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Corporate governance and performance: the case of Jordanian stock companies

Moh'd Mahmoud Ajlouni Yarmouk University, Jordan

Abstract

This study aims at examining the effects of ownership structure, mix and foreign ownership on firm performance. Using Amman Stock Exchange (ASE) listed companies during the period 1992–1994, the analysis is performed by employing three ratios as proxies of firm performance, Market Value to Book Value (MVBV), Return on Equity (ROE) and Return on Assets (ROA). Empirical results show little evidence on the role for the large and institutional shareholders in monitoring and controlling the behaviour of the management. Similarly, there were no evidences on the effect of government ownership and firm performance. Finally, ASE does not value ownership mix. The weak and insignificant results might be due to the parametric model specifications used. It might be useful to suggest the use of non-parametric techniques, such as Data Envelopment Analysis (DEA).

1 Introduction

Corporate Governance (CG) has developed often in response to corporate failure, crisis, fraud and abuse and incompetence. The Asian crisis of the 1997 and the failure of large corporations, such as Enron of USA and Vivindi of France, were due to poor governance. These led many governments and international organisations, such as the World Bank (WB), International Monetary Funds (IMF) and Bank of International Settlement (BIS), to promote CG mechanisms.

Private sector investment, inter alias, has been identified as a key for economic growth and sustainable development. Restructuring State-Owned Enterprises (SOEs) has been considered as a cornerstone of economic reform and cultural changes. Jordan has been witnessing rapid economic growth and a changing investment environment, due to a series of privatisation initiatives and a record high of Arab direct and indirect investments. Jordan is making every effort to make it attractive to investors. Since the mid-1990s, Jordan is fostering a transparent investment climate. Stock companies are regulated by the Companies Act, which is supervised by the Controller of Companies, as well as by the Securities Act, which is supervised by the Securities Exchange Commission (SEC), Amman Stock Exchange (ASE) and the Securities Depository Center (SDC).

2 The concept of CG

Governance, as a political term, is

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“an analytical concept that specifies the forms of power and authority, patterns of relationship and rights and obligations might typify a particular approach to governing… [it] has become a shorthand term used to describe a particular set of changes” (Newman, 2001, p.11).

It designates a set of deceptive significant shifts in the way governments seek to govern (Pierre and Peters, 2000). It refers to the enhancement of ways of coordinating economic activity that go beyond the limitations of both hierarchy and markets (Rhodes, 1997).

CG, as an economic term, is a managerial discipline that specifies a system by which firms are directed and governed. It emerged as a result of growing separation of ownership and control in the modern corporations of the 1930s. The transformation of mom and dad businesses into large corporations has created a higher demand for large capital that could no longer be financed individually (Jensen, 1993). This new structure of ownership has created a new paradigm (Jensen and Meckling, 1976). Under the agency theory, such relationship has become as a principal – agent relationship, whereby the shareholders are the principals and the managers are the agents (Fama and Jensen, 1983).

3 CG mechanisms

CG mechanisms are economic and legal foundations that can be forced through the political process (Shleifer and Vishny, 1997). Agency theory is concerned with the asymmetric information in the principal-agent relationship on one hand; and with the contract design (compensation) that motivates the agent to act in the principal’s interests, on the other hand. CG can be devised by internal initiatives or through external pressures, explained as follows.

1 Internal governance mechanisms: agency theory introduces the notion of internal governance mechanisms as agency controls in order to minimise agency costs and the subsequent damage to principal’s wealth. Internal mechanisms centre on contracts and incentives and focus on ownership and organisational structures. The main agency controls are executive compensation schemes (Hallock and Murphy, 1999a,b) and governance structures such as the Board of Directors and the separation of roles between Chief Executive Officers (CEOs) and Chairpersons of companies (Machold and Vasudevan, 2004). The agency costs are real as any other cost. However, firm’s directors face a number of pressures of varying intensity that help align their interests with those of shareholders. These include the threat of legal action of violation of fiduciary duties (Starks, 1987), the threat of removal by dissatisfied shareholders (proxy fight), and the discipline of the non-executive directors.

2 External governance mechanisms: in addition to the internal mechanisms, firm’s directors face a number of external pressures. These include the threat of hostile takeover (Manne, 1965), and the competition from other potential directors is supplied by the managerial labour market (Jensen and Meckling, 1976). In addition, the capital markets constrain the agency cost. On one hand, when incompetent management depreciates the market value of the firm, shareholders have the option of selling their firm. Also, rival firms may induce shareholders to sell their firm in a process of takeover. In either case, agency costs will be eliminated completely (Jensen and Meckling, 1976). On the other hand, the capital market provides directors with an opportunity to invest their inside information in insider trading. Ajlouni (2004) shows that this will have a

Corporate governance and performance 3

positive effect on director’s effort, which is in line with the shareholders’ interest and thus reducing the agency costs at no cost. CG policy is better being internally driven. That is so because, on one hand, principals obviously prefer internal controls (Walsh and Seward, 1990) because they have lesser impact on their own wealth than the external regulations (Smallman, 2004). On the other hand, agents naturally would not prefer external pressures that carry the threat of firing and penalties.

