The Influence of Foreign Direct Investment on Corporate-Governance Practices: a Conceptual Framework

Transcription

1 The Influence of Foreign Direct Investment on Corporate-Governance Practices: a Conceptual Framework Abdullah N. Alsubaie Abstract Researchers have found positive effects of foreign direct investment (FDI) on economic growth, technology transfer and productivity of local firms. Moreover, the positive effects of FDI in corporate-governance practices have been documented with regard to local firms that have either been acquired by, or entered into joint venture with, foreign firms. However, the changes in corporategovernance practices of local firms that compete or deal directly with FDI have never been examined. According to the theoretical literature of institutional isomorphic change, FDI should have an effect on these firms through competition or other types of affiliations. This study aims to fill the gap in the literature and provide hypotheses and a framework to examine the changes in corporate governance of firms that compete or deal directly with firms acquired by FDI. It attempts to determine the scope of FDI effects beyond those that have a direct impact on acquired local firms. It intends to clarify the role of FDI in corporate governance changes, such as changes in board of directors, executive compensation, ownership concentration and investor protection. The study demonstrates the leading function that FDI plays in organizing both our economic and social institutions. It also establishes a framework to examine the nature of the relationship between FDIs and local firms on one hand, and on the other hand, their effect on the corporate governance of local firms. Keywords Corporate Governance, Corporate-Governance Index, Foreign Direct Investment, Spillover Framework T I. INTRODUCTION HE subject of corporate-governance practices is one of the most important and controversial that has surfaced in recent years. Previous studies have shown the importance of corporate governance and found positive links between best corporate-governance practices and the market value of firms [1], [2]. Bai, Liu, Lu, Song and Zhang [3] have empirically determined that better corporate-governance practices positively affect the market value of publicly listed firms that have better corporate practices in China, and that investors are willing to pay larger premiums for firms that have better governance practices. The literature indicates that local firms acquired by FDI from developed countries change their governance practices to those of the acquirer [4]. It also indicates that firms with better Abdullah N. Alsubaie, PhD, CM, CFM is an assistant professor of finance at the Institute of Public Administration, P.O. Box 205 Riyadh 11343, Saudi Arabia, fax: subieea@ipa.edu.sa. governance practices are valued more by investors [5]. However, it does not indicate what would be the response of the local rivals and affiliated firms (suppliers and buyers) toward the new changes that are brought by FDI. Will they also change their management and governance practices to efficiently compete with the new FDI that has better corporate-governance practices? Will the reactions of the competitors and affiliated firms differ, depending on the origin of the FDI? Moreover, what is the direction of these changes? More precisely, what mechanisms of the governance practices of local firms are induced more by being a competitor with, or an affiliate of, FDI? This study will set hypotheses and a framework to test whether or not the FDI from developed countries has significant effects in promoting better governance practices in a host-country s firms. The content of the study is organized in sections as follows: The "Literature Review" discusses and distinguishes between corporate-governance systems and corporate-governance practices and reviews the literature in FDI and corporategovernance practices. It also introduces the concept of formal, functional and contractual convergence of corporate governance. Moreover, it covers FDI effects on the governance practices of a host country's firms and introduces the hypotheses of the study. The "Proposed Methodology" discusses constructing a corporate governance index and corporate governance variables used n this study. Finally, the "Conclusion" summarizes the contribution of the study. II. LITERATURE REVIEW It is important that we distinguish between corporategovernance practices and corporate-governance systems, as this study focuses on the latter. A system of corporate governance consists of those formal and informal institutions, laws, values and rules that generate the menu of legal and organizational forms available in a country and which in turn determine the distribution of power, how ownership is assigned, managerial decisions are made and monitored, information is audited and released, and profits and benefits allocated and distributed. [6] This definition concentrates on the overall institution and legal system of a country. On the other hand, corporate- 144

