QUALITY OF GOVERNANCE AND FIRM

PERFORMANCE: EVIDENCE FROM SPAIN

Eloisa Pérez de Toledo

Universitat Autònoma de Barcelona – Dept. Economia de l’Empresa
Eloisa.Perez@uab.es

Supervisor :
Prof. Carles Gispert Pellicer
Universitat Autònoma de Barcelona – Dept. Economia de l’Empresa
Carles.Gispert@uab.es

ABSTRACT
Corporate governance is a set of mechanisms relevant to economic efficiency since it
can minimize agency problems. The question is to determine how governance and firm
performance interact. Recent research shows that firm-level corporate governance
mechanisms are more important in countries with low investor protection, suggesting
that firms can partially compensate for ineffective legal environments. Within this
context, the main objective of this paper is to construct a robust proxy for quality of
governance for the Spanish public companies. A second objective is to verify which are
the determinants of governance in the case of Spain, and to assess whether they
influence the performance of the companies. Thus, after providing an extensive
literature review on the field, I construct a governance index (GOV-I) for a sample of 97
Spanish non-financial public companies and, through simple and multiple OLS
regressions, I assess the interaction between governance and performance. The results
show a significant relationship between governance and performance, future growth
opportunities and size, demonstrating that Spanish firms adopt better standards of
governance to compensate for the low level of investor protection holding in the
country. The results support the prevalent hypothesis of a positive relationship between
corporate governance and performance.

Keywords: corporate governance, governance index (GOV-I), firm performance,

investor protection, Spain.
JEL classification: G32, G34
 TABLE OF CONTENTS

1. Introduction 3

2. Problem Statement And Objectives 5

2.1 Determinants of the Quality of Corporate Governance 6
2.2 Quality of Governance and Performance 8
3. Governance And Performance: Theory And Practice 9
3.1 What Does the Literature Say? 11
3.2 The Construction of Indexes as a Proxy for Quality of Governance 15
3.3 Designing the Research: Questions and Hypotheses 16
4. Methodology 17
4.1 Sample Selection and Data Collection 19
4.2 The Corporate Governance Index (GOV-I) – definition and
19
specifications
4.3 Determinants of the Quality of Corporate Governance 20
4.4 Relationship between Governance and Performance 21
5. Empirical Results 25
5.1 Descriptive Statistics 25
5.2 The Governance Index (I-GOV) description 28

5.3 Empirical Results 31

6. Discussion and Conclusions 36

References 38
 3

1. INTRODUCTION
In a capitalist economy, financing is fundamental to the viability of companies and to
the persistence of the capitalism itself. The availability of funds depends on the efficient
allocation of resources by the economic agents from financial markets to productive
investments, e.g. for the creation of new ventures or to finance the growth process of
established companies. An efficient allocation depends on the investors expected return,
but also, on the investors belief that the firm will be managed in order to maximize the
investment and that the cash flows promised in exchange for the investment will
effectively be returned. The economic viability of investment projects can be assessed
through capital budgeting techniques and risk-return trade-off analysis for asset
allocation decisions. Nevertheless, investors trust depends on a broad set of factors as
the legal, institutional and regulatory environment that guarantees the investor
protection. In this sense, corporate governance surges to mitigate the agency problems
derived from the relationship between principals and agents.

Shleifer and Vishny (1997) define corporate governance as a set of mechanisms relevant
to economic efficiency due to its influence over the decision of investors to provide
finance, debt or equity, to the firm. The purpose of a governance structure is to assure a
significant flow of capital to the financing of firms. The separation between ownership
and control, as described by Berle and Means (1932), aggravated by the problem of
information asymmetry between managers and providers of capital, can lead to the
expropriation of the capital suppliers’ wealth. An efficient governance structure should
be able to guarantee that the agent will undertake the optimal level of investment and
minimize the amount of rent seeking behavior. In the presence of agency problems, it is
necessary a mechanism that is able to govern the way in which decisions will be taken
in the future in face of an event that was not contemplated in the contract established
between agent and principal, as described by Hart (1995, p.679) “(…) governance
structure matters when some actions have to be decided in the future that have not been
specified in an initial contract: governance structure provides a way for deciding these
actions”.

A variety of governance mechanisms can be used in order to design efficient

governance structures, for instance, the organization of a board of directors, the
ownership structure and control, stock options and other incentives programs to
management and employees, the capital structure, the market competition, the product
competition, the presence of an active market for corporate control, among others.

Another reason why corporate governance is relevant to economic growth is related

with its possible impact on the performance of the companies. The basic idea is that in a
population of companies, some can be distinguished as “companies with good
governance”. These firms would become more attractive to investors, ceteris paribus,
increasing their access to capital. As a result of such increment in the availability of
credit, the cost of capital of these companies would be reduced, both the cost of debt
and the cost of equity, which implies that companies with good governance should
experience a reduction in their weighted average cost of capital (WACC). As a
consequence of such reduction in the cost of capital, there would be an increment in the
 4

market value of these companies1. Besides, the reduction in the required rate of return
allows the firm to accept a greater number of investment projects which could increase
its competitiveness.

In a broad sense, research on corporate governance is justified by its contribution to the

increase in the access to capital and, consequently, to the reduction of the cost of capital
in a given economic system. As stated by Shleifer and Vishny (1997), the suppliers of
finance use corporate governance structures to ensure that they will get a return on their
investment. Moreover, according to Rajan and Zingales (2004, p.51) there are three
obstacles in the way of broadening access to finance: (1) the degree to which risk is
concentrated (in a developed system the risk is widely distributed and allocated to the
players that can best hold it, which reduces the risk premium demanded by investors);
(2) the limited information financiers or investors have about borrowers and their
prospects; and, (3) the possibility that borrowers may not act in the best interest of the
financiers. Research on corporate governance can reduce the third problem by analyzing
and defining the mechanisms that assure that firms (managers) will use the funds in the
best interest of the investors.

There are some firm characteristics that are associated with the governance of the public
companies, the so-called internal and external mechanisms of governance. Ownership
concentration and board structure are pointed to be the primary internal mechanisms,
while an active market for corporate control is the main external mechanism. These
mechanisms are alleged to work together “in a system to affect the governance of the
firms” (Cremers and Nair, 2005). In this paper, I try to provide some empirical evidence
of how these mechanisms interact within the Spanish reality. For reaching this objective
I ask two questions: Which observable factors make companies adopt different levels of
governance under the same contracting environment? Does quality of governance affect
firm performance? In order to proxy quality of governance, and following a new trend
in governance studies, I construct a governance index for the Spanish public companies,
namely GOV-I.

This paper has two major contributions. First, I construct a governance index (GOV-I)
for Spain. And, second, I assess the relationship between governance and performance
through the use of OLS regressions. The results show a positive relationship between
corporate governance and firm performance, for instance, firms with higher standards of
governance receive higher market valuations, measured by Tobin’s q.

Generally, the paper shows that ownership concentration (measured by the presence of a
controlling shareholder and the presence of large blockholdings) and leverage are the
significant governance mechanisms in the case of Spain. On the other hand, other
traditional mechanisms such as board independence, board size or duality CEO-
Chairman did not show a significant impact on the valuation of the firms.

The paper is organized as follows. Part 2 states the problem, defines the objectives and
puts forward the hypotheses. Part 3 presents the theoretical framework and offers a
revision of the extant literature. In Part 4 there is a description of the research

1
The logic of such increment in the value of the firm is based on the fundamentals of capital budgeting.
The value of a company is calculated discounting its expected free cash flows by the weighted average
cost of capital (WACC).
 5

methodology, data and design. Part 5 presents the empirical results. In Part 6, I discuss
the results and conclude the paper.

2. PROBLEM STATEMENT AND OBJECTIVES

The theoretical discussion about corporate governance is based on two hypotheses,
firstly that governance mechanisms influence the performance of the firms, and, second
that firm performance also influences the governance system adopted by the firms.
Essentially, the basic issue is to detect whether the performance is determined by
internal or external mechanisms of governance. Gillan (2006, p.385) divide the internal
mechanisms into 5 categories: (1) the board of directors; (2) managerial incentives; (3)
capital structure, (4) bylaw and charter provisions (antitakeover measures); and (5)
internal control systems. Similarly, the external mechanisms of governance are also
divided into 5 categories: (1) law and regulation; (2) the markets (capital markets,
market for corporate control, labor markets, and product markets); (3) the providers of
capital market information (credit, equity, and governance analysts); (4) accounting,
financial and legal services from parties external to the firm (auditing, insurance, and
investment banks); and, (5) private sources of external oversight (media and external
lawsuits).

Hitherto, there is still no conclusive empirical evidence in the literature about whether
and how governance mechanisms influence the performance of the firms; and, about
how governance mechanisms interact (in a complementary or substitute way) (Bøhren
and Ødegaard, 2003). According to Chi (2005), there are three possible causal
relationships between quality of governance and firm performance (or market value
proxy by Tobin’s q), as illustrated by Figure 1. The first possibility is that there is a
direct causal relationship with governance enhancing firm performance. In the second
possibility, causality runs in both ways and, finally, the third possibility is that
governance and performance are not directly related, but they are spuriously connected
through other variables (Chi, 2005 p.67).

Most studies analyze exclusively the possible influence of specific governance

mechanisms on specific corporate performance variables. In these studies, governance
mechanisms are treated as independent variables and performance measures as
dependent variables. In this sense, governance mechanisms are considered and treated
as exogenous variables with no relation with other governance mechanisms or other
firm’s characteristics. Himmelberg et al. (1999), however, argue that the ownership
structure of the firm may be endogenously determined by the firm’s contracting
environment, which differs across firms in observable and unobservable ways. For
instance, if the scope for perquisite consumption is low in a firm, then a low level of
management ownership may be the optimal incentive contract.

The endogeneity of management ownership has also been noted by Jensen and Warner
(1988, p.13): “A caveat to the alignment/entrenchment interpretation of the cross-
sectional evidence, however, is that it treats ownership as exogenous, and does not
address the issue of what determines ownership concentration for a given firm or why
concentration would not be chosen to maximize firm value. Managers and shareholders
have incentives to avoid inside ownership stakes in the range where their interests are
not aligned, although managerial wealth constraints and benefits from entrenchment
could make such holdings efficient for managers.”
 6

FIGURE 1
THREE POSSIBLE CAUSAL RELATIONSHIPS BETWEEN GOVERNANCE AND
PERFORMANCE

Possibility I

Firm causal Quality of

performance (P) governance (G)

Spurious
correlation
observed
Firm Quality of
performance (P) governance (G)

Firm causal
Quality of causal Other factors causal
performance (P)
governance (G) (observable and
unobservable)
Possibility II
Possibility III

Source: Adapted from Chi (2005, p.68).

Finally, the set for exploring these matters is the Spanish governance system which is
characterized, according to Demirgüç-Kunt and Maksimovic (1996), as having an
underdeveloped capital market both in terms of market capitalization and in volume of
traded shares, the banking sector is of greater importance in financing firms, and,
according to La Porta et al. (1998), the degree of investor protection is low since it is
based on the Civil law system.

Within this context, the main objective of this paper is to assess whether the
mechanisms of governance are exogenous and influence the performance of the Spanish
public companies. To reach this objective the study is divided into two parts:

1. Determinants of the quality of corporate governance – to assess the possible

factors that make companies adopt different levels of governance under the same
level of investor protection (legal, institutional and regulatory environment).