4 CG models

The differences in the conceptualisation of corporations as well as their governance have led to the emergence of different CG models. The two main models are:

1 The Anglo-Saxon view: the shareholder model – a liberal and individualist approach to property and CG (Letza and Sun, 2004), this model is mostly adopted in the UK, USA, Canada and Australia. Frederick von Hayek and Milton Friedman are the major proponents of this model, which focus solely on protecting and maximising shareholders’ wealth. Other stakeholders should be served by contracts and government regulation, and should not be a function of CG. To sum up, this model is characterised by three distinct features: a the Board of Directors represents the shareholders only b very concerned shareholders c the variability of the shareholders whose investment horizon is short term.

2 The German–Japanese view: the stakeholder model – this model is mostly adopted in the continental Europe and Japan. It views the corporation as a social institution with a distinct public role and responsibilities (Kay and Silberston, 1995). Thus, the firm is not a private organisation and shareholders are not the only constituency with the rights to be heard. Employees, suppliers, government and the whole community are all represented in the Board of Directors. Financial institutions are dominant shareholdings (Machold and Vasudevan, 2004). To sum up, this model is characterised by three distinct features: a the Board of Directors represents employees, suppliers, large customers and

other stakeholders, in addition to the shareholders b unconcerned shareholders c the stability of and longer-term shareholders investment in the firm.

Other models of CG include the stewardship model (Davis et al., 1997), the finance model (Manne, 1965), the myopic model (Keasey et al., 1997), the social entity model (Gamble and Kelly, 2001), the pluralistic model (Kelly and Parkinson, 1998), the trusteeship model (Kay and Silberston, 1995) and the most recent Community Interest Company (CIC) model (Low and Cowton, 2004).

5 CG in emerging markets: the case of Jordan

The 1990s Asian financial crisis demonstrated what risks would arise when financial institutions are subject to political influence, particularly, when corporate management is weak and lacks accountability, transparency and control (Wade, 2000). As a result of the crisis, CG in the emerging markets has come under scrutiny. However, the literature on CG models in emerging markets is limited (Shleifer and Vishny, 1997), while that in

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Jordan is dearth. However, the emerging markets tend to favour the Anglo-Saxon shareholder model, while not ignoring the stakeholder model.

Jordan is a small, but vital country, located in the heart of the Arab World. It has a population of 5.5 million. The majority of the population is Muslim, and Islamic customs govern the general way of life. The population is highly educated. Jordan has one of the most open political systems in the region. The basic infrastructure is well developed. Skill forces, communications, tax incentives and other facilities required for business are exceptionally good. The government has made efforts to create a liberal and attractive business environment. Capital market in Jordan is among the oldest ones in the region. Established in 1978, it consists of three separate, but related entities. These are Jordan Securities Commission (JSC), ASE and the Securities Depository Centre (SDC). There are more than 175 companies listed, with more than US$10 billion market value, representing more than 100% of the GDP and an average of one billion shares and 70 million bonds traded annually.

Jordanian corporations are regulated by the Companies Act of 1997 and Securities Act of 2002. Both laws require interval, transparency and timely disclosures of financial and non-financial information. The Controller of Companies and JSC are playing a vital role in supervising companies and performing an agency control on the management of companies. Both authorities have the power to issue warnings, fines, suspend and de-list companies. There is no recent evidence of CG scandal in Jordan and disclosures can be assessed as relatively good. That is so because Jordanian corporations are directed by good CG and disclosure principles. Ownership rights are secured and distinctly organised. Companies listed in the First Market of ASE are required to issue financial statement information quarterly, while those on the Second Market semiannually. However, the Board of Directors is appointed, not elected. The government, through its investment arm, the Investment Unit of the Social Security Corporation (SSC), holds a substantial stake in most of ASE large corporations. Although financial disclosure is somehow good, access to and dissemination of non-financial information is relatively weak.

6 The data

Using data for the listed companies in ASE, we examine the effects of state ownership, legal person ownership and individual private ownership on firm’s performance. The data set includes all ASE listed companies during the period 1992–1994. There were 119 firms listed in 1992 and 148 firms listed in 1994. Table 1 shows the summary statistics of financial information and profitability ratios of Jordanian listed companies, exhibited according to the four main sectors during 1992 and 1994 while Table 2 shows the ownership structure of Jordanian listed companies, exhibited by type and nationality of the investors, and sectoral category during 1992 and 1994.