2 governance practices can be defined as: those rules that apply to specific financial markets and organizational forms, and that establish the discretion of parties that possess control rights and the information and mechanisms at their disposal to choose management, propose or confirm major strategic decisions, and to determine the distribution of remuneration and profit.[6] Some scholars argue that some systems are better than others. La Porta et al. [1] argues that common-law countries generally have the strongest governance systems in protecting investors, while the French civil-law countries are the weakest, and the German- and Scandinavian civil-law countries are ranked somewhere in between the two. This study does not attempt to determine what the best governance system is, but it does take into account specific practices that are considered to be better by many scholars and organizations, regardless of the corporate system in which they exist. Following the distinction above, this study concentrates on the mechanisms that most scholars and organizations, such as Organization for Economic Co-operation and Development OECD, view as best practices. They agree that good governance practices are those that solve problems related to conflicts of interest. Two essential problems with regard to corporate-governance practices are noted in the literature. The first conflict is the agency problem, which is the separation of ownership and control. It refers to the difficulties owners have in assuring that their funds are not expropriated or wasted on unproductive projects by managers [7]. The second example of a conflict of interest is when controlling shareholders take action that is for their own benefit and at the expense of the minority. La Porta et al. [1] argue that restricting expropriation in minority shareholders by the controlling shareholders is the central agency problem in large corporations throughout the world. Controlling shareholders who perform self-serving activities, such as giving themselves excessive compensation or loan guarantees, or issuing dilutive shares, encourage the expatriation of the minority. When large owners gain full control of the corporation, they prefer to generate private benefits of control that are not shared by minority shareholders [7]. This problem is more apparent in East Asian countries [8]. This study would consider corporate mechanisms that solve these two governance problems as better corporate practices. With the increasing global trade between many multinational corporations (MNCs) from different origins with different corporate-governance systems, a large debate noted in the literature deals with the issue of the convergence or nonconvergence of corporate governance. In most cases, this debate deals only with the formal convergence in corporate governance. Gilson [9] makes distinctions among the three types of convergence that are functional, formal or contractual. Functional convergence is that change in corporate practice that does not require a change in the country s laws or institutions. It occurs when the existing institution is flexible enough to respond to the pressure of changed conditions without changing the institutions' formal characteristics. Gilson argues that empirical studies have shown functional not formal convergence in recent empirical research concerning the German, Japanese and American governance systems. In the case of the effects of FDI on corporate governance of developing countries, I expected to find a functional convergence and not a formal convergence, which requires legislative action to change the basic structure of existing governance institution. Functional convergence is more often observed because every institution has the flexibility to find a solution within its path-dependent limit. Contractual convergence takes the form of a contract between different corporate governances, such as the change induced by cross-border mergers and acquisitions. It happens when existing governance institutions lacks the flexibility to achieve functional convergence, and when the cost and political barriers restrict the ability for formal institutional change [5]. Gilson [9] argues that functional convergence is likely the first response to competitive pressure because changing the form of an existing institution is costly. However, Aguilera and Gregory [10] argue that convergence and path dependence are false theoretical reasoning of change in corporate-governance practice. They expect that what will happen is a hybridization of corporategovernance models, in which the practice of specific corporate governance from one country is transferred to other country but with some adaptation to local setting Some argue that globalization will pressure firms to change their corporate-governance practice and will force these firms to adopt best practice, while others argue that this will not happen because of the force of path dependence of a country's legal and institutional system [11]. However, as discussed earlier, path dependence may prevent formal convergence, but not functional convergence (which I expect to occur). Henry and Reinier [12] argue that the main reason for convergence is the widespread normative consensus that requires managers to act in the interest of shareholders, including minority shareholders. They add three important reasons: the competitive success of contemporary British and American firms, the growing worldwide influence of academic disciplines of economics and finance and the diffusion of share ownership in developed countries. They also argue that the competitive pressures of global commerce, the failure of alternative models (the manager-oriented model, the labor-oriented model, the state-oriented model and stakeholder models) and the shift of interest-group influence in favor of an emerging shareholders model are the main factors driving convergence into the shareholders model. Other important economic forces encouraging convergence are those that come from competitive pressure to favor convergence. The force of example and competition by companies from common-law systems, in particular American companies that have performed well in recent years, in comparison with East Asian and Continental European 145