2. Relationship between corporate governance and corporate performance – to

assess the influence of the quality of governance on the performance of the Spanish
public companies through the use of OLS simple and multiple regressions.

2.1. Determinants of the Quality of Corporate Governance

First of all, it is preemptive to define quality of corporate governance. Durnev and Kim
(2005, p.1463) define the quality of governance as (1 − d), where d is the proportion of
firm value diverted for private gains. Thus, a high level of d implies poor governance
practices, where d is broadly defined to include a wide range of value-decreasing
activities from what Jensen and Meckling (1976) define as excessive evasion and
corporate benefits to direct stealing of tangible and intangible corporate resources. This
 7

definition of the quality of governance captures various governance and managerial

practices in place that may or may not be legally compulsory.

Recent research has been focused in analyzing the quality of corporate governance
among firms operating in different country-level investor protection. It is possible,
however, that, due to some observable characteristics, not all firms operating in the
same country (with the same legal environment) offer the same degree of protection to
their investors. As hypothesized by La Porta et al. (1998), the legal system is
fundamental to corporate governance. In particular, they argue that the extent to which a
country’s laws protect investor rights and the extent to which those laws are enforced
are the most basic determinants of the ways in which corporate finance and corporate
governance evolve in that country.

Within this framework, Klapper and Love (2004) provide a cross-country study of firm-
level corporate governance practices and they conclude that companies operating in the
same level of investor protection show different levels in the quality of corporate
governance. They found firms with a high level of corporate governance provisions in
countries with weak legal environments and vice-versa.

This approach, developed by Himmelberg et al. (1999), Himmelberg et al. (2002) and
Klapper and Love (2004), states that investor protection has an external component
related to the legal environment and an internal component related to the activity
developed by the firm and other characteristics (endogenous protection). According to
Himmelberg et al. (2002, p.2) “(…) ‘investor protection’ refers collectively to those
features of the legal, institutional and regulatory environment – and characteristics of
firms or projects – that facilitate financial contracting between insider owners
(managers) and outside investors.” Thus, it is probable that firms operating in the same
country offer different degrees of investor protection, due to specific operational
characteristics and to particular interests. It is corroborated by the research of La Porta
et al. (2000). They find that firms in common law countries where investor protection is
stronger make higher dividend payouts when the firms’ investment opportunities are
poor than do firms in countries with weak legal protection.

According to Klapper and Love (2004) corporate governance is likely to be

endogenously determined and they point out three sources of endogeneity that in theory
could be associated with firms adopting better governance mechanisms: (1) the
composition of a firm’s assets; (2) unobservable growth opportunities; and, (3) firm
size. The composition of a firm’s assets will affect its contracting environment because
it is easier to control and harder to steal fixed assets (equipments, etc.) than “soft”
capital (intangibles, R&D, etc.). In that sense, a firm with a high level of intangibles
may find optimal to adopt a higher level of corporate governance (and avoid possible
misuse of these assets). The variable ‘unobservable growth opportunities’ is related with
the fact that firms with good growth opportunities will need capital to finance the
expansion process and they can find optimal to improve their level of governance in
order to reduce the cost of capital. And finally, firm size has ambiguous effects because
large firms may have greater agency problems due to destination of their free cash flows
and small firms may have better growth opportunities and greater need for external
finance, thus, both have incentives to adopt better governance mechanisms.

Besides these three variables, other variables will be introduced, for instance, ownership
structure, corporate performance, and issuance of stocks in an American or European
 8

(non-Spanish) stock market2. As a proxy for quality of governance, it will be built a

governance index (GOV-I). For the construction of the index, the approach to be used is
the one developed by Gompers, Ishii and Metrick (2003) and strengthened by Brown
and Caylor (2004), but departing from the determinants of governance detected by
Klapper and Love (2004).

The use of indexes in the field of corporate governance is relatively new, and the
authors that have built and/or used governance indexes for analyzing the reality of
different countries are Black (2001) for Russia, Gompers et al. (2003) for the US,
Klapper and Love (2004) for emerging markets, Brown and Caylor (2004) also for the
US (they strengthen the index developed by Gompers Ishii and Metrick 2003), Leal and
Carvalhal-da-Silva (2004) and Silveira (2004) for Brazil, Black et al. (2005) for Korea,
Durnev and Kim (2005) for emerging markets, Cremers and Nair (2005) for the US,
and, Beiner et al. (2006) for Switzerland.

2.2. Quality of Governance and Firm Performance

Ownership structure is one of the most important mechanisms of governance. The vast
majority of the initial studies in the field tried to capture the influence of this
mechanism in the performance of the firms, for instance Demsetz and Lehn (1985),
Mørck et al. (1988), McConnell and Servaes (1990) and Hermalin and Weisbach
(1991). In sum, the results of these studies pointed to a positive and significant
relationship between ownership concentration and corporate performance. Recently, a
research line initially developed by La Porta et al. (1998) try to assess how ownership
structure vary across countries, hypothesizing that the decisive factor to explain
differences among countries is the degree of investor protection.

From this perspective, firms’ ownership structure is an equilibrium response to the legal
environment in which they operate. The research of La Porta et al. (2000), La Porta et
al. (1999), Claessens et al. (2002) and Beck et al. (2001) suggest that country-level
differences in law systems and law applicability cause differences in ownership
structure, dividend policies, availability of external finance and in the valuation of
corporate bonds. In this sense, most of the literature on ownership structure try to assess
whether differences in the level of investor protection within distinct contractual
environments (different countries) promotes a greater ownership concentration.

Demsetz (1983, p.377) was the first to propose an approach in which ownership
structure is an endogenous result of a corporate efficiency maximization process. To test
this hypothesis, Demsetz and Lehn (1985) developed an empirical model in which
specific firm or industry characteristics, such as size, riskiness and regulation could be
assessed as the determinants of ownership concentration. The authors argue that the
causal relationship between ownership structure and performance is spurious, since
ownership concentration can be considered an endogenous variable.

Himmelberg et al. (1999), in the same line of research as Demsetz and Lehn (1985),
broaden their results through the introduction of other independent variables for
explaining ownership concentration and the use of panel data. The authors propose that
investor protection, besides having an external component related to the legal

2
The idea is that companies that issue stocks in an American or European stock exchange (besides listing
in the Madrid Stock Exchange) are likely to present higher standards of governance.
 9

environment (legal protection), also has an internal component related to the nature of
the firms operation and to other firm characteristics (endogenous protection). In this
sense, ownership concentration is a function of legal protection, but also of firms’
intrinsic protection, that is different for firms operating in distinct contracting
environments.

Among the endogenous aspects mentioned by Himmelberg et al. (1999) as the

determinants of ownership concentration, three can be pointed as the most important:
size, managers’ discretion, and idiosyncratic risk. According to the authors, size has a
priori a dubious effect on ownership concentration. On the one hand, agency costs and
monitoring could be more severe in big companies increasing the need for ownership
concentration. On the other hand, big companies can make use of economies of scale in
monitoring management, for instance, using rating agencies. In relation with
management discretion, they argue that as fixed assets are observable and easier to
monitor, firms with high level of tangible assets should present a lower optimal level of
ownership concentration. In companies with a high level of intangibles, instead, high
ownership concentration can improve monitoring. Finally, with relation to the
idiosyncratic risk, the authors point out that, ceteris paribus, high ownership
concentration implies to the investor a less diversified portfolio. Thus, as higher a firm
systematic risk the lower its optimal level of ownership concentration.

De Miguel et al. (2003) analyze ownership concentration in Spain, in order to test the
monitoring and expropriation hypotheses, and to analyze insider ownership seeking
evidence of the convergence-of-interest and entrenchment hypotheses. Their results
confirm not only the monitoring but also the expropriation effect for the very high
levels of ownership concentration of Spanish firms. The authors conclude that due to
the fact that Spanish majority shareholders manage to expropriate the wealth of
minority shareholders, unlike UK, US, Germany or Japan, differences in corporate
governance systems lead to different value-ownership relations.

3. GOVERNANCE AND PERFORMANCE: THEORY AND

PRACTICE
The conceptual framework for the present study is given by a combination of
approaches to the theory of the firm: the neoclassical theory of the firm, the principal-
agent theory, the transaction cost economics, the property rights approach and the
institutional theory. The theory of the firm is the classical theoretical framework for the
studies in the field of corporate governance. The neoclassical theory is the one that
provides the first notions of the firm. Nevertheless, despite its formalism and rigor in
the construction of economic models, the neoclassical theory portrays the firm in a
rudimentary way. In the words of Hart (1996 p.200), “(n)eoclassical theory describes in
rudimentary terms how firms function, but contributes little to any meaningful picture
of their structure”. Trying to fulfill the gap, important theories were developed in the
twentieth-century by academics like Knight (1921), Coase (1937), Alchian and Demsetz
(1972), Williamson (1975), Jensen and Meckling (1976), among others, that aimed to
incorporate characteristics of the real world in a new theory of the firm.

The agency theory surges to explain the agency problem and the costs associated with
it. The discussion about the need for improving the governance of the firms is a
response to many cases of expropriation of shareholders’ wealth by the top executives,
 10

but also by the majority shareholders at the expense of the minority shareholders. This
phenomenon describes quite well the agency problem, when the agents take decisions in
order to maximize their own best interests rather than those of the shareholders (the
same apply to the appropriation by the majority shareholders of the private benefits of
control).

The agency problem is an essential element within the contractual view of the firm,
developed by Coase (1937), Alchian and Demsetz (1972) and Fama and Jensen (1983).
The theme of corporate governance is inserted within this context and the development
of governance mechanisms aims to mitigate this problem. According to Jensen (2001)
the contractual view is based on the idea that the firm is a nexus of contracting
relationships among clients, workers, executives and suppliers of goods and capital. In
line with this view, executives and shareholders sign a contract specifying how firm
resources must be managed. In theory, a complete contract should be designed,
specifying all actions the agent must undertake in face of any possible situation or
contingency. The problem is that, since many contingencies are hard to predict,
complete contracts are unviable. Due to this problem, investors have to allocate their
residual control rights or their right to decide in circumstances not predicted in the
original contract.

The institutional theory provides the conceptual basis for the discussion about the
degree of investor protection holding in each country. The property rights are the
explicative variables of the level of economic development in a given institutional
environment, and of the governance model adopted by the companies, since it has an
impact on their ownership structure. Moreover, the new institutional economics
visualize the firm as a nexus of contracts and, for North (1990) the institutions are the
“rules of the game” in a society. The institutions determine not only the economic
performance, but also the governance structure and the governance model adopted by
the firms. It is necessary to understand the evolution of the institutions in a given
environment (e.g. country) to understand its patterns of corporate governance.

Nevertheless, all these approaches to the theory of firm that try to develop a more
realistic picture of the famous ‘black box’ have weaknesses as pointed by Hart (1996):
the “(p)rincipal-agent theory enriches neoclassical theory significantly, but still fails to
answer the vital questions of what defines a firm and where the boundaries of its
structure are located”. The transaction cost economics provides the basis for introducing
the idea of planning and contracting costs that was neglected by the neoclassical theory,
but despite the contribution of Williamson (1975, 1985), “the precise nature of these
costs are unclear” (Hart, 1996 p.204). The same reasoning can be applied to the
property rights approach to the firm, even though being more complete than the
previous approaches (property rights contains common features of all described
approaches)3, it does not consider the separation between ownership and control that is
actually present in the large public corporations. As a consequence, Hart (1996)
concludes that a formal model of the firm that incorporates all these features, including
an explanation of firm’s financial structure is an important (but not impossible) task for
future research.

