Investors’ best protection

By Jeff Pittman & Omrane Guedhami
Illustration: Ryan Snook

The notion that Canada is the “wild west” of lax securities regulation is prevalent. can more regulations reform our image?

Recent prominent financial reporting failures in several countries have renewed regulators’ interest in improving corporate disclosure by imposing civil and criminal penalties on auditors for issuing clean opinions on materially misleading financial statements. For example, auditors technically can be imprisoned for up to 10 years under the securities fraud provisions of the Sarbanes-Oxley Act of 2002. Jurisdictions outside the US, including Canada, have begun enacting similar legislation meant to restore investor confidence in the capital markets.

However, evidence of the impact of these legal institutions, which discipline auditors through civil lawsuits and criminal sanctions, on investors’ perceptions about the credibility of firms’ financial statements is scarce. Some scholars argue isolated reforms intended to improve financial reporting quality, such as requiring a country’s firms to follow international accounting standards, will be futile without concurrent changes to its securities laws that hold auditors more responsible. According to Prof. Ray Ball: “Litigation rights seldom are raised in the context of international accounting, but in my view they constitute the single most essential requirement for an efficient disclosure system. Without litigation, the incentives of auditors to reduce management’s discretion over financial reporting are considerably reduced.” ¹

For widely held US public companies, shareholders will be concerned by management’s potential ability to divert resources to its own benefit, i.e., an agency problem. Outside the US, the presence of controlling shareholders capable of directly monitoring the managers they appoint becomes a rational substitute for weak legal protection of minority shareholders from managerial expropriation.²

However, a concentrated ownership structure brings another problem: the potential diversion of corporate resources by controlling shareholders at the expense of minority investors. Financial economists label this fraction of corporate value that is captured by inside shareholders who control and frequently manage the firm, rather than being shared among all shareholders, as the “private benefits of control.”

Large shareholders typically exert control by owning shares with superior voting rights, constructing ownership pyramids or appointing submissive directors to the board. This control enables dominant shareholders to accrue private benefits through excessive salaries and expense claims, manipulating transfer prices, subsidized personal loans, non arm’s length transactions and even outright theft.³ Collectively, prior research implies that without strong legal protection preventing the expropriation of minority shareholders, a smaller fraction of the firm’s earnings will be returned to them as interest or dividends.

New evidence on the role of financial reporting on preventing expropriation
Importantly, the large private benefits of control that accompany high ownership concentration stem from poor external corporate governance.⁴ However, countries can intervene in their capital markets with legislation that reduces expropriation by improving contracting. Recent research finds that laws mandating more disclosure and facilitating private enforcement of securities laws enhance corporate governance, stimulating stock market development.⁵ Consistent with their argument that information disclosure is a prerequisite to any legal action, professors Alexander Dyck and Luigi Zingales report that firms in countries with better accounting standards enjoy lower private benefits of control. Transparent financial reporting is valuable to noncontrolling shareholders as it becomes more difficult for controlling shareholders to divert corporate resources without incurring legal penalties or damaging their reputations when accurate information is available.

Consequently, accounting transparency plays a natural role in alleviating the agency conflict between controlling and minority shareholders given that the expropriation of corporate resources hinges on these private benefits remaining hidden. Ball argues that strong shareholder protection should constrain insiders’ opportunism in financial reporting. Reinforcing that controlling shareholders have stronger motives to conceal actual firm performance when they are diverting more, earnings management is more pervasive in economies with weak investor protection. Other research stresses the impact of legal institutions on curbing the amount of these private benefits by providing investors with recourse against controlling shareholders. Altogether, this evidence implies that more disclosure will lead to firms becoming better known in the capital markets, thereby reducing the private benefits that controlling shareholders consume to the detriment of the remaining shareholders. However, Ball explains that despite its economic importance, international accounting research neglects studying any form of expropriation.

Professors Omrane Guedhami and Jeffrey Pittman begin to rectify this oversight by examining whether ownership concentration subsides in firms located in countries that mandate more disclosure, which may help minority shareholders identify any diversionary practices.⁶ Dyck and Zingales explain that by their very nature, private benefits of control are difficult to observe given corporate insiders’ hiding incentives.

However, emerging research in accounting and finance relies on ownership concentration — for example, the equity stake held by the largest three shareholders — to estimate private benefits of control. In other words, this measure captures minority shareholders’ rational reluctance to invest in companies that are more conducive to controlling shareholders siphoning corporate resources; i.e., more credible financial reporting should translate into lower ownership concentration. Still, professors Guedhami and Pittman find only weak evidence in their sample of 31 countries that enhancing disclosure standards reduces ownership concentration.

Additionally, Guedhami and Pittman analyze whether minority investors perceive that certain incentives seriously motivate auditors to improve financial reporting quality — specifically, their interest in preserving their brand-name reputations and legal institutions that discipline public accounting firms in the event of audit failure — which, in turn, lowers ownership concentration. There is considerable theory and evidence that more credible financial reporting lowers firms’ cost of capital. Moreover, lenders demand higher interest rates on debt issues made by US firms without Big Four auditors to compensate for the greater uncertainty about these securities.⁷ However, international research seldom focuses on the impact of auditor choice on investor perceptions.