The ownership of Jordanian government and its agencies in ASE listed companies decreased from 13% of the total ownership in 1992 to 12% in 1994. However, its direct ownership increased from 1% to 6% while its agencies ownership decreased from 12% to 6% during the period of the study. In fact, the reason behind that is the conversion of public enterprises into public shareholding companies, of which the government owns 100% of the companies, but planning to sell its shares to strategic local and/or foreign investors.

Corporate governance and performance 5

7 The analysis

The analysis of the data is performed by using three financial ratios as proxies of firm performance. These are Market Value to Book Value (MVBV), Return on Equity (ROE) and Return on Assets (ROA). Ownership structure is represented by two measures: concentration ratio, which is the percentage of shares held by top 10 shareholders (CR10) and Herfindahl index of ownership concentration, which is the sum of squared percentage of shares held by top 10 shareholders (HERF). ASE companies guide, issued every other year, reports CR10 for all listed companies, while HERF is calculated in this paper.

Let P represent performance measures, P = MVBV, ROA and ROE, and OC represent ownership concentration ratios, OC = CR10 and HERF. If ownership structure does not matter, there would be no correlation between P and OC. Thus, the first null hypothesis would be:

Hypothesis I: There is no relationship between ownership structure and firm’s performance. That is the irrelevance of ownership concentration.

Control variables used in this paper that might affect the performance include Net Income (NI), Debt Ratio (DR) and the industrial sector of the firms as a dummy variable. Firms listed in ASE are classified into four major sectors. These are banks (DUMb), insurance (DUMi), service (DUMs) and manufacturing (DUMm) sectors. This hypothesis is tested by the following equation:

4

1 2 3 41

DUM NI DR CR10 HERFi ii

P α β β β β ε=

= + + + + +∑ (1)

where all Greek letters are coefficients, ε is the error term with a covariance matrix COV(εj, εk) = 0 for j ≠ k, and VARεj ≠ VARεk. That is, the variance of εj differs across firms. DUM(ij) = 1 if firm j is in industry i and zero otherwise.

Equation (1) tests the null hypothesis for 1992 and 1994 data. Estimation results are reported in Table 3. Regardless of the performance measure used (MVBV, ROA or ROE), the null hypothesis cannot be rejected at 5% level of significance or less, for both 1992 and 1994 data. That is, ownership concentration is irrelevant to firm’s performance. However, the table reports that the concentration ratio (CR10) in 1994 is significant at 6% level, and the model (F = 1.93) at 9%. However, none of the control variables is significant. On the other hand, 1992 model of ROA was the best in explaining 63.6% of the relationship between performance and concentration, control and dummy variables, and significant at less than 1%. However, only one independent variable is significant, that is, NI.

Theoretically, well-functioning markets, such as the product market, the managerial labour market and the merger market, are the keys in establishing CG and, thus, ownership is irrelevant. Fama (1980) claims that ownership is an irrelevant concept since the firm is a set of contracts. Jensen (1993) demonstrates the role of the market for corporate control. Thus, the second null hypothesis would be:

Hypothesis II: There is no relationship between ownership mix and firm's performance. That is the irrelevance of ownership mix.

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Table 1 Summary statistics of financial information and profitability ratios of all Jordanian listed companies, exhibited by sector, during 1992 and 1994

Corporate governance and performance 7

Table 1 Summary statistics of financial information and profitability ratios of all Jordanian listed companies, exhibited by sector, during 1992 and 1994 (continued)

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Table 2 Ownership structure of all Jordanian listed companies, exhibited by type and nationality of the investors, during 1992 and 1994

Corporate governance and performance 9

Table 2 Ownership structure of all Jordanian listed companies, exhibited by type and nationality of the investors, during 1992 and 1994 (continued)

10 M.M. Ajlouni

Let P represent performance measures, P = MVBV, ROA and ROE, and OM is the number of shares owned by the government divided by the total number of shares outstanding. OM represents ownership mix ratios, FG1 = Fraction of equity owned by government agencies and FG2 = Fraction of equity owned by government itself. If ownership structure does not matter, there would be no correlation between P and OM. The following equation tests this hypothesis:

4 2

1 21 1

DUM NI DR FGi i j ji j

P Bα β β ε= =

= + + + +∑ ∑ (2)

where all Greek letters are coefficients, ε is the error term with a covariance matrix COV(εj, εk) = 0 for j ≠ k and VARεj ≠ VARεk. That is, the variance of εj differs across firms. DUM(ij) = 1 if firm j is in industry i and zero otherwise.