3
“It is based on maximizing behavior (like neoclassical approach); it emphasizes incentives issues (like
the principal-agent approach); it emphasizes contracting costs (like transaction costs approach); it treats
the firm as a ‘standard form’ contract (like the nexus of contracts approach); and it relies on the idea that
a firm’s owner has the right to alter membership of the firm (…)” (Hart, 1996 p.210).
 11

The theoretical framework could be improved by the inclusion of an approach

developed by Jensen (2001), the ‘corporate objective function’. Actually there are two
corporate objective functions discussed by the literature: “the value (or shareholders)
maximization proposition” and the “stakeholder theory”. The stakeholder theory has
been gaining great acceptance among professionals and governments but also among
academics whose argument is that managerial decisions impact investors but also a
number of stakeholders who have an intrinsic relationship with the firm: employees,
clients, suppliers, the community were the firm is located, etc, the so-called externalities
by the economists. In the words of Tirole (2001, p.4), “Why should institution design
ignore the natural stakeholders, and favor the investors, who are ‘stakeholders by
design’, by giving them full control rights and by aligning managerial compensation
with their interests?”, and goes further, defining corporate governance as “the design of
institutions that induce or force management to internalize the welfare of stakeholders.”

Nevertheless, neither the theory of the firm with the value (shareholder) maximization
paradigm nor the stakeholder theory with its multiple objectives offers a clear picture of
the exact direction of the causality between governance and firm value. Governance
theories suggest that strong shareholder rights can mitigate agency problems and, as a
consequence, increase firm value. However, shareholders rights can be restricted by the
managers. Therefore, no causal inferences can be drawn from the theory since it is not
clear that there is a causal relationship and its direction. Due to this lacuna in the
theoretical framework, many researchers have been showing empirically that
governance drives performance. However, they point out the limitations of their results
warning that they may not be robust to some unobservable firms’ characteristics (Chi,
2005).

In the sequence, a literature review on the field of corporate governance is provided,

giving special attention to the relationship between governance and performance.

3.1. What Does the Literature Say?

3.1.1. Ownership Structure and Performance

The relationship between ownership structure and performance was firstly approached
by Berle and Means (1932). They suggest that, due to the separation between ownership
and control in the American big corporations, there is an inverse relation between
disperse ownership and performance. Four decades after, Jensen and Meckling (1976)
and Stulz (1988) developed theoretical models trying to formalize the relationship
between ownership and performance, arguing that ownership influences performance.
The model of Stulz (1988) predicts a concave relationship between managerial
ownership and firm value. In the model, as managerial ownership and control increase,
the negative effect on firm value associated with the entrenchment of manager-owners
starts to exceed the incentive benefits of managerial ownership.

The first empirical studies in the field aimed to test this hypothesis assessing the impact
of ownership structure on performance through the use of linear regressions with
ownership structures as the independent variables. Among the first empirical studies,
the most important are Mørck et al. (1988), McConnell and Servaes (1990) and
Hermalin and Weisbach (1991). In all these studies, the authors find a significant
relationship between ownership structure and firm value that can be interpreted as
consistent with the theoretical hypothesis formulated by Jensen and Meckling (1976)
 12

and Stulz (1988). Mørck et al. (1988) find an inverse U-shaped relationship between
managerial equity ownership and firm valuation for a sample of US firms. One
interpretation is that firms' performance improves with higher managerial ownership,
but after a point, managers become entrenched and pursue private benefits at the
expense of outside investors. McConnell and Servaes (1990) also provide empirical
support for this relationship for US firms.

Demsetz and Lehn (1985) formulate an alternative hypothesis assuming that ownership
structure is endogenously determined under the assumption of equilibrium. To test this
hypothesis, more recent studies make use of sophisticated econometric techniques and
consider the ownership structure variables as endogenous rather than exogenous. These
studies have not been corroborating the hypothesis that ownership structure is an
exogenous variable and that it influences performance (Cho, 1998; Himmelberg et al.
1999; Demsetz and Villalonga, 2001).

Cho (1998) examines the relationship between ownership structure, investment and
corporate value in the United States. According to the author, common sense says that
ownership structure must influence corporate investment decisions, and that the last
must influence corporate value. In the first part of the study, the author uses the method
of ordinary least squares (OLS) to test the hypothesis. The initial results suggest that
ownership concentration (considered as the independent variable) has a significant
impact on corporate investment (proxy by capital investments and investments in
R&D). Thus, these results corroborate the assumption that ownership structure
influences firm value. In the sequence, the author changes the method to simultaneous
equations systems and considers ownership structure as an endogenous variable. Cho
(1998) concludes that causation is reversed, running from performance to ownership
structure rather than in the opposite way, with investments influencing corporate value
and corporate value, in its turn, influencing the ownership structure. The author presents
empirical evidence showing that probably ownership structure is not an exogenous
variable, and questions previous research that tried to demonstrate the causal
relationship between ownership structure and performance.

Himmelberg et al. (1999) analyze the determinants of insider ownership and the
relationship between ownership structure and performance in the US. The study follows
the methodology proposed by Demsetz and Lehn (1985) and tries to find evidence that
insider ownership is endogenously determined by other corporate variables like size and
industry. After introducing other possible variables as capital intensity, R&D expenses,
free cash flow (FCF) and investment rate, the authors, through the use of panel data
analysis, try to isolate unobservable firm characteristics that did not vary across the time
period under analysis. They conclude that insider ownership and performance are
endogenously determined by some characteristics of the legal environment and that they
are only partially observable.

Demsetz and Villalonga (2001) analyze the relationship between ownership and
performance primarily using the traditional approach of isolated regressions (OLS)
considering ownership structure as the independent variable. Their results indicated that
ownership structure has a significant influence on performance so as the results obtained
by Mørck et al. (1998) and McConnel ans Servaes (1990). Then, the authors run some
tests using a two simultaneous equation system through the procedure of 2SLS (two
stages least square). The results produced by this approach showed that ownership
structure has no statistically significant influence on performance.
 13

De Miguel et al. (2003) investigate the relationship between ownership structure and
value in the Spanish firms. They provide new evidence on this relation, since the
Spanish corporate governance system differs from the ones considered in previous
theoretical and empirical research (e.g. US, UK, Germany). The authors use panel data
methodology and control for potential endogeneity using instruments. Their results
confirm the monitoring and the expropriation effect for the very highest concentration
values in Spanish firms. The fact that Spanish majority shareholders manage to
expropriate the wealth of minority shareholders confirms the idea that differences in
corporate governance systems are related to the legal environment as described by
Klapper and Love (2004) and Himmelberg et al. (2002).

More recently, De Miguel et al. (2005) examine how different control mechanisms
relate to one another in the Spanish corporate governance system. The authors propose a
new empirical approach that consists in analysing control mechanisms according to the
non-linearity of the value-ownership relation. They conclude that the Spanish corporate
governance system is very different from the US one. Moreover, their results show that
control mechanisms (especially insider ownership, debt and dividends) are used in a
complementary way by Spanish firms.

3.1.2. Board Composition and Firm Performance

The Board of Directors has a fundamental role in a corporate governance system,

considered a major internal mechanism along with ownership concentration, is used to
reduce agency costs between shareholders and executives, and between controlling and
minority shareholders.

The work of Hermalin and Weisbach (1991) offers a summary of the United States
evidence on the board mechanism: (a) higher proportions of outside directors are not
associated with superior firm performance, but are associated with better decisions
concerning issues such as acquisitions, executive compensation, and CEO turnover; (b)
board size is negatively related to both general firm performance and the quality of
decision-making; and, (c) poor firm performance, CEO turnover, and changes in
ownership structure are often associated with changes in the membership of the board.
Evidence from other countries is offered by Wymeersch (1998) for Europe, Rodriguez
and Anson (2001) for Spain, Mak and Yuanto (2002) for Malaysia and Singapore,
Eisenberg, Sundgren, and Wells (1998) for Finland, and Dahya, McConnell, and
Travlos (2002) for the UK.

Rodriguez and Anson (2001) examine the market reaction to announcements of

compliance to the Olivencia Code by Spanish firms. They observe that the stock prices
react positively to announcements of compliance when such announcements imply a
major restructuring of the board. Besides, this reaction is stronger for firms that have
been performing poorly.

Wymeersch (1998) provides a wide narrative of the composition of European boards of

directors. The author reports that, in most European countries, the role of the board of
directors is not defined by law. So, the shareholder wealth maximization has not been
the primary goal for European boards. This varies across countries, with the British,
Swiss, and Belgian systems being closer to the American model. European Boards are
most often unitary, as in the United States. However, in some European countries the
two-tiered system is the rule. A two-tiered structure is compulsory in some countries,
 14

e.g. Germany and Austria, and optional in others, e.g. France and Finland. Two-tier
boards generally consist of a managing board, composed by executives of the firm, and
a supervisory board. In the case of Germany, employees are represented in the
supervisory board, a system called co-determination, and it is mandatory for firm with
more than 500 employees.

Dahya, McConnell, and Travlos (2002) address the effect of the Cadbury Committee
(UK Code of Best Practice) on board effectiveness. Among other things, the Code
recommends that boards of UK corporations include at least three outside directors and
that the positions of chairperson and CEO is held by different individuals. The
compliance to the Code is voluntary. Nevertheless, the London Stock Exchange requires
that all listed companies explicitly indicate whether they are in compliance with the
Code, and if not, an explanation is required.

As consistent with US evidence, there is some evidence of a negative relation between

board size and firm performance in several non-US countries. Mak and Yuanto (2002)
find evidence of an inverse relationship between board size and Tobin’s Q in Singapore
and Malaysia, while Eisenberg, Sundgren, and Wells (1998) document an inverse
relation between board size and profitability for SME’s in Finland. Carline, Linn, and
Yadav (2002) find that board size is negatively related to operating performance
improvements after UK mergers.

3.1.3. Large Shareholdings and Firm Performance

The presence of large shareholders can have positive or negative effects on firm
performance. Many researches have been conducted in order to assess the positive
effects of large shareholdings in the maximization of firms’ value. However, less
attention has been given to the costs associated with the presence of large investors, as
pointed out by Claessens, Djankov, Fan and Lang (2002). The authors conducted an
analysis with 1,301 publicly traded corporations from eight East Asian economies4.
They find that relative firm value (measured by the market-to-book ratio of assets)
increases with the share of cash-flow rights in the hands of the largest shareholder. This
result is consistent with previous studies on the positive incentive effects associated
with increased cash-flow rights in the hands of one or a few shareholders. But, on the
other hand, they find that the entrenchment effect5 of control rights has a negative effect
on firm value.

The findings of Claessens et al. (2002) complement the findings of Mørck, Stangeland,
and Yeung (2000) for Canada. The authors show that large shareholdings control
impedes the growth of Canadian public companies, because entrenched controlling
shareholders take many advantages in maintaining the current value of the firm.

