What Matters in Corporate Governance in Emerging Markets: Time-Series Evidence from the BRIKT Countries (Brazil, Russia

1. What Matters in Corporate Governance in Emerging Markets: Time-Series Evidence from the BRIKT Countries (Brazil, Russia, India, Korea, Turkey) Bernard Black Northwestern University (Law School and Kellogg School of Management) (coauthors: Antonio Gledson de Carvalho; Vikramaditya Khanna; Woochan Kim; Burcin Yurtoglu)

2. Some broad research questions • How does optimal firm-level governance vary across countries? • Across firms within countries? • How do we measure “corporate governance”, anyway? • Can we build a meaningful, firm-level “corporate governance index” • that predicts share price, profitability, tunneling, or other performance measures within country • What are the components of such an index? • How will such an index vary across countries? Different question (LLSV etc.): Effect of country-level governance on firm value; economic development, etc.

3. Array of methodological issues • “Construct validity” issues: • What is “good” governance? • Can we measure it? • How does it vary across countries? • Tobin’s q (as dependent variable) is a construct too • Several flavors of “endogeneity”: • Omitted variables • Reverse causation (value  governance) • Optimal differences between firms • Differences in local legal rules • What varies across firms is country specific • Local practices vary [often idiosyncratic] • Data limitations • Data on governance • Data on control variables

4. Two Main Approaches • [Massively] Multicountry studies (broad and shallow) • Indices: S&P disclosure (2002); CLSA (2001); ISS/RiskMetrics (2003-) • Papers:Klapper Love (JCF 2004); Durnev Kim (JF 2005); Aggarwal Erel Stulz Williamson (RFS 2006); Bruno Claessens (JFI 2009); Doidge Karolyi Stulz (JFE 2007); Dahya Dimitrov McConnell (JFE 2008) • Country studies (narrow and deep). Representative list in emerging markets: • Brazil (Black, de Carvalho, Gorga, JCF 2012; Leal and Carvalhal-da-Silva, 2007, Braga-Alves and Shastri, FM 2011) • China (Cheung, Jiang, Limpaphayom and Lu (2009) • Hong Kong (Cheung, Connelly, Limpaphayom and Zhou, 2007, 2009) • India (Black and Khanna, JELS 2007; Balasubramanian, Black and Khanna 2009; Dharmapala and Khanna, JLEO 2013) • Korea (Black Jang and Kim, JLEO 2006; Black & Kim, JFE 2012; Black Kim Jang and Park 2012) • Russia (Black, EMR 2001; Black, Love and Rachinsky, EMR 2006) • Turkey (Ararat, Black, Yurtoglu, working paper 2012)

5. This project: Blend of the two approaches • Country studies • in 5 major emerging markets: BRIKT • Not China, less generalizability • Examine: What is generalizable? • And what isn’t • Big picture answer: Not much is generalizable • Cast doubt on massively multi-country efforts

6. Why Country Studies?Why focus on emerging markets? • Core corporate governance issues are different in developed vs. emerging markets. Stylized view: • Core US issue: ensure good management • Core emerging markets issue: control self-dealing • Governance more important in emerging markets • No good multicountry index • ISS/RiskMetrics: US-centric only developed countries • Other multicountry indices are dated, limited: • S&P (2002): run once; only disclosure • CLSA (2001): run once; some elements subjective

7. Why Country Studies - II? • Endogeneity is key issue: we care about causation, not just association: • Will Δgovcause Δy y = Tobin’s q; other outcome variable • Simple regression isn’t enough: • Regress y = a + b*gov+ c*controls + ε • Coefficient b on govtells us about association, not causation • One example, reverse causation: Regress gov= a’ + b’*y + c’*controls + ε • b and b’ usually have same sign, similar statistical significance

8. To assess causation • minimum: extensive control variables • better: panel data, firm fixed or random effects • Address unobserved time-invariant firm characteristics • best: respectable natural experiment/shock • not available in most countries (No good non-shock instruments exist) • Suppose we require a study to be about (or include) emerging markets and want even one of these . . . (Or results so strong that alternate explanations are unlikely)