3 countries, will pressure companies to show partiality for convergence to the shareholder model [12]. Foley [13] argues that because MNCs from developed countries have access to home-country institutions, capital, talent or technology, they might operate more efficiently than local firms and can apply pressure for the convergence of corporate governance. Carati and Alirza [14] similarly argue that competition and the work of the market system will force firms to adopt efficient practices to force managers to act in the interest of shareholders. Kogut and Muir [15] argue that MNCs will improve the productivity of their local operations and generate positive externalities, and therefore will improve the performance of competitors and suppliers. One of the most influential works related to organizational change is the article by DiMaggio and Powel [16] about institutional isomorphism. They identify three mechanisms of isomorphic change: coercive, mimetic and normative. Coercive isomorphism results from both formal and informal pressures exerted on members of an organization by other organizational members and by cultural expectations from within the organizational society. The corporate-governance change induced by borders mergers and acquisitions might fall into this type of institutional isomorphism because the foreign firm essentially exercises its power to make the change in the acquired firm. The authors describe normative isomorphism as related to professionalization, which they depict as the collective efforts of members of a profession to define the conditions and methods of their work. The third source of change which is related to this study is mimetic isomorphism. It occurs when organizations respond to uncertainty by following the patterns of other successful organizations. When organizational technologies are poorly understood, when goals are ambiguous, or when the environment creates symbolic uncertainty, organizational actors may model themselves on other actors [16]. Looking at this theory in the context of FDI effects, local firms may follow the practices of successful FDIs. It is well known that MNCs are large corporations that have larger resources and come from developed countries, which makes them attractive models for a local firm s managers. The hypotheses of this study are built according to previous empirical studies and the prediction of mimetic isomorphism. Meyer and Sinani [17] demonstrate that FDI, under certain circumstances, does generate positive spillovers to local firms that vary within the context of the FDI. They have argued that the major driving forces of such contextual variation are local firms motivation and capability to react to foreign entry, which are grounded in their human capital and the institutional framework. Other studies have demonstrated that local firms that were acquired by foreign firms change their corporate and management practices to the acquirer's practices. Child, Faulkner and Robert [4] examine whether nationally distinct approaches to management were introduced, following acquisitions, among a sample of 201 UK subsidiaries of French, German, Japanese, US and UK companies. They found that the process of being acquired and controlled by a foreign parent company generally led to significant changes in management practices of the acquired firms. These empirical studies have basically used the prediction of coercive isomorphism. Building on the previous literature review and the prediction of mimetic isomorphism, I expect FDIs to have an effect on the local firm, as the following hypotheses predict: H1 a: Local firms that compete with FDIs would adopt the corporate-governance practices of these FDIs. H1 b: Local firms that have a direct relationship with the FDIs would adopt the corporate-governance practices of these FDIs. Bai et al. [3] developed a model that empirically assesses Chinese-listed companies' governance practices and created an index that ranks Chinese firms (from the best to the worst) according to their governance practices, named the "G index." In this study, we utilize a similar methodology to the G index, in which we rank firms according to their corporategovernance practices from best to worst. If these firms that compete with FDI change their corporate governance as hypothesized previously, then we expect,based on theoretical and empirical studies which indicate that FDIs have better corporate-governance practices, these firms to have a higher ranking than other controlling firms that do not compete with FDI. Therefore, the second hypothesis tests this prediction as follows: H2a: Firms that compete with FDIs would have a higher ranking in the corporate-governance practice index than those that do not have this relationship. Because FDIs depend on their local partners in some operations and extend credit to their buyers, they would take care to improve the corporate-governance practices of their affiliates [15]. Local firms that deal as suppliers or buyers with FDIs would be induced to change their governance practices to effectively deal with better governed FDIs. The following hypothesis tests whether the suppliers'/buyers' relationship would increase the corporate-governance ranking of these firms: H2b: Firms that deal directly as suppliers or buyers with FDI would have a higher ranking in the corporategovernance practice index than those that do not have this relationship. Khemani and Chad [18] argue that, in the case where "competition is intense and global in scope, more firms realize that corporate governance makes good business sense. Investors seek out firms that run the business efficiently, treat shareholders equitably and comply with high standards of disclosure, even when they are not mandatory." Firms with better corporate governance would develop good reputation and efficient access to finance, which lowers their cost of capital and enhances their ability to compete. Therefore, I expect the intensity of competition to be a strong factor in 146