Given the significance of accounting transparency to minority shareholders eager to prevent the diversion of corporate resources, it is important to analyze whether external monitoring by a Big Four auditor is valuable.⁸ (Although all public accounting firms must comply with minimum professional standards, the Big Four voluntarily invest in higher levels of expertise and have incentives to provide higher quality audits to protect their reputations.) Hiring a higher-quality auditor to enhance the credibility of financial reporting may enable firms to persuade smaller investors that controlling shareholders will have less opportunity to siphon firm value by, for example, manipulating transfer prices or concealing related-party transactions. The absence of a Big Four auditor may render firms’ disclosures less informative, leading to higher ownership concentration as potential investors protect against insiders’ greater discretion over financial reporting. Outside investors may perceive that a Big Four auditor will ensure that managers responsible for preparing the financial statements have less flexibility in their choice of accounting policies and estimates. However, Guedhami and Pittman fail to find that the presence of a Big Four auditor explains ownership concentration, suggesting that minority investors do not consider that auditor choice affects whether firms’ financial statements properly reflect underlying economic performance.

In stark contrast, Guedhami and Pittman report strong evidence that countries’ auditors’ liability regime mitigates the agency conflict between controlling and minority shareholders, consistent with Ray Ball’s predictions. Specifically, they detect that ownership concentration is lower in jurisdictions with securities laws that set a lower burden of proof in civil and criminal cases against auditors. Moreover, their evidence suggests that these provisions, which subject auditors to more severe private and public enforcement, dominate almost all other factors shown in prior research to curtail the private benefits of control evident in ownership concentration.

Guedhami and Pittman interpret their findings as implying that investors worldwide value legal institutions that discipline auditors in the event of financial reporting failure over both auditor choice and better disclosure standards. In documenting the sobering impact of civil and criminal litigation on auditors’ incentives to constrain insiders’ discretion over the financial reporting process, this evidence complements recent international research that finds that institutions that affect managers’ incentives matter more than formal disclosure standards to accounting quality. Governments that expose auditors to serious civil and criminal penalties seem to benefit from firms having more dispersed ownership, reflecting that minority investors perceive that financial statements are more credible in these countries.

Conclusions
In summary, prior research suggests that high ownership concentration in firms worldwide, coupled with poor disclosure and weak legal protection, provide controlling shareholders with strong incentives to exploit their position as insiders to consume private benefits. In contrast, transparent financial statements protect outside investors since the diversion of corporate resources by controlling shareholders depends on these private benefits remaining hidden.

Accordingly, Guedhami and Pittman’s cross-country research contributes to our understanding of the corporate governance mechanisms that support high-quality financial reporting. Their evidence implies that reforms aimed at relieving the agency conflict between controlling and minority shareholders should focus on relaxing the burden of proof in both civil and criminal cases against firms’ auditors and, to a lesser extent, requiring more disclosure. Fortunately, these prescriptions are relatively straightforward for governments to implement in order to improve their securities markets. Nevertheless, we caution that research on investors’ perceptions cannot isolate which factors actually affect financial reporting quality, although the recent shift toward appearance-based standards governing auditors reinforces the importance of shedding light on the role of auditing in shaping the perceptions of financial statement users.

From a policy perspective, there are at least three reasons that recent research on which legal institutions limit the private benefits of control is particularly relevant to the Canadian public accounting profession. First, as recent civil and criminal litigation involving Canadian companies such as Hollinger and Livent apparently demonstrate, Canada is not immune to corporate insiders extracting private benefits, suggesting that we could conceivably learn from the experiences of other countries about which corporate governance reforms investors genuinely value. In fact, Canada trails the US and the UK on mandatory disclosure, enforcement, and litigation aspects of securities laws.9 For instance, Bank of Canada Governor David Dodge highlights that the notion that the country is a “wild west” of lax securities regulation is prevalent among international investors, making it harder for domestic companies to raise money abroad. Second, in comparison to our US neighbours, Canadian firms frequently have high ownership concentration. This may be behind Dyck and Zingales’s evidence that large premiums are paid for voting stock relative to nonvoting stock in Canadian firms, implying that a controlling equity stake in this country is quite valuable for extracting private benefits. Third, in striving to improve corporate financial reporting, Canada has been converging toward international accounting standards. However, recent evidence suggests that mandating better disclosure standards to improve accounting transparency will be largely ineffective without surrounding legal institutions that hold auditors more liable for materially misleading financial statements.

Omrane Guedhami, PhD, and Jeffrey Pittman, PhD, CA, are associate professors at Memorial University of Newfoundland

Technical editor: Michel Magnan, PhD, FCA, associate dean, external affairs at the John Molson School of Business at Concordia University in Montreal

References

1. Ball, R. 2001. “Infrastructure requirements for an economically efficient system of public financial reporting and disclosure.” Brookings-Wharton Papers on Financial Services: 127-169.

2. Boubakri, N., J.-C. Cosset, and O. Guedhami. 2005. “Postprivatization corporate governance: The role of ownership structure and investor protection.” Journal of Financial Economics 76: 369-399.

3. Morck, R., M. Percy, G. Tian, and B. Yeung. 2004. “The rise and fall of the widely held firm: A history of Canadian corporate ownership.” In Randall Morck, ed. A Global History of Corporate Governance. University of Chicago Press.

4. Johnson, S., R. La Porta, F. Lopez-de-Silanes, and