9. Emerging markets, plus decent econometrics: • Multicountry studies • Papers:Klapper and Love (JCF 2004); Durnev and Kim (JF 2005); Doidge, Karolyi and Stulz (JFE 2007); Dahya Dimitrov McConnell (JFE 2008) [Nothing left.] • Country indices • Brazil(Black and de Carvalho, JCF 2012) • Hong Kong (Cheung, Connelly, Limpaphayom and Zhou, 2009) • India(Black and Khanna, JELS 2007; Dharmapala and Khanna, JLEO 2013) • Korea(Black Jang and Kim, JLEO 2006; Black and Kim, JFE 2012; Black, Kim Jang and Park, working paper 2012) • Russia(Black, EMR 2001; Black, Love and Rachinsky, EMR 2006) • Turkey (Ararat, Black and Yurtoglu, working paper 2012) [Apologies for the self-citation, but that’s what exists, to my knowledge.]

10. Country studies have problems too • Hard to generalize from one study • Endogeneity still a major concern • Indices not fully comparable across studies • Still, can get time series, firm fixed or random effects, good controls • In Korea and India, decent natural experiments • Maybe Turkey too (shock in late 2011; research underway) • My ongoing research strategy: • Time series, country studies in BRIKT countries • Similar indices (not identical because laws vary) [mostly lose Russia] • Exploit natural experiments, when they exist • Local coauthors to ensure I understand what matters • Look for similarities and differences across countries

11. This project: Combine data across countries • Brazil corp. gov. surveys: 2004, 2007, 2009 • India surveys: 2005, 2007, 2012 • Turkey: 2006-2011 (extending through 2011) • Korea: 1998-2004 (extending through 2009) • Russia: 1999-2005 (can partly extend thru 2008)

12. Each country: build local index • Index elements in each country must be: • Measurable • Meaningful (in judgment of local coauthors) • We think they might reflect “good” governance • Lots of judgment here! • Significant variation across firms • Not required by law • Not otherwise nearly universal or rare • Similar subindices, to extent feasible

13. Endogeneity: How Big an Issue • Important in developed markets • E.g., low performance  high boardindependence (Bhagat & Black, 2002) • Maybe, smaller issue in emerging markets • hard to predict firm-level governance choices (Black, Jang and Kim, JCF 2006a, Korea) • similar in India (adj. R2 < 0)  Large role for apparently idiosyncratic firm choice • More work needed on what firm-level factors predict governance across emerging markets: • . . . next project

14. Similar indices, subindices • In each country: Build broad corp. governance index • Rely on our own surveys, to supplement public data • Similar subindices, to extent feasible • Often only partly feasible, as we’ll see • Why different subindices? • What elements are required by law? [If so, little/no variation across firms] • What are typical practices? • Which elements have meaningful variation across firms? • What data exists?

15. Brazil Corp Gov Index (BCGI) in 2005 • Use Brazil to illustrate approach and complexities • Subindices (each 0 ~ 1) for: • Board Structure (7 elements) • Ownership Structure (5 elements) • Board Procedure (6 elements) • Disclosure (12 elements) • Related Party Transactions (5 elements) • Minority Shareholder Rights (7 elements) • BCGI = [∑(subindices)/7] • Range: [0.32, 0.81) • BCGInorm = normalized [∑(normalized subindices)]

16. What’s in BCGI? Focus on Board Structure Subindex (2004) • Note: Only 2/7 elements rely on public data • Guessing may not work well. For Brazil: • Dahya Dimitrov McConnell (2008) estimate 57% indep directors • Our data: 2004 mean (median) = 24% (20%)

17. Importance of local knowledge Brazilian institution: fiscal board • Can be permanent (in charter) or near-permanent (demanded every year or most years by minority shareholders) • Function similar to audit committee • Might be more effective: must include representative of minority shareholders • Brazil: substitute for audit committee • Many firms have one or the other; few have both • Audit committees rare (mean = 0.14) • Fiscal board more common (mean = 0.68)

18. Compare Brazil to Korea for Board Structure • NP = no public data (we use our survey) • Only common elements are: • 50% outside directors (uncommon in Brazil) • audit committee (rare in Brazil; misleading alone)

19. Example 2: Board procedure subindexStart with Brazil & India: see if avail in Korea, Turkey With only public data, can’t build Brazil index at all Even with surveys, can’t build consistent subindex across countries