Dick and Zingales (2004), estimate the private benefits of control for 39 countries in an
international comparison. They conclude that higher private benefits are associated with
less developed capital markets, more concentrated ownership and more private
negotiated privatizations. The authors point out the lack of empirical evidence on this
topic despite the importance of this concept. It is related, according to the authors, to the
4
Hong Kong, Indonesia, South Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand.
5
The entrenchment effect occurs when large controlling shareholders pursue the private benefits of
control at the expense of other groups (minority shareholders and other stakeholders). This effect was
originally formulated by Stulz (1988).
 15

nature of the phenomenon and its difficult observation. In general, the international
evidence indicates that the accumulation of control rights in excess of cash flow rights
reduces the observed market value of firms.

As summarized by Denis and McConnell (2003, p.26), “a number of conclusions can be

drawn from the international literature on the ownership of publicly-traded firms. First,
ownership is, on average, significantly more concentrated in non-US countries than it is
in the US. Second, ownership structure appears to matter more in non-US countries than
it does in the US – i.e. it has a greater impact on firm performance. Overall, private
ownership concentration appears to have a positive effect on firm value. Third, there are
significant private benefits of control around the world, and they are more significant
for most non-US countries than they are for the US. Structures that allow for control
rights in excess of cash flow rights are common, and generally value-reducing”.

3.2. The Construction of Indexes as a Proxy for Quality of Governance

The main objective of an empirical study in the field of corporate governance is to

assess whether governance drives performance. To reach this objective, recent studies
have constructed corporate governance indexes that put together in only one measure all
relevant information about a series of governance mechanisms.

Black (2001) analyzes the hypothesis that good governance practices affect firms’
market value in Russia. As a proxy to quality of corporate governance, the author uses a
corporate governance ranking created by the Brunswick Warburg Investment Bank.

Gompers Ishii and Metrick (2003) use the incidence of 24 different provisions to build a
governance index for about 1,500 firms per year, and then they study the relationship
between the index and several performance measures during the 1990s. The authors find
a strong relationship between corporate governance and stock returns. They also find
that weaker shareholder rights are associated with lower profits, lower sales growth,
higher capital expenditures, and a higher amount of corporate acquisitions.

Klapper and Love (2004) evaluate the differences in the governance practices of
fourteen companies in emerging markets through the use of a corporate governance
index developed by the Credit Lyonnais Securities Asia (CLSA), an investment bank.
The authors verified a huge variation in the quality of corporate governance among
companies, and the average quality of corporate governance was superior in countries
with more efficient legal systems.

Bøhren and Ødegaard (2003) analyze the relationship between corporate governance
and performance in Norway. The authors find that corporate governance matters for
economic performance, insider ownership is the most important, outside ownership
destroys market value, and direct ownership is superior to indirect. Their results persist
across a wide range of single-equation models, suggesting that governance mechanisms
are independent and may be analyzed one by one. The authors conclude that the lack of
significant relationships in the tests allowing for endogeneity may not reflect optimal
governance, but rather an underdeveloped theory of how governance and performance
interact.

Leal and Carvalhal-da-Silva (2004) analyze the relationship between quality of

corporate governance and the performance of the Brazilian public companies. The
 16

authors also construct an overall governance index composed by fifteen questions

divided into four categories: disclosure, board composition, ownership structure and
shareholder rights. They found evidence that companies with best governance practices
have a higher market value (proxy by Tobin’s Q).

Brown and Caylor (2004) develop an index called Corporate Governance Quotient
(CGQ). They found that firms with weaker corporate governance are less profitable,
since they have lower return on assets, lower return on average equity, lower return on
equity, and lower return on investment than do firms with stronger governance
(measured by the CGQ). Besides, the authors also find evidence that firms with weaker
corporate governance are riskier, have lower dividend payouts and lower dividend
yields than firms with stronger corporate governance. They examine four factors: board
composition, managerial compensation, takeover defenses, and audit. Board
composition is the most important factor while takeover defenses is the least important
for the firm’s quality of corporate governance.

Black et al. (2005) report evidence that corporate governance is an important factor for
predicting the market value of South Korean firms. The authors construct a corporate
governance index for 515 Korean companies listed in the Korea Stock Exchange. The
study offers evidence consistent with a causal relationship between an overall
governance index and higher share prices in emerging markets. Finally, the authors
allege that they report the first evidence consistent with greater board independence
causally predicting higher share prices in emerging markets.

In the case of Spain, the literature on corporate governance is concentrated on the

analysis of ownership structure and the effects of ownership concentration on the
performance of the companies, which is justified given that ownership concentration is
the main control mechanism in the Spanish corporate governance system. Nevertheless,
the construction of an index that considers other dimensions of governance can offer a
more complete picture of the Spanish reality.

3.3. Designing the Research: Questions and Hypotheses

In the first part of the empirical research the objective is to assess the possible factors
that make companies adopt different levels of governance under the same level of
investor protection (legal, institutional and regulatory environment), what takes us to the
following research question and hypothesis:

Part 1: Determinants of the quality of governance

Research question: Which observable factors make companies adopt different levels of
governance under the same contracting environment?

H1 (Hypothesis 1)

There is a significant relationship between the variables selected as possible

determinant factors and the level of corporate governance adopted by the companies of
the sample. Moreover, the direction of the relationship is the one proposed by the
literature.
 17

In the second part, the objective is to assess the influence of the quality of governance
on the performance of the Spanish public companies, thus the question to be answered
and the correspondent hypothesis are:

Part 2: Relationship between corporate governance and performance

Research question: Does corporate governance influence corporate performance?

H2 (Hypothesis 2)

There is a significant relationship between the quality of governance and the

performance of the companies. Besides, companies with higher quality of governance
present better performance, ceteris paribus.

4. METHODOLOGY
Empirical research in the effectiveness of corporate governance mechanisms are subject
to the problem of endogeneity and reverse causality. Nevertheless, endogeneity and
reverse causality are under-explored theoretically and empirically (Bøhren and
Ødegaard, 2003). According to the authors, “endogeneity occurs when mechanisms are
internally related, (…) and reverse causation is when performance drives governance”
(Bøhren and Ødegaard, 2003, p.2). And, according to Gompers Ishii and Metrick (2003,
p.4) “the governance structures of a firm are not exogenous, so it is difficult in most
cases to draw causal inferences. For this reason, we make no claims about the direction
of causality between governance and performance”.

Similarly, Bhagat and Jefferis (2002, p.3) analyze the efficiency of antitakeover
mechanisms and state: “(w)e argue that takeover defenses, takeovers, management
turnover, corporate performance, capital structure, and corporate ownership structure
are interrelated. Hence, from an econometric viewpoint, the proper way to study the
relationship between any two of these variables would be to set up a system of
simultaneous equations that specifies the relationships between these six variables.
However, specification and estimations of such a system of simultaneous equations are
nontrivial”.

Empirical research on the evidence about the relationship between governance

mechanisms and performance can be classified according to the methodology used.
Bøhren and Ødegaard (2003, p.8) propose the following classification presented in
Table 1:

TABLE 1
MECHANISM INTERACTION AND MECHANISM-PERFORMANCE CAUSALITY

Causation

Mechanisms One-way Two-way

Exogenous 1 3
Endogenous 2 4
Source: Bøhren and Ødegaard (2003, p.8)
 18

According to the authors, almost all studies can be classified in cell 1, where the
econometric approach considers governance mechanisms as externally given, causation
is supposed to run from insider ownership to performance, and where the single-
equation regression typically contains one or two mechanisms. Among the most tested
mechanisms of governance are the internal mechanisms: ownership structure, Board
composition and managers’ compensation; and, the external mechanisms: active market
for corporate control, capital structure and the presence of institutional investors.

Himmelberg et al. (1999) are closed to cell 2. They analyze one-way causation from
insider ownership to performance, similarly to the studies classified in cell 1. However,
they point out that ownership structure is determined by the country-level investor
protection, and in that sense, they treat ownership structure as an endogenous variable.
According to Bøhren and Ødegaard (2003), research in cell 3 is not viable since two-
way causation cannot be modeled without considering at least one governance
mechanism as endogenous related to performance. Finally, in cell 4 are the empirical
researches that estimate the coefficient of the governance mechanisms and performance
measures through the use of simultaneous equations. Cell 4 methodology has been used
in a series of studies: Agrawal and Knoeber, 1996; Barnhart and Rosenstein, 1998; Cho,
1998; Demsetz and Villalonga, 2001; Bhagat and Jefferis, 2002; Claessens et al. 2002;
Klapper and Love, 2004; Bøhren and Ødegaard, 2003; Silveira, 2004, and Beiner
(2006). In all these studies, most of the significant results disappear.

Due to the occurrence of endogeneity and reverse causality, research in corporate

governance should be developed in cell 4 methodology, more specifically with
simultaneous equations systems. Nevertheless, Bøhren and Ødegaard (2003) argue that
successful implementation of this method depends on whether corporate governance
theory can offer well-founded restrictions on the equation system. In other words, we
cannot find in the theoretical framework of corporate governance reference about
whether and how governance mechanisms interact, which are the exogenous variables
(not related to governance) driving two-way causation or the nature of the equilibrium
in terms of an optimal combination of governance mechanisms for a given set of
exogenous variables. The opened question is to know whether the results obtained using
cell 4 methodology is reliable.

Recent research and the extant literature in the field consider the use of different
econometric approaches as very important for capturing the reverse causality between
governance and performance and the potential endogeneity among the mechanisms of
governance, as corroborated by all quoted studies. Nevertheless, still in line with the
research on the field, the objective of this paper is to answer the research questions
proposed through the use of statistics, concretely, through the use of OLS simple and
multiple regressions (cross-sectional analysis). The use of more a sophisticated
methodology, for instance simultaneous equations aims a database with a longer
horizon of time for the development of a panel data, for example, in order to be robust
and to avoid misspecifications. Thus, since our governance data were collect only for
the year 2005, the use of this methodology is a suggestion for a future study. For this,
our study belongs to cell 1 methodology. The vast majority of studies in corporate
governance are classified in cell 1 methodology, and since my study is a first
approximation to the dynamics of the Spanish non financial firms’ governance system,
the methodology adopted is justified.
 19

4.1. Sample Selection and Data Collection

The sample is composed by all Spanish non-financial listed companies in the Madrid
Stock Exchange (Mercado Continuo). The main data source is the web pages of the
companies, but also the Spanish Securities Exchange Commission (Comisión Nacional
del Mercado de Valores – CNMV) and the Madrid Stock Exchange (Bolsa de Madrid)
databases for all governance related information (board composition, ownership
structure and control, etc.). All financial and accounting information (balance sheets,
income statements, capital structure, industry/sector, book values, stock prices, etc.)
were obtained from COMPUSTAT. The data refers to the year 2005 for all governance
related information (GOV-I and board composition) and for the years 2004 and 2005 for
all financial information (sales, assets, ROA, Tobin’s q, etc.) except for sales growth
that captures the growth in sales in the last three years, covering the period from 2002 to
2005.

The final sample is composed by 97 firms and the selection criteria are (1) to be a
Spanish firm and (2) to not belong to the financial and real estate sectors. During the
collection of the data, one firm has presented insufficient information to construct the
index, so it was excluded from the sample. The rational for such selection criteria is that
the foreign companies listed in the Madrid Stock Exchange are not located and
operating in Spain, thus they are not exposed to the legal, institutional and regulatory
environment holding in Spain. The financial and real estate sectors are regulated by
specific rules which influence their governance model directly, for this reason they were
excluded from the sample.

