected governance and financial data for all companies listed on the TSX Venture Exchange in 2004 to analyze the governance practices in these smaller businesses. We find that good governance is indeed an important driver of small firm performance, a factor that owners and managers should not neglect. However, we also find that small firms are likely limited in their ability to select good governance because of resource constraints. These results raise an important question: If corporate governance best practices contribute to firm performance, particularly stock market performance, then why would firms not voluntarily choose to adopt them? One reason could be that while the costs of achieving good governance (i.e., bigger boards, more committees, more expensive auditors) are easily measured and understood, the benefits are not, so firms may weigh the costs more heavily. Our results suggest that this could be a mistake. A second possible explanation is that firms do understand the relevant costs and benefits, and for some firms, the costs simply outweigh the benefits. Additionally, our results suggest that the costs are higher for smaller firms. Thus, even among these smaller firms, size matters. We find that the larger companies in our sample have significantly better corporate governance practices than the smaller companies. On average, the larger companies also have larger board sizes. These differences suggest that smaller firms with smaller boards may not have the resources to comply with best practices in corporate governance. In addition, larger companies are likely to be able to recruit higher-quality board members. These differences may also be driven by the larger companies’ internal plans to move from the TSX Venture Exchange to the TSX, where better
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corporate governance performance would be expected. The costs and benefits of adopting governance best practices may also depend on firms’ ownership structures. We find that larger numbers of block holders are associated with better governance, but the effect is reduced when there are board members related to block holders. Thus, there may be private benefits of control that cause closely held firms to adopt different governance practices. For owners and managers of small firms, our results clearly suggest that close attention should be paid to the benefits of adopting good governance practices. If adoption is costly, then firms should consider ways to reduce costs by focusing on particular aspects of governance. For example, investors tend to more highly value the composition component of corporate governance. Small firms could usefully focus on this component, rather than the policies component. For investors, our results suggest that good corporate governance is a useful metric to consider when building portfolios. We also note that where there is evidence of private benefits of control (i.e., concentrated ownership and weak governance), investors should be cautious. For public policy makers, our results suggest that a one-size-fits-all policy is likely to place substantial costs on smaller firms. Thus, flexible regulatory mechanisms may be preferable. Indeed, the Canadian system of voluntary compliance with mandatory disclosure seems appropriate. This is the system required of TSX Venture Exchange firms as of 2005, when it was recognized that some governance practices may not be appropriate for all firms. Finally, for researchers, our study raises several questions begging future investigation. What will become of these firms as they become subject to TSX guidelines? What will happen to firms that move from the Venture Exchange to the TSX? Why are the determinants of earnings quality not more similar to those of financial performance? The scholarly environment is ripe for additional exploration.
Acknowledgment We acknowledge helpful comments from M. Parent and the participants at the 2011 Global Finance Association conference, the 2011 European Accounting Association conference, and the 2011 Canadian Academic Accounting Association conference. Hrazdil acknowledges financial support from the Social Sciences and Humanities Research Council of Canada and Gordon acknowledges the support of the Certified General Accountants Association of British Columbia.
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Appendix. TSX guidelines on and scoring of the corporate governance disclosures for the TSX Venture Exchange companies Relevant TSX guideline
Scoring*
1. The board of directors of every corporation should explicitly assume responsibility for stewardship, specifically for the following: Adopting a strategic planning process Identifying risk and risk-management systems Developing succession planning Formulating a communications policy Maintaining the integrity of internal control and management information systems
Coded 1 if the disclosures explicitly state the following: - The board assumes responsibility for stewardship - The board has established a strategic planning process - The board assumes responsibility for identifying risk - The board has a clear succession policy
2. The board of directors should constitute a majority of individuals who qualify as unrelated directors
Coded 1 if disclosures state the following: - The majority of the board is independent of management - The board reviews the status of a director with respect to significant shareholders
3. The circumstances of each individual director should be examined in determining their relationship; firms should disclose annually whether a majority of directors are unrelated
Coded 1 if disclosures indicate for each director who is independent
Coded 1 if disclosures indicate the following: 4. Firms should have a committee of directors for nominating new directors and assessing directors on an - The company has a nominating committee ongoing basis; members of this committee should be non- - The nominating committee is composed management completely of independent directors 5. Firms should implement a process for assessing the effectiveness of the board, its committees, and individual directors
Coded 1 if disclosures indicate that there is a process for assessing the performance of the board, its committees, and its members
Max Score
4
2
1
2
1
6. An orientation and education program should be provided Coded 1 if disclosures indicate that the to new board members company has a formal orientation program
1
7. The board should consider its size and the potential for No TSX Venture Exchange company provided reduction this information
0
8. The board should review the adequacy and form of directors’ compensation
1
Coded 1 if disclosures indicate that the company has a compensation committee
9. Committees of the board of directors should generally be Coded 1 if disclosures indicate that all composed of outside directors, a majority of whom are committees described are composed unrelated directors completely of independent directors
1
10. Firms should have a committee with responsibility for Coded 1 if disclosures indicate that the governance issues company has a corporate governance committee
1
11. Together with the CEO, the board of directors should Coded 1 if disclosures indicate the following: develop position descriptions for the board and for the - The company has a code of business CEO involving the definition of the limits to conduct/ethics - The company has a written charter management’s responsibilities
2
12. Firms should have structures and procedures so the board can function independently of management
Coded 1 if disclosures explicitly state the following: - The board chair is separate from the CEO - The company has a lead director - The board chair is an independent director - Directors are able to meet independently of management
4
13. The audit committee should be composed only of outside Coded 1 if disclosures explicitly indicate that directors, have its roles and responsibilities specifically the audit committee consists entirely of defined, have direct communication channels with independent directors internal and external auditors, and have oversight responsibility for management reporting on internal control
1
Corporate governance in publicly traded small firms: A study of Canadian venture exchange companies
591
Appendix (Continued )
Relevant TSX guideline 14. The board of directors should implement a system that enables an individual director to engage an outside adviser at the expense of the corporation in appropriate circumstances
Scoring* Coded 1 if disclosures indicate that there is a formal process for allowing directors to engage outside advisors at the company’s expense
Max Score 1
Note: 0 = no or not mentioned; 1 = yes (explicitly stated or, if the answer is yes, can be determined from the information disclosed).
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