4 inducing better corporate practice. Based on that expectation, I developed the following third hypothesis: H3: The more intense the competition of the local firm with FDI, the higher the rank of the firm in the corporategovernance practice index. In their study, La Porta et al. [23] determined that countries with common-law systems provide the best corporategovernance systems with regard to protecting investors. In their study of the effect of cross-borders mergers on corporate governance, Bris and Christos [5] find that the Tobin's Q of the targeted industry value increases when the acquisitions come from a country with a better corporate-governance system, such as those that come from the English and Scandinavian legal systems, and negatively decreases when the acquisitions come from less protective legal systems, such as the French and German systems. Therefore: H4: The rank of the firms in the corporate-governance index would be higher when it competes with common-law origin FDI. The following section describes the proposed methodology to test the study s hypotheses. III. PROPOSED METHODOLOGY The hypotheses of this study can be applied and tested in any country. The result may, or may not, be similar, depending on the country of origin of FDI on one hand, and on the other hand, the host country's legal, economic and social systems. This potential disparity is one aspect that makes this study more difficult to apply and generalize, yet valuable, as it explains the different effects of FDI in different countries. Another difficult aspect is determining how we measure best corporate-governance practices. Therefore,we need to construct mechanisms that measure corporategovernance practices within our particular context. The following sections explain these mechanism. For Hypothesis 1, the study will use specific mechanisms of corporate-governance practices to determine whether there have been changes in these mechanisms of rival and affiliated local firms after dealing with FDIs. I will examine the practice of local firms before the FDI's relationship and three years after the arrival of FDI, so changes would have had a chance to be implemented. Then, I will determine what changes in those mechanisms have occurred if any and compare them with another controlling group, comprising firms that have not experienced a relationship with FDIs. For Hypotheses 2, 3 and 4, I will utilize a methodology similar to the one used by Bai et al. [3], which establishes specific variables that measure the mechanisms of good corporate-governance practices of Chinese-listed companies, and then ranks these firms according to their governance practices, from the highest to the lowest. They created an index, which they named the "G index." They ranked 1,006 listed companies in China according to their best corporategovernance practices. I will identify firms that compete or deal with FDIs in the host country and locate their rank in the G index. I also will identify firms that do not compete or deal with FDIs and locate their rank. I expect to find an association between the ranking of a firm in the index and its relationship with FDIs, as I stated in my hypotheses. The variables of good corporate-governance practice vary, according to the literature. Denis and McConnell [19] define corporate governance as "a set of mechanisms both institutional and market based that induces a company's selfinterested controllers to make decisions that maximize the value of the company to its owners." Bai et al. [3] introduced two sets of mechanisms to measure the better corporate governance in China. The mechanisms they used are basically market-based model mechanisms that are popular among American MNCs. They used four internal mechanisms: ownership structure, executive compensations, board of director and financial disclosures. Bai et al. also used three external mechanisms: the market for corporate control, legal infrastructure and protection of minority shareholder and product market competition. The following section describes these mechanisms and the variables used to measure corporate-governance practices. It also will elaborate on how these mechanisms actually represent the practice of corporate governance of MNCs from countries that have common-law systems, especially those firms from the United States. 1- Board of directors The board of the directors is the instrument shareholders can use to exercise control over management and ensure that management makes decisions based on the shareholders' interests. The first variable to measure this mechanism is a dummy variable, assuming that the CEO is the chairman or vice chairman of the board of directors. When a CEO controls the board, it is hard for the board to exercise control over the management, so it negatively affects the rank of the firm as placed on the corporate-governance index. This is parallel to the practice of most MNCs from the United States and to the global standard of good corporate practices. The second variable is the proportion of outsider directors, defined as the ratio of non-paid members (independent directors) to the total number of directors. Independent directors are expected to play a more effective monitoring role than nonindependent directors. The greater the ratio, the better the corporate-governance practice of a firm. 2- Executive compensation The information on stock options and executive compensation are not widely available, Therefore, Bai et al [3] developed a variable to measure the alignment of the interest of executives with that of shareholders. The variable is: shareholding by the top five executives of the firm. When executives have more stakes in the firm, their interest goes best with that of shareholders. Notice here that American 147