20. Example 3: Ownership Structure Brazil vs. India, Korea • Only potential common elements are: • ownership by largest shareholder • Existence of outside 5% shareholder. • How meaningful are these? • India: Choose not to build ownership structure subindex

21. Disclosure subindex: Compare Brazil to ISS • ISS disclosure index: • consulting fees to auditors < audit fees • audit committee has solely independent directors • shareholders approve auditor Nothing about what firms actually discloses!? • Compare Brazil: • Address auditor independence through audit firm rotation (every 5 years) • 80% of firms pay 0 consulting fees to auditor (only 6% pay > 10% of audit fees) • audit committee at only 14% of firms, solely independent at 1 firm in 2004 • Control group  shareholder approval of auditor not meaningful • Brazil firm scores: almost always 1, minimal variation • 1 point for low consulting fees • 0 for solely indep audit committee • 0 for shareholders approve auditor

22. Lesson: index must be country-specific • If we require the same elements in each country: • Can measure little • What we can measure may not be very relevant • Problem gets worse if add more countries • Even if measure same thing, meaning will differ • Consider proportion of outside directors • US: minimum 51%; median 70% • India: minimum 1/3 (+ CEO ≠ board chair); otherwise min 50% • Korea: minimum 25%; median 33% [> 50% required for large firms] • Turkey: minimum 0 (75% of firms), mean 25% • With country fixed effects, estimate impact of typical within-country variation • Not really measuring the same thing across countries?

23. Severe construct validity questions • We’re not sure how to measure “governance” • We’re not sure what counts as “good” governance, for which firms, in which countries • We have. . . • Different overall index in each country • Different subindices in each country • Very different subindex elements in each country

24. Tobin’s q is a construct too • Common approach: q as dependent var. • One possible definition: • BVE = book value of equity • MVE = market value of equity • Problem: q captures many things: • Growth opportunities • Intangible assets (not included in book assets) • Real and quasi rents (not captured in book assets) • Other book-to-market differences in assets • Value of share liquidity • And value of governance (higher market value for same assets) • Empirical strategy: • control for other factors • hope that Δq captures value of Δgov

25. So what do we do? • We give subindices similar names • We thenhope(pretend?) they measure a common construct • OK, what do we see?

26. Simple cross-section results across countries

27. This is only association. How about firm FE

28. Firm fixed effects across countries

29. Firm FE summary • Turkey results are fragile • vanish completely with firm FE or RE • vanish without control variables • Russia results weaken, but survive • Korea: • Results remain strong for board structure index • Good causal inference (1999 legal reforms) • Shareholder rights vanishes • Brazil, India: results to come

30. Pretend all indices & subindices created equalPooled OLS (Brazil, India, Korea, Russia) Decent control variables, but lose some from country regressions

31. Compare OLS to Fixed Effects (Korea, Russia, Turkey) Caveat: Board structure results driven by Korea; opposite in Brazil Little time variation in ownership, so FE is weak

32. Next steps to see what survives • Firm FE, RE in all countries • Effects for interesting subsamples: • Large versus small • Manufacturing vs. other • High vs. low growth rate • High vs. low profitability • Business group or not • Old vs. young firms

33. Next steps II • Use common index elements • As in multicountry indices • Construct validity issue changes, doesn’t go away • Use only the limited control variables available in multi-country studies

34. Is Everything Endogenous (or Irrelevant)? Russia (1999 data)Regress: Ln(Value Ratio) on Governance Score n = 21 firms r = -0.90 R2 = 0.81 t = -8.97 Source: Black (EMR, 2001) (high ranking implies worse governance) Worst-to-best = factor of 700 increase in value ratio!

35. Is Everything Endogenous or Irrelevant II:Bulgaria (2002) response to anti-tunneling reform High vs. low tunneling propensity firms Source: Atanasov, Black, Ciccotell, Gyoshev (JFE 2010)

36. Korea: RPTs and Expropriation Risk • Event study: Large firm reform in June-August 1999) • Large-plus (1-4T won) vs. mid-sized index (0.5-1T won) • Source: Black, Kim, Jang and Park (working paper 2012)