The effect of board structure on firm value: a multiple identification strategies approach using Korean data
Korea Unversity Business School
A minimum number of outside directors (perhaps a majority), and an audit committee staffed principally or solely by outside directors, are standard corporate governance prescriptions. Both are prescribed by law in many countries, and are central components of most “comply or explain” corporate governance codes. Yet empirical strategies that can address the likely endogeneity of governance and let us assess how these prescriptions affect firm value are often not available.
The Principal advance in this paper is to use a legal shock to governance as a basis for identification for a connection between board structure and firm market value, peroxided by Tobin’s q. In 1999, in response to the 1997-1998 East Asian financial crisis, Korea adopted governance rules, effective partly in 2000 and partly in 2001, which require "large" firms (assets greater than 2 trillion won, around $2 billion) to have 50% outside directors, an audit committee with an outside chair and at least two-thirds outside members, and an outside director nominating committee. Smaller firms must have 25% outside directors.
Prior papers that seek to address endogeneity include Wintoki, Linck, and Netter (2009), who use Arellano-Bond “internal” instruments and find no connection between board composition in the US. Dahya and McConnell (2007) report that UK companies which comply with the voluntary Cadbury Committee recommendation to have at least three nonexecutive directors experienced improved performance. Black, Jang and Kim (2006a), a predecessor to this paper (henceforth BJK), use the same legal shock as we do and find that firms subject to these rules have higher Tobin’s q’s than smaller firms. BJK use cross-sectional data from 2001. Un contrast, we build a panel data set which includes board structure data from 1996-2004 and full governance data from 1998-2004, covering almost all public companies listed on the Korea Stock Exchange (KSE). We seek to identify a change in the market value of large firms, relative to mid-sized firms, both in size (is 2-trillion-won threshold) and in time (does the value of large firms jump when the reforms are announced). We conduct event study and difference-indifference (DiD) estimation of the effect of adopting of these rules, with large firms as the treatment group and mid-sized firms as the control group. We support the event study and DiD analyses with instrumental variable (IV) analyses. We report consistent evidence across approaches for a connection between board structure (outside directors and audit committees) and firm market value. A central empirical challenge is to assess whether large firms rose in value for reasons unrelated to the legal shock. We do so in a number of wats. First, we use a regression regression discontinuity framework to control for a possible continuous effect of firm size on firm market value. Second, the share prices and Tobin’s q’s of large firms jump relative to mid-sized firms when they should during the mid-1999 period when the main legislative events occur. Third, we find no near-term changes in large firms’ profitability or growth which might explain the 1999 jump. Fourth, we conduct event studies in six comparable East Asian countries and find no evidence that large firms outperform mid-sized firms there during our event period. Fifth, smaller firms which voluntarily adopt the principal reforms have similar value increases to those we observe for large firms.
The estimated effects are economically important. In our event study, large firms' share prices rise by an average of 15% relative to mid-sized firms over a broad window covering our principal events. Our DiD results suggest a roughly 0.13 increase in ln(Tobin's q) from June 1, 1999 through the end of 1999 this period captures the full legislative process).