4.2. The Corporate Governance Index (GOV-I) and the quality of governance

The governance index is created for proxy quality of governance. It is constructed based
on a questionnaire with binary objective questions and the answers must be obtained
exclusively from secondary data. Since the ultimate objective is to measure the degree
of transparency of the companies, the use of secondary data is justified (annual reports,
companies’ webpage, and the securities exchange commission webpage – CNMV).

The questions of the governance index (GOV-I) were developed based on the Credit
Lyonnais Securities Asia (CLSA) questionnaire used by Klapper and Love (2004) and
in the questions developed by Brown and Caylor (2004) when building their Gov-Score.
For a detailed description of provisions and antitakeover measures, the reference was
the work of Gompers et al. (2003). The construction of the index is straightforward, I
first code the 25 variables as 1 or 0 depending on whether the firm has satisfactory
corporate governance standards or not. Each positive answer adds one point to the
index, and the companies present a corporate governance level that ranges, in theory,
from 0 to 25. The main source of information is the Annual Report on Corporate
Governance prepared by the companies for the year 2005.

The index is composed by four dimensions in order to assess good governance

practices: (1) access and content of the information; (2) structure of the board; (3)
ownership structure and control; and, (4) progressive practices. Table 9 provides the
questions compounding the index.

The governance index (GOV-I) is one proxy for quality of governance. Other proxies
used in the study are: board independence (BIN), board size (BSZ), and duality CEO-
 20

Chairman. These mechanisms are also contemplated and measured by the GOV-I. Table
2 provides a description of each dimension and the question that assess each of them.
These dimensions could also be called subindices.

TABLE 2
I-GOV DIMENSIONS

DIMENSION QUESTIONS

GOV-I 1 Access and content of the information 1-7

GOV-I 2 Structure of the board 8-16
GOV-I 3 Ownership structure and control 17-20
GOV-I 4 Progressive practices 21-25

4.3. Determinants of the Quality of Governance

Based on the work of Himmelberg et al. (1999), Himmelberg et al. (2002) and Klapper
and Love (2004), the governance determinants to be tested are: future growth
opportunities, firm size, composition of firm’s assets, ownership structure, corporate
performance, and listing in an American or European (non-Spanish) stock market,
besides the control variable industry.

Future growth opportunities are measured following Klapper and Love (2004) through
the average annual sales growth over the past three years (2002-2005). There are three
measures of performance, Tobin’s q, return on assets (ROA) and EBITDA. Tobin’s q
reflects firm performance and also firm profitability, the other two accounting variables
are used to proxy operating profitability (EBITDA) and net profitability (ROA). Firm
size is proxy by the logarithm of the total assets. Finally, composition of firm’s assets is
proxy by the ratio of fixed assets to net sales.

Table 3 describes the variables, the rational for introducing each variable in the analysis
explaining its possible influence in the governance of the companies and the code
attributed to each of them.

The governance index (GOV-I) is constructed for proxy quality of governance, as

described in the previous section, and a cross-sectional OLS model is used to directly
examine the relation between governance and the selected operational characteristics
measured by the above mentioned variables. The general model to be tested is the
following:

GOV-Ii = α+ β1 GROWTHi +β2 SIZEi +β3 TANGi +β4 INTSMi +β5 IBEX-35i +
+β6 OWNCONi +β7 PERFi +Σδj INDji + εi

EQUATION 1
 21

The coefficients are expected to be statistically significant and to present the following
signals:

β1, β4, β5, β7 > 0;

β3 < 0;

since the effect of firm size and ownership structure on governance are
ambiguous, in theory, no signal is expected for β2 and β6;

δj is the coefficient for the binary variable of industry, no signal is

expected for it.

4.4. Relationship between Governance and Performance

This part of the study aims to contribute to the body of knowledge in the field of
corporate governance by answering the following question: Does corporate governance
influence corporate performance of the Spanish public companies? As described earlier,
the direction of the causality is not clearly defined by the theory, nevertheless, it is
conceived that causality may run both ways. Nevertheless, assuming that all relations
are linear, in this second part of the study, I first run a series of regressions as an initial
approach to assess the relationship between governance mechanisms and performance
measured by Tobin’s q (Q) (equation 2). The regressions are run considering
performance as an endogenous variable and the governance variables as exogenous but
including other variables to control for observable firm heterogeneity.

In order to assess the impact of quality of governance on the valuation of the firms,
another equation is estimated with Tobin’s q (Q) as the dependent variable. Since
Tobin’s q must also reflect firm’s profitability, ROA is included in equations (2) and (3)
in order to capture a possible interrelation between operating profitability and firm-
specific governance. Besides, the introduction of ROA is based on simple valuation
models: Q may depend on ROA and Beta (Chi, 2005; Beiner et al., 2006). In this sense,
ROA is introduced in equation 2 to capture a possible influence of operational
profitability on firm valuation. Finally, as the calculation of the traditional Tobin’s q is
“costly both in terms of its data requirements and computational efforts” (p.70), I
propose the use of the approximation of Tobin’s q proposed by Chung and Pruitt
(1994)6.

PERFi = α+ β1 GOVi +β2 GROWTHi +β3 SIZEi + β4 TANGi + β5 ROAi +

+Σδj INDji + εi

EQUATION 2

6
Defined as: Tobin’s q ≅ (MVE + PS + DEBT)/TA.
Where: MVE is the product of a firm’s share price and the number of common stock shares
outstanding (or the market value); PS is the liquidating value of the preferred stocks; DEBT is the value
of the firm’s short-term liabilities net of its short-term assets, plus the book value of the firm’s long term
debt; and, TA is the book value of the total assets of the firm.
 22

Where:

PERFi – is represented by Tobins’s q (Q) and is measuring performance and firm

profitability.
GOVi – represents the governance mechanisms: GOV-I (the Governance Index),
BSZ (Board Size), BIN (Board Independence) and CEO-CHAIR (duality between CEO
and Chairman of the board), ownership structure (OWNCON and OWNmain), and
LEVER (Leverage).

And finally, a final equation is estimated considering all governance mechanisms

simultaneously. This regression allows for the adoption of different governance
mechanisms at the same time, which is conceivable with the practice where companies
adopt a series of mechanisms together.

PERFi = α+ Σβj GOVji +β7 GROWTHi +β8 SIZEi + β9 TANGi + β10 ROAi +
+ β11 LEVERi +Σδj INDji + εi

EQUATION 3

Where:

GOVji – represents the governance variables: GOV-I (the Governance Index),

BSZ (Board Size), BIN (Board Independence) and CEO-CHAIR (duality between CEO
and Chairman of the board).

Table 4 provides a description of each research variable used in the study as well as the
descriptive statistics.
 23

TABLE 3
POSSIBLE DETERMINANTS OF GOVERNANCE

GOVERNANCE REASONING CODE

DETERMINANT

A growing firm with large needs for outside financing has

Future Growth
more incentive to adopt better governance practices in order GROWTH
Opportunities
to lower its cost of capital (Klapper and Love, 2003).

The effect of size is ambiguous as large firms may have

greater agency problems (because it is harder to monitor
them, so they need to adopt better standards of governance SIZE
Firm Size to compensate. On the other hand, small firms may have
better growth opportunities and greater need for external
finance, so they may present better governance mechanisms
(Klapper and Love, 2003).

Managers and shareholders have incentives to avoid inside

ownership stakes in the range where their interests are not
aligned, although managerial wealth constraints and benefits
Ownership Structure from entrenchment could make such holdings efficient for OWNCON
(OWN) managers (Jensen and Warner, 1988). Besides, several OWNmain
studies describe a positive and significant relationship
between ownership concentration and corporate
performance.

The best is the performance of the company, the higher the Q

Performance governance standards we could expect, due to the lower
external shareholders expropriation. Besides, the ROA
(PERF) performance variables are used to assess the possible
occurrence of reverse causality with corporate governance. EBITDA

The composition of a firm's assets will affect its contracting

environment because it is easier to monitor and harder to
Composition of Firm’s
steal fixed assets than intangibles. Hence, the firm operating TANG
Assets
environment will affect its governance system. (Himmelberg
et al., 1999).

Companies that are included in the Spanish Market Index

IBEX-35 (IBEX-35) are expected to adopt higher standards of IBEX-35
governance.

Companies that are listed in an American or European stock

Listing in another stock
market (non-Spanish) must adopt higher standards of INTSM
market
governance.

Industry is expected to influence governance. Mostly

because there are more regulated economic sectors than
Industry IND
others, but also due to the competition holding in certain
sectors.
 TABLE 4
SUMMARY OF THE RESEARCH VARIABLES

CODE VARIABLE DEFINITION N Mean Median Std Dev Min Max

GROWTH Future Growth Opportunities Average sales growth in the last 3 years
95 0,09 0,07 0,16 -0,49 0,71
SIZE Firm Size Log of net sales
96 5,76 5,74 0,85 3,78 7,68
GOV-I Corporate Governance Index Index composed by 25 binary questions
97 13,38 14,00 2,77 4,00 21,00
BSZ Board Size Total number of board members
97 10,67 10,00 3,78 3,00 20,00
BIN Board Independence % of independent and external directors
97 0,36 0,33 0,19 0,00 0,87
CEO- CEO and Chairman are not the same 1 if the CEO and the Chairman are not represented by the same
CHAIR person person; 0 otherwise
97 0,41 0 0,49 0 1
Σ % of shares owned by the controlling shareholders
OWNCON Ownership Concentration
(shareholders with more than 5% stake in the firm)
97 0,62 0,66 0,22 0,03 0,97
OWNmain Ownership of the main shareholder % of shares owned by the main shareholder
97 0,32 0,25 0,23 0,01 0,94
Ratio of the market value of equity plus the book value of debt
Q Tobin’s q
to book value of total assets
93 1,45 1,12 1,02 0,18 5,61
ROA Return on Assets Net income / Total assets
96 0,04 0,04 0,09 -0,54 0,33
Earnings Before Interests Taxes
EBITDA EBITDA / Total assets
Depreciation and Amortization
96 0,10 0,09 0,11 -0,46 0,47
TANG Composition of firm’s assets Fixed assets / Net Sales
95 0,85 0,56 1,03 0,04 7,24
LEVER Capital Structure Total debt / Total assets
96 0,23 0,25 0,18 0 0,75
IBEX-35 Belong to the IBEX-35 1 if the company belongs to the IBEX-35; 0 otherwise
97 0,26 0 0,44 0 1
1 if the company is listed in an American or European (non-
INTSM Listing in an International Stock Market
Spanish) stock market; 0 otherwise
97 0,33 0 0,47 0 1
This table provides descriptive statistics for all variables included in the empirical analysis. The initial sample consists of 97 companies and the total number of observations
for each variable is included in the table (N). The data is for the year 2005.
5. RESULTS

5.1. Descriptive Statistics

The descriptive statistics for the governance index (GOV-I) are presented in Table 5 and the
histogram and the normal curve of the distribution are drawn in Figure 2. The mean for the
GOV-I is 13,38 and the median is 14, indicating a relatively symmetric distribution. Appendix
1 provides histograms for the total sample and for the firms that belong to the Spanish stock
market index (IBEX-35). As one could expect, the companies that compose the IBEX-35
present a significantly higher mean for the GOV-I than the other firms compounding the
sample. Besides, the histogram can reveal that there is a wide distribution for the GOV-I
between the firms compounding the sample, the minimum value is 4 and the maximum is 21
(16% and 84%, respectively) which mitigates possible sample selection bias (Beiner et al.,
2006).