5 MNCs have a strong tendency toward incentive contract such, as stock options and high compensation to encourage CEO to maximize the wealth of shareholders [20]. 3-Ownership variables "Concentrated equity ownership is regarded as a bad mechanism in corporate governance since it gives the largest shareholders more discretionary powers of using firm resources in the area that only serve their own benefit" [3]. One variable they used in measuring concentration of ownership is: shareholding of the largest shareholders. When this sharing increase it negatively affects the rank of the firm in the governance index as this shareholder has more opportunity to engage in fraud activity. The second variable is whether the firm has a parent company which negatively impacts the firm's corporate governance as the parent company can "expropriate other shareholders of the concentrated firm through various business dealing between them, or concentrated transaction [3]."In the United states large shareholding, and especially majority ownership are relatively uncommon-probably because of legal restrictions on high ownership and exercise of control by banks, mutual funds, insurance companies, and other institution [21]. Here we see that the variable to measure the good corporate practice of ownership is popular among MNCs for the US. 4-The market for corporate control "The existence of an active market for corporate control is essential for efficient allocation of resources. It allows inefficient managers to be removed and replaced with able managers who gain control of large amounts of resources in a short period of time. The market for corporate control can operate in three ways: proxy contests, friendly managers and hostile takeover [3]. They developed the following variable to measure this mechanism: concentration of the shareholding in the hands of the second to the tenth largest shareholder. It is defined as the sum of squares of the percentage shareholding by the second to the tenth largest shareholders. The higher is the concentration of shareholding in the hands of these large shareholders, the more positive the effect on the firm ranking. Dahiya [22] indicates that the dispersed control is found mainly in English speaking countries and the concentrated ownership structure is found in German and Japanese model. That also explains the relationship between the variables used in the governance index and MNCs from common-low systems. 5-Legal framework and protection of minority shareholder Studies have emphasized the role a country s legal system assumes in protecting investors and creditors. La Porta et al. [23] demonstrate the superiority of the common-law legal system in protecting investors. Bai et al. [3] introduced a variable that measures whether the company has listed its stock in either the Hong Kong or New York stock exchanges, and use this variable as a proxy to measure the effect of good legal environment in enforcing corporate governance. Here we see that they used a variable of listing a stock in the New York Stock Exchange as an indication of good corporate practice. Notice that the index uses the mechanisms of a market model of corporate governance as a best corporate practice. 6-Government as controlling shareholders The corporate-governance index introduced a dummy variable to measure whether or not the government is the controlling shareholder. They developed this dummy variable to measure the impact of government on corporategovernance practice. IV. CONCLUSION In this study, I have reviewed the literature and introduced four supported hypotheses related to the effects of FDI on the corporate governance of local firms. I also proposed a methodology that is needed to test these hypotheses and define all variables needed to construct a corporategovernance index of better governance. The importance of this study lies in that it illustrates the effects of FDI beyond those that have a direct impact on acquired firms. It intends to clarify the role of FDI in governance changes such as changes in boards of directors, executive compensation, ownership concentration and investor protection. It would help policy makers determine the different effects of FDI, depending on its origin, and will help to determine which FDIs to attract in order to achieve the desired corporate and management practices. The study contributes to the field by introducing a connectional framework pertaining to the role of FDIs on corporate convergence and management practices. This study can be extended to include cross-country analysis, thereby providing an in-depth explanation of how different institutions react to FDIs. The study also provides insight as to whether FDIs play different roles in different countries with different institutions and legal systems REFERENCES [1] La Porta, Rafael, Florencio Lopez-De-Silanes, Andrei Shleifer and Robert Vishny, 2002, Investor Protection and Corporate Valuation, The Journal of Finance, 57, [2] Gompers, Paul A., Joy L. Ishi and Andrew Metrick, 2003, Corporate Governance and Equity Prices, Quarterly Journal of Economics. [3] Bai, Chong-en, Qiao Liu, Joe Lu, Frank Song and Junxi Zhang, 2003, Corporate Governance and Firms Valuation in China, William Davidson Institute Working Papers Series, William Davidson Institute at the University of Michigan Business School. 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