Equation (2) tests the null hypothesis for 1992 and 1994 data. Estimation results are reported in Table 4. The null hypothesis is rejected at 6% level of significance for 1992 data. That is, ownership structure, represented by the percentage of governmental agencies to the total ownership, is relevant to firm’s performance, when performance is measured by MVBV, but not with ROA or ROE. The debt Ratio (DR) and the dummy variable of the service sector are significant at 5% or less. Similar to results of Table 3. Table 4 reports that 1992 model of ROA is the best in explaining 62% of the estimation between performance and ownership structure, control and dummy variables, and significant at less than 1%, with only one independent variable significant, that is, NI.

Since ownership structure and mix are irrelevant, and based on the theory of the firm and the role of markets in corporate control, one might argue that foreign ownership is irrelevant too. Thus, the third null hypothesis would be:

Hypothesis III: There is no relationship between foreign ownership and firm’s performance. That is the irrelevance of foreign ownership.

Let P represent performance measures, P = MVBV, ROA and ROE, and FO is the number of shares owned by Arab and foreign investors divided by the total number of shares outstanding. FO represents foreign ownership ratios, FO1 = Fraction of equity owned by Arab individual investors, FO2 = Fraction of equity owned by Arab companies, FO3 = Fraction of equity owned by foreign individual investors, FO4 = Fraction of equity owned by foreign companies, FO5 = Fraction of equity owned by non-Jordanian governments and FO6 = Fraction of equity owned by other type of non-Jordanian shareholders. If foreign ownership does not matter, there would be no correlation between P and FO.

This hypothesis is tested by the following equation:

4 6

1 21 1

DUM NI DR FOi i j ji j

P Bα β β ε= =

= + + + +∑ ∑ (3)

where all Greek letters are coefficients, ε is the error term with a covariance matrix COV(εj, εk) = 0 for j ≠ k and VARεj ≠ VARεk. That is, the variance of εj differs across firms. DUM(ij) = 1 if firm j is in industry i and zero otherwise.

Corporate governance and performance 11

Table 3 Estimation results of Hypothesis I irrelevance of ownership concentration to firm’s performance

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Table 4 Estimation results of Hypothesis II irrelevance of ownership mix to firm’s performance

Corporate governance and performance 13

Equation (3) tests the null hypothesis for 1992 and 1994 data. Estimation results are reported in Table 5. The null hypothesis cannot be rejected at even 10% level of significance for 1992 and 1994 data. That is, ownership mix, represented by the percentage of non-Jordanian to the total ownership, is irrelevant to firm’s performance, when performance is measured by MVBV, ROA or ROE. Once again, Table 5 reports similar results to Tables 3 and 4 in that, the 1992 model of ROA is the best in explaining 59% of the estimation between performance and ownership mix, control and dummy variables, and significant at less than 1%, with only NI significant control variable.

8 Conclusion

Empirical results produced in this paper show little evidence on the importance of relative ownership concentration on firm’s performance. That is, there was no role for the large and institutional shareholders in monitoring and controlling the behaviour of the management. In fact, the correlation between performance and the concentration ratios was very weak and insignificant. The correlation between MVBV and CR10, for example, was 11.4% (23.4%), between ROA and CR10 was 9.1% (12.6%), and between ROE and CR10 was 19.8% (4.5%) in 1992 (1994). One explanation for this conclusion would be the fact that ownership of Jordanian firms is not highly concentrated. The percentage of owners who own 10% or more (CR10) was only 29% (27%) in 1992 (1994). However, institutional investors owned about 42% of Jordanian firms in 1992 and 1994 (see Table 2).

Similarly, there were no evidences on the effect of government ownership and firm performance. That is, ownership structure of Jordanian firm is irrelevant to their performance. Government ownership has no positive or negative impact on performance. The correlation between performance measures (MVBV, ROA and ROE) and ownership structure (government ownership) was −1.6%, −4.2% and −2.0% (−0.5%, 8.9% and 1%) in 1992 (1994), respectively. Thus, reducing or increasing government shares in listed companies is irrelevant to firm’s performance. In other words, the market does not value ownership structure of Jordanian firm. That is because publicly traded companies do not suffer from free-ride problem that most companies do in the emerging markets. This might be used as an indication of transparent and efficient market for listed companies in Jordan.

Finally, ownership mix is irrelevant to Jordanian firm’s performance. It seems that ASE does not value ownership mix, and that share prices do not reflect this variable. The correlation between performance measures (MVBV) and ownership mix (all Arab and all foreign investors) was 9.2%, and −4.5% (−10.5% and −3.6%) in 1992 (1994), respectively. The weak and insignificant results of this paper might be due to the model specifications used, including but not limited to the model being a parametric one. It might be useful to suggest the use of non-parametric model to investigate the relationship between firm’s performance and ownership concentration, structure and mix. The Data Envelopment Analysis (DEA) might be the alternative one to be used in this context.

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Table 5 Estimation results of Hypothesis III irrelevance of foreign ownership to firm’s performance

Corporate governance and performance 15

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