TABLE 5
THE GOVERNANCE INDEX (GOV-I)
2005
Governance Index (GOV-I) absolute %
Minimum 4,0 16,00
Mean 13,381 53,53
Median 14,0 56,00
Mode 14,0 56,00
Maximum 21,0 84,00
Standard Deviation 2,770 11,08
Number of Firms
GOV-I ≤ 10 14
GOV-I = 11 3
GOV-I = 12 15
GOV-I = 13 13
GOV-I = 14 20
GOV-I = 15 10
GOV-I = 16 13
GOV-I = 17 6
GOV-I ≥ 18 3
TOTAL 97
Means by Dimension absolute %
Access to information (GOV-I 1) 4,948 79,69
Board structure (GOV-I 2) 4,186 46,51
Ownership and control (GOV-I 3) 1,268 31,70
Progressive practices (GOV-I 4) 2,979 59,59

This table provides summary statistics on the distribution of GOV-I, the Governance Index for the Spanish
public companies, and the dimensions (Access to information, Board structure, Ownership and control, and
Progressive practices) for the year 2005. GOV-I was constructed from the questionnaire presented in Table 9 as
described in Part 4.

Table 6 presents the GOV-I per industry with aerospace and defense being the sector with the
higher score, 16, followed by transport/airlines with 15,5. Then, we have the vast majority of
companies in the range between 14 and 12 and, finally, the sector presenting the lowest
average is textile/apparel.
 26

TABLE 6
THE GOVERNANCE INDEX (GOV-I) PER INDUSTRY
INDUSTRY N mean std dev
Food 10 12,6 2,836
Textil & Apparel 5 10,6 4,393
Paper Products 6 11,7 4,033
Pharmaceuticals 6 12,7 3,327
Leisure 3 13,7 1,528
Media Entertainment 5 14,2 2,049
Transports/Airlines 2 15,5 2,121
Logistics 3 12,7 2,517
IT & Telecom 7 14,3 1,890
Other Services 6 14,5 2,588
Gas & Utilities 9 14,6 2,128
Steel & Metals 8 13,8 3,412
Industrial Machinery 9 12,9 3,060
Construction 10 14,3 1,059
Chemicals 2 13,0 1,414
Engineering 5 12,6 2,510
Aerospace & Defense 1 16,0 0
This table provides summary statistics on the distribution of the Governance Index GOV-I by industry.

Table 7 shows the correlation coefficients between Tobin’s q (Q) and the governance
mechanisms used in the study. Despite not being significantly correlated with any variable,
what is frequent in governance studies, we can analyze the nature of the relationship, if it is
positive, negative or nonexistent.Thus, we find a positive correlation between Q and GOV-I
as was expected, so as with the other governance mechanisms (BIN, BSZ, CEO-Chair and
OWNmain), except for ownership concentration (OWNCON) with what we find a negative
correlation. On the other hand, the GOV-I is significantly positive correlated with the other
three mechanisms of governance (BIN, BSZ and CEO-Chair) and negatively correlated with
the variables of ownership (OWNCON and OWNmain). It is also expected since the GOV-I
is constructed based on the recommendations of the Spanish code of best practices (Aldama
and Olivencia Codes) and is composed by the aforementioned four dimensions of governance
that are also reflected in the other variables. The two ownership variables (OWNCON and
OWNmain) present a significant and positive correlation between them and a negative
correlation with board size and board independence. Nevetheless, the ownership variables
present a positive correlation with CEO-Chair. Board independence is negatively correlated
with board size and with CEO-Chair. And, finally board size and CEO-Chair are positively
correlated.

Table 8 provides descriptive statistics for the board structure variables. In relation with the
size of the boards (BSZ) the average number of directors in the Spanish Boards is 10,67. This
is an acceptable average size since the consensus is in something between 5 and 15.
Nevertheless, it is clear that the size of the board depends largely on the number of influent
shareholders that can nominate “external” directors as their representatives7. The more
influent the shareholder the large the number of directors he/she indicates.

7
In the case of Spain, the external directors indicated by large shareholders are called “dominicales”.
 27

TABLE 7
CORRELATION MATRIX BETWEEN GOVERNANCE MECHANISMS AND TOBIN’S Q
I-GOV Tobin's Q OWN CON OWNmain BIN BSZ
Tobin's Q 0,0271 1
(0,7962)
OWN CON -0,1109 -0,0059 1
(0,2796) (0,9555)
OWNmain -0,0617 0,1294 0,6443*** 1
(0,5486) (0,2163) (0,0000)
BIN 0,2516** 0,0207 -0,2082** -0,1098 1
(0,0129) (0,8440) (0,0407) (0,2843)
BSZ 0,3036*** 0,0089 -0,0793 -0,0876 -0,0649 1
(0,0025) (0,9326) (0,4402) (0,3933) (0,5277)
CEO-CHAIR 0,2716*** 0,0748 0,0363 0,1407 -0,0588 0,0958
(0,0071) (0,4758) (0,7239) (0,1693) (0,5671) (0,3507)
This table reports Pearson correlation coefficients between Tobin’s q and the governance mechanisms for the
year 2005. The variables are described in Table 4. Significance at the 10, 5 and 1 percent levels is indicated by *,
** and *** respectively.

Board independence (BIN) is related to the number of independent directors in the board and
the percentage is obtained considering all independent and external directors over the total
number of directors. The best practices in corporate governance recommend that at least 50%
of the directors compounding the board be independent. And, independent means with no
relation with any shareholder or executive of the firm. In the case of Spain, the companies
must inform if the director is executive, external indicated by a shareholder, or external and
independent. This separation is extremely important, because investors are able to understand
the dynamics of ownership and control within the target company just by reading the
Corporate Governance Annual Report issued by the firms.

From Table 8, we can appraise the independence of the Spanish boards with an average
independence of 36,28%. It means that, on average, 4 out of 10 directors are independent in
sample firms. It can and should be improved by the companies, mainly because there are
firms with no independent directors and because the Aldama code strongly recommends the
increase in the number of independent directors in the boards of the public companies.
Finally, in 41,24% of the companies compounding the sample the CEO and the Chairman are
not the same person, which means that in 58,76% of the inquired companies they are
represented by the same person.

TABLE 8
DESCRIPTIVE STATISTICS FOR THE BOARD STRUCTURE VARIABLES
BOARD STRUCTURE
CEO- N
BSZ BIN
Chairman (Companies)
Mean 10,67 36,28% 41,24%
Std Dev 3,78 19,32% -
Median 10,00 33,33% - 97
Min 3,00 0,00% -
Max 20,00 86,67% -
 28

5.2. The Governance Index (I-GOV) description

As described in Table 5, the mean for the GOV-I is 13,38 with a standard deviation of 2,77.
A mean of 13,38 out of 25 (53,53%) can be interpreted as “low” if we consider that many
questions compounding the index were related to basic concepts of corporate governance,
such as access to information and transparency. Besides, one can observe that the questions
with higher percentage of firms with a “yes” are those recommended by the Spanish codes of
best practices on corporate governance (Aldama and Olivencia Codes). The company with the
higher score is Arcelor which is actually a company that operates within the regulation of
Netherlands8, in this sense it is expected that Arcelor shows a higher standard of governance.
Table 9 describes in detail the percentage of “yes” obtained in each question.

The results showed in Table 9 show that virtually all companies are concerned about
governance issues, since 94,85% provide information in the corporate website about its
governance system. On the other hand, only 64,95% provide the same information in English,
many times we can see the icon “English” in the home page of the company, but after
accessing the link what appears is a message such as “information not available” or “page
under construction”. Question 4 is related to the disclosure of information about the
company’s future strategies and the projection of the results, it also shows a low rate
(59,79%) of positive answers, mainly if taken into account that the sample is composed by the
biggest publicly traded corporations in the country that are supposed to disclosure this kind of
information.

FIGURE 2
HISTOGRAM AND NORMAL CURVE OF THE I-GOV

30

25

20

15

10

Mean = 13,381
Std. Dev. = 2,770
0 N = 97
3 6 9 12 15 18 21

I-GOV

This table shows the distribution of the GOV-I for the 97 listed companies in the “mercado continuo” of the
MSE. The index was constructed based on a questionnaire with 25 binary questions that were designed to proxy
four categories of governance: (1) Access to information,(2) Board structure, (3) Ownership and control, and (4)
Progressive practices. Better-governed firms have higher index scores.

8
The headquarters of Arcelor are located in the Netherlands and the company is subject to the legislation of this
country.
 29

The publication of the Corporate Governance Annual Report (question 22) is a question with
a high percentage of positive answers, but one important point to mention is that many
companies produce a very low quality report; it seems that they are just complying with an
obligation, not to be “out of the market”. Moreover, question 5 “Does the company disclosure
information about its next or tree-year ROA or ROE targets?” presents a disappointing 0%.
This is the type of information that should be disclosed if the companies were interested in
attract new capital, or even to renew the outstanding debt or equity. Since the main function
of the managers is precisely to create value for the company, they were expected to disclose
information about the creation or destruction of value.

In question 9, “Is the Chairman an independent, non executive director?” only 9% of the
companies have an independent director as the Chairman of the board, which is actually a
progressive practice in Western Europe and highly recommended as a good governance
practice. As a contrast, in question 17, “The Chairman and the CEO are not represented by the
same person”, 41,24% of the companies have nominated the CEO as also the Chairman of the
board. Considering the traditional ownership structure of the Spanish companies, as to say
“familiar ownership structures”, the CEO as Chairman can clearly create favorable conditions
to the appropriation of the benefits of control by the majority shareholders. The same is valid
for question 8, “Are the audit committee and the nominating committee exclusively composed
by independent outside directors? “, for which only a quarter of the companies said yes.

Question 10, “Does the CEO serve on no more than one additional board of other public
company?”, shows an interesting phenomenon: the cross participation of the same individuals
in many boards. Analyzing the composition of the boards, one can figure out that the same
names appear many times in different boards. There are Chairmen appearing in more than
twenty five boards, and a question that naturally rises from this fact is if they have time to
manage their own company if they are so busy participating in so many board meetings
during the year. Another point is that, in question 10, I only consider the participation in
boards other than those of the companies’ same group, which aggravates the problem.
Questions 13 (Golden Parachutes) and 20 (Casting Vote) also show the power of the
Chairman/CEO with 45,36% and 39,18% of the companies presenting these provisions,
respectively.

In relation to the board composition and functioning, question 11 “Is the board composed by
no less than 5 and more than 15 members?” shows a 85,57% of the companies compounding
the sample with an acceptable board size. This question is complemented by question 12 “Is
shareholder approval required for changing the board size?”, which is actually dictated by the
bylaws of the firms and, as a consequence, presents a 100% of positive answers. Question 14
shows a 80,41% of the companies not having representatives of banks in the board. This is an
important question because having representatives of banks in the board is very negative and
20% of the companies present such problem. Nevertheless, in the Spanish case, banks play an
important role as shareholders and, in order to adapt the research to this reality, the companies
that have a “no” in question 14 are only those who inform that besides the equity relationship
they also maintain commercial relations with the bank. In any case, this situation should be
avoided by the firms, since there is a clear conflict of interests between the companies and the
banks. Finally, question 15 shows that the Spanish public companies are far from having an
independent board, since in only 31,96% of the firms compounding the sample the
independent directors account for more than 50% of the board. In the item “are board
members elected annually?” (question 16) another disappointing 1,03%.
 30

TABLE 9
I-GOV QUESTIONS

Percentage of firms
Dimension of
# QUESTION OF THE GOVERNANCE INDEX (GOV-I) with a "YES" in the
Governance
Question
Does the company website provide information about its governance
1 system? 94,85%

Does the company have an English version of its website where

2 results and corporate governance related information are promptly 64,95%
updated (no later than one business day)?

3 Does the company have an Investors Relation Department? 87,63%

Does the company disclosure enough information or analysts’
Access to presentations with what any investor can make projections for the
Information 4 59,79%
company?

Does the company disclosure information about its next or tree-year

5 0,00%
ROA or ROE targets?
Does the company publish/announce quarterly reports within two
6 months of the end of the quarter? 90,72%

Has the public announcement of results promptly published in the

7 web page of the company? 96,91%

Are the audit committee and the nominating committee exclusively

8 composed by independent outside directors? 27,84%

9 Is the Chairman an independent, non executive director? 9,28%

Does the CEO serve on no more than one additional board of other
10 public company? 40,21%

Is the board composed by no less than 5 and more than 15 members?

11 85,57%

12 Is shareholder approval required for changing the board size? 100,00%

Board
Have the Board approved any Golden Parachute Provision for the
Structure 13 45,36%
senior executives?
Does the board include no direct representative of banks and other
14 large creditors of the company? (having any representatives is 80,41%
negative)

Do independent, non-executive directors account for more than 50%

15 of the board? 31,96%

Are board members elected annually (they have a unified mandate of

16 one year and the reelection is not automatic?) 1,03%

17 The Chairman and the CEO are not represented by the same person. 41,24%
Do directors receive part of their remuneration in stocks/stock
Ownership 18 options? 16,49%
Structure and
Is directors’ stock ownership at least 1% but not over 30% of total
Control 19 29,90%
outstanding shares?
20 Does the Chairman have Casting Vote? 39,18%
21 Does the company offer tag along to the minority shareholders? 3,09%
Does the company publish the “Corporate Governance Annual
22 Report” (as stated by the Aldama Code)? 90,72%
Progressive
Practices 23 Does the board have outside advisors? 84,54%
24 Do directors term limits exist? 71,13%
25 Does mandatory retirement age for directors exist? 48,45%
 31

In terms of the directors’ remuneration, question 18 points that only 16,49% of the firms
believe in the stock options as a mechanism of governance capable of aligning the interests of
managers and shareholders. Question 19 deserves deeper research on the causes of such
problem, since only 29,90% of the boards have a percentage ranging between 1% and 30% of
the total outstanding shares in their hands.

Progressive practices in corporate governance were assessed through questions 21 to 25.

Three questions reached a high rate of positive answers (questions 22, 23 and 24) showing
that the companies are progressively incorporating the Aldama Code suggestions and are now
publishing the Corporate Governance Annual Report (90,72%), establishing directors term
limits (71,13%), and hiring outside advisors to assist the directors when necessary (84,54%).
On the other hand, only half of the companies have mandatory retirement age for the directors
(48,45%), for the rest it is still a problem, mainly in the case of family companies.
Nevertheless, the critical point within this dimension is definitely the fact that practically no
company (3,09%) offers tag along to the minority shareholders.

5.3. Empirical results

The empirical analysis proceeds as follows: First, I estimate equation (1) using ordinary least
squares (OLS) regressions in order to assess whether there is a relationship between the
variables selected as possible determinant factors and the level of governance adopted by the
sample firms. Second, I estimate equations (2) and (3) using OLS regressions to verify
whether there is a significant relationship between quality of governance and performance.
The equations include a series of control variables as described in section 4.3 and 4.4.

5.3.1. Determinants of governance

Table 10 presents the results from OLS regressions of GOV-I on the selected variables as its
determinants. The results of the regressions show that future growth opportunities and
composition of firm’s assets have a statistically significant positive effect on the quality of
governance. Size also presents a positive effect on governance for the sample firms. However,
it is not statistically significant. Moreover, performance also has a positive effect on the
quality of governance showing that firms with higher performance adopt higher standards of
governance9. These findings support Hypothesis 1, since these are the factors described in the
literature as the possible determinants of governance.

The effect of ownership concentration is ambiguous, so no signal was expected for this
variable. For instance, a firm with a more concentrated ownership structure could present
poorer quality of governance due to the high level of ownership concentration of the main
shareholder; nevertheless, this fact could also take the company to adopt better governance
practices to compensate for the higher likelihood of expropriation of the minority
shareholders. I found a negative effect of both proxies of ownership concentration (OWN
concentration and OWN main shareholder) on the quality of governance, this result is
maintained for the three proxies of performance: Q, ROA and EBITDA. These results suggest
that the quality of governance could be a function of the probability of expropriation of the
minority shareholders due to the company’s ownership structure and control. Besides, the
coefficients indicate that the negative effect on governance is more accentuated for the

9
This result could indicate a problem of reverse causality since performance can improve governance but
governance can also enhance performance.
 32

ownership concentration in the hands of the main shareholder than for the ownership
concentration of blockholdings.

In summary, Table 10 presents six columns. Column (1) shows the results for the regressions
of GOV-I on the selected variables along with Q and OWNCON. Column (2) shows the
results for the regressions of GOV-I on the selected variables along with Q and OWNmain.
Columns (3) and (4) show the results for the EBITDA and OWNCON and OWNmain
respectively. Finally, Columns (5) and (6) show the results for the ROA as a proxy of
performance and OWNCON and OWNmain respectively.

TABLE 10
RESULT FROM OLS REGRESSIONS
POSSIBLE DETERMINANTS OF THE QUALITY OF GOVERNANCE (GOV-I)

Dependent variable = GOV-I

Independent (1) (2) (3) (4) (5) (6)

variable
Constant 11,876*** 11,818*** 13,552*** 13,530*** 14,093*** 13,871***
(0,003) (0,002) (0,001) (0,000) (0,000) (0,000)
GROWTH 3,901*** 4,016* 3,719* 3,721* 3,788* 3,768*
(0,003) (0,056) (0,089) (0,082) (0,077) (0,074)
SIZE 0,677 0,695 0,511 0,500 0,462 0,468
(0,251) (0,230) (0,383) (0,389) (0,428) (0,418)
TANG 0,547* 0,630* 0475 0,536 0,465 0,525
(0,010) (0,059) (0,157) (0,111) (0,160) (0,114)
IBEX-35 0,387 0,224 0,383 0,231 0,498 0,324
(0,736) (0,844) (0,739) (0,841) (0,664) (0,779)
INTSM -0,374 -0,518 0,132 0,147 -0,042 0,006
(0,765) (0,676) (0,910) (0,899) (0,971) (0,996)
Q 1,284** 1,444**
(0,030) 0,015
EBITDA 2,055 2,372
(0,368) (0,296)
ROA 3,835 3,911
(0,187) (0,176)
OWNCON -0,721 -0,853 -1,137
(0,613) (0,557) (0,430)
OWNmain -2,028 -1,590 -1,633
(0,155) (0,296) (0,251)
Industry Included Included Included Included Included Included
Adjusted R2 0,198 0,220 0,151 0,162 0,162 0,171
Probability F 0,018 0,011 0,048 0,038 0,037 0,031
Companies (N) 90 90 92 92 92 92
This table reports the results from OLS regressions of GOV-I on its determinants. The definition of the variables
is provided in Table 4. Control variables for 17 industries (IND) were included in the regressions but do not
appear here due to the limitation of space. The data is relative to the year 2004 and the GOV-I was constructed
based on information relative to the year 2005. The numbers in parentheses are probability values for two-sided
F test. ***, **, * denotes statistical significance at the 1%, 5% and 10% level respectively.
 33

5.3.2. Governance and performance

Table 11 reports the correlation matrix between the I-GOV and the performance variables, as
well as the control variables TANG, LEVER, GROWTH and SIZE. I-GOV has a positive
significant correlation with EBITDA and ROA, and a positive correlation with Q. It is also
positive and significantly correlated with GROWTH and SIZE, which could indicate that
bigger firms present higher future growth opportunities and adopt higher standards of
governance. In the same sense, LEVER is positively correlated with TANG and SIZE but
negatively correlated with ROA as well as TANG is negatively correlated with ROA. These
signals are expected since, otherwise being equal, firms with higher levels of leverage and
tangibles should present lower ROA than if the same firm was all equity financed, due to the
interest and depreciation expenses. Nevertheless, the EBITDA should be equal for both firms,
all equity financed and the leveraged firm, and this is not the case for the companies
compounding the sample. There is a negative correlation also between EBITDA, TANG and
LEVER. This result should be better explored before concluding anything.
Table 12 presents the results from the OLS regressions of performance (Q, EBITDA and
ROA) on individual governance mechanisms along with the exogenous variables included in
equations (2) and (3). Column (1) shows that the governance index (GOV-I) has a positive
impact on firms’ performance measured by EBITDA and ROA and on firms’ valuation
measured by Tobin’s q, nevertheless the effect is not statistically significant. This result
partially support the hypothesis that firms adopting higher standards of governance are better
valued by the market, ceteris paribus.

The only governance mechanism that shows a significant coefficient is LEVER in all
specifications; nevertheless, the results show a negative effect of leverage on firm’s
performance10 which notably contradicts the mainstream hypothesis that leverage can
improve governance due to the debt discipline. This is a typical result from a cross-sectional
study that aims a deeper scrutiny through the use of a panel data and a simultaneous equation
system to capture the reverse causality of leverage and performance, but also the endogeneity
of leverage since the legal and institutional environment has a clear influence in the capital
structure decisions.
An important result from the regressions is that ownership structure, more specifically the
ownership concentration of blockholdings (OWNCON) has a negative statistically significant
impact on Tobin’s Q which means that more concentration of ownership is associated with
lower firm valuation. This observation is consistent with the results obtained by De Miguel et
al. (2005) for Spain that reports a negative impact of high levels of ownership concentration11
on the valuation of the firms since a concentrated ownership structure allows the
expropriation of minority shareholders. Another important finding is that a higher
shareholding of the largest shareholder (OWNmain) is associated with higher firm valuation
which could be a consequence of the more efficient monitoring provided by concentrated
shareholding.

10
Regressions of ROA and EBITDA on LEVER not shown here also exhibit a negative statistically significant
relationship between the variables.
11
They report a quadratic relationship between firm value and ownership concentration and that beyond the
breakpoint firm value is negatively affected by ownership concentration.
 34

In columns (9), (10) and (11), all variables are considered together disregarding the
interdependence of different governance mechanisms. The results remain unchanged, with
LEVER appearing as the most significant mechanism of governance for the Spanish public
companies. In that sense the degree of leverage of the firms is negative related with their
valuation, but also with their performance. Ownership concentration of blockholdings is also
statistically significant and has a negative impact on the valuation of the firms, while the
concentration of ownership in the hands of the main shareholder has a positive impact on the
value of the firms. Nevertheless, ownership structure has no significant impact on corporate
performance.

Finally, the coefficients of the exogenous variables (ROA, SIZE, GROWTH and TANG)
show, generally, the expected signs. The adjusted R2 is ranging from 0,631 to 0,674 for the
regressions on Q and are significantly lower for the performance variables EBIT and ROA
(0,276 and 0,232 respectively).

TABLE 11

CORRELATION MATRIX BETWEEN I-GOV AND THE PERFORMANCE VARIABLES

I-GOV LEVER TANG GROWTH SIZE Tobin's Q EBITDA
LEVERAGE 0,003 1
(0,975)
TANGIBLES -0,038 0,366*** 1
(0,712) (0,000)
GROWTH 0,240** 0,131 -0,231** 1
(0,019) (0,204) (0,025)
SIZE 0,344** 0,317*** -0,047 0,268*** 1
(0,001) (0,002) (0,652) (0,009)
Tobin's Q 0,027 -0,169 0,001 0,249** -0,176* 1
(0,796) (0,105) (0,995) (0,016) (0,091)
EBITDA 0,181* -0,141 -0,146 0,282*** 0,335*** 0,396*** 1
(0,077) (0,170) (0,158) (0,006) (0,001) (0,000)
ROA 0,175* -0,191* -0,206** 0,354*** 0,299*** 0,349*** 0,906***
(0,089) (0,063) (0,045) (0,000) (0,003) (0,001) (0,000)
This table reports Pearson correlation coefficients between I-GOV and performance variables (Tobin’s q,
EBITDA and ROA) besides the control variables TANG, SIZE, GROWTH and LEVER for the year 2005. The
variables are described in Table 4. Significance at the 10, 5 and 1 percent levels is indicated by *, ** and ***
respectively.
 TABLE 12
RESULT FROM OLS REGRESSIONS OF PERFORMANCE ON GOVERNANCE MECHANISMS
Dependent variable Q EBITDA ROA

Independent variable (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)
Constant 1,203 1,235 1,326 1,247 1,716 0,923 -0,034 0,704 0,676 -0,419** -0,268*
(0,271) (0,259) (0,211) (0,254) (0,123) (0,386) (0,975) (0,562) (0,581) (0,026) (0,092)
GOV-I 0,010 0,008 0,003 0,004
(0,729) (0,801) (0,536) (0,370)
Ln(BSZ) 0,050 0,060 0,046 0,011 0,003
(0,816) (0,773) (0,833) (0,754) (0,926)
BIN -0,123 -0,200 -0,226 -0,028 -0,055
(0,744) (0,581) (0,551) (0,630) (0,265)
CEO-CHAIR 0,029 -0,053 -0,063 0,001 -0,009
(0,849) (0,716) (0,677) (0,962) (0,643)
OWNCON -0,394 -0,892** -0,891** -0,028 0,011
(0,260) (0,040) (0,042) (0,671) (0,845)
OWNCON-Main 0,526 0,864* 0,871* 0,028 -0,007
(0,125) (0,053) (0,054) (0,666) (0,901)
LEVER -1,589*** -1,157** -1,145* -0,192** -0,173**
(0,004) (0,049) (0,054) (0,017) (0,011)
ROA 3,179** 3,239** 3,227** 3,267** 3,276** 3,487** 1,328 2,054 1,997
(0,017) (0,014) (0,014) (0,012) (0,011) (0,007) (0,333) (0,157) (0,177)
-0,088 -0,089 -0,081 -0,078 -0,106 -0,054 0,108 0,033 0,028 0,058*** 0,034**
SIZE
(0,432) (0,440) (0,467) (0,487) (0,344) (0,627) (0,377) (0,798) (0,833) (0,005) (0,045)
GROWTH 1,302** 1,320** 1,338** 1,320** 1,412** 1,322** 1,411*** 1,580*** 1,566*** 0,096 0,144**
(0,014) (0,012) (0,011) (0,013) (0,008) (0,011) (0,005) (0,002) (0,003) (0,199) (0,026)
TANG 0,151 0,152 0,156 0,155 0,147 0,165 0,268** 0,232** 0,229** -0,009 -0,010
(0,162) (0,157) (0,145) (0,148) (0,167) (0,118) (0,014) (0,036) (0,041) (0,615) (0,478)
Industry Included Included Included Included Included Included Included Included Included Included Included
Adjusted R2 0,631 0,631 0,631 0,631 0,637 0,643 0,672 0,674 0,669 0,276 0,232
Probability F 0,000 0,000 0,000 0,000 0,000 0,000 0,000 0,000 0,000 0,003 0,009
Companies (N) 92 92 92 92 92 92 92 92 92 94 94
This table reports the results from OLS regressions of Q on each governance mechanism along with the exogenous control variables. The definition of the variables is
provided in Table 4. Control variables for 17 industries (IND) were included in the regressions but do not appear here due to the limitation of space. The data is relative to the
year 2005. The numbers in parentheses are probability values for two-sided F test. ***, **, * denotes statistical significance at the 1%, 5% and 10% level respectively.
6. DISCUSSION AND CONCLUSIONS
This paper addresses two questions: (1) whether the quality of governance is determined by
some firm specific and observable characteristics, and (2) whether quality of governance
influences firm performance. In order to create a measure for the quality of governance, I
construct a governance index (GOV-I) composed by twenty-five questions covering four
dimensions, (1) access and content of the information; (2) structure of the board; (3)
ownership structure and control; and, (4) progressive practices. The population under scrutiny
is the Spanish non financial publicly traded companies, which resulted in a final sample of 97
firms.

The GOV-I first dimension, access and content of the information, intends to capture the
relevance firms put on transparency and the results show that the Spanish public companies
are paying great attention to this issue. Over 85% of the companies in the sample comply with
at least 4 questions out of 6 (approximately 70% of the total). The only exception is for
question 5, “Does the company disclosure information about its next or tree-year ROA or
ROE targets?”, with 0% as the rate of positive answers. It indicates that the firms do not
disclosure information about their projections of future creation or destruction of value, but
also about their strategic plans.

The second and third dimensions can be grouped into a broader dimension, the decision
making process of the top executives through the use of the Board and the control and
ownership of shares. And, in this scenario, the Spanish companies show a divergent behavior
from the one previously described. Compared with the first dimension, only 16,5% of the
companies in the sample comply with at least 6 questions out of 9 (approximately 70% of the
total) for the second dimension (board structure) and 10,3% of the companies comply with at
least 3 questions out of 4 (75% of the total) for the third dimension (ownership and control).
In contrast with those “transparent” companies offering a lot of information in their websites
and showing themselves as really concerned about governance matters, after reading the
procedures, bylaws and annual reports, one finds out the other face of these companies: a very
tied structure of ownership, a high level of cross-participation on the boards, and the control
centralized in the person of the CEO-Chairman. Furthermore, after a quick scrutiny, it is clear
that the questions with higher percentages of “yes” in the I-GOV are those recommended by
the Spanish codes of best practices (Aldama and Olivencia Codes). It could indicate that the
companies are just following the normative to be “adjusted” to the market, and raises concern
about whether they are really committed to governance matters.

In the second part of the paper, I empirically assess (1) the determinants of the quality of
governance and (2) the relationship between quality of governance and firm performance in
Spain. The vast majority of studies in the field of corporate governance are focused in the US
and emerging markets sets. Only recently, we are witnessing the appearance of this type of
study for the European countries. The main contribution of this paper is to provide a picture
of the Spanish corporate governance system. Spain is a very interesting set for exploring
governance matters due to its particularities: (1) high levels of ownership concentration; (2)
the boards are inefficient; (3) the capital markets are underdeveloped; (4) the market for
corporate control is practically nonexistent; and, (5) there is a low degree of investor legal
protection.

My most important result for the first part supports the hypothesis that there is a significant
relationship between the selected factors and the level of governance adopted by the
 37

companies. This result is also in consonance with the literature. Specifically, Tobin’s q has a
statistically significant positive impact in governance, what can indicate that performance
drives governance. Another conclusion is that companies with higher future growth
opportunities present better governance standards; this result is also in accordance with the
literature. Firm size has a positive effect in the quality of governance, which means that
bigger firms adopt higher standards of governance. Nevertheless, composition of firm’s assets
showed a divergent relationship than the hypothesized one. The results indicate that, in the
case of Spain, firms with a more “hard” assets structure tend to present better governance
structures. This result can indicate two things: (1) a sample selection bias, since the
companies compounding the sample are the biggest companies in the country with a high
participation of fixed assets in its assets structure; or, (2) intangible assets can also be proxy
by R&D investments, which means that there is a close relationship between intangibility and
the extent to which firms invest in research and development, and Spain is known by the low
rate of investments in R&D. Due to this fact, it is conceived that the results show a inverse
relationship between tangibility of assets and quality of governance.

In the second part of the empirical study, I assess the relationship between performance and
the governance structure of the firms. The most important result in the second part of the
study is the positive relationship between quality of governance and firm performance which
supports the hypothesis that companies with higher quality of governance present better
performance. Besides, I found evidence that high levels of ownership concentration of
blockholdings have a significantly negative impact on the valuation of the firms (Q), but not
in the corporate performance measured by ROA and EBITDA. For providing a more
complete picture, I use the governance index (GOV-I) and six other governance mechanisms:
board independence, board size, duality CEO-Chairman, blockholdings ownership, ownership
of the main shareholder, and leverage, in order to assess the impact of governance on
performance.

The empirical results have important limitations. The most important limitation is the problem
of time, since in the second part of the empirical research I am using only data for the year
2005. This is the only year for which I have governance related information, and the
performance variables (Tobin’s q, EBITDA and ROA) are calculated based on the financial
reports also for the year 2005. The solution for this problem of time is to collect data for the
year 2006 and reassess the relationship, what is my intention for a future study.

Another important limitation is the well described problem of endogeneity and reverse
causality inherent to the research in corporate governance and that cannot be captured by OLS
regressions. But could be also a problem of substitution, since I am using all mechanisms of
governance together, as a consequence the results could be spurious. Nevertheless, the index
is not directly related to the other governance mechanisms and the overlaps that cannot be
controlled must not be causing major problems. Even so, the solution to all these problems
either the reverse causality or the misspecifications is the use of simultaneous equations and
panel data, what is my suggestion for a (near!) future study.

Overall, the results confirm the positive relationship between governance and the determinant
factors: performance, future growth opportunities and size what can be interpreted as evidence
that the Spanish firms adopt better standards of governance to compensate for the low level of
investor protection holding in the Spanish institutional environment. On the other hand, as
was expected, our result show a negative relationship between quality of governance and the
extremely high levels of ownership concentration holding in Spain. With regard to
performance, the major result is the positive relationship between quality of governance and
 38

firm performance (both in terms of valuation and profitability), but also the negative
relationship between value and blockholdings ownership concentration and the positive
relationship between shareholdings of the main shareholder and firm’s valuation. The study
has also important implications for the practitioners that want to improve the governance of
its companies and to investors and analysts that now have a more complete picture of the
Spanish corporate governance system.

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 41

APPENDIX 1
HISTOGRAM AND NORMAL CURVE OF THE I-GOV - COMPARATIVE
30

25

20

15
IBEX-35
10 firms
5

30

25

20 All sample
firms
15

10

0
3 6 9 12 15 18 21

I-GOV

IBEX-35 N Mean Std. Deviation Std. Error Mean

0 72 12,889 2,934 0,346
I-GOV
1 25 14,800 1,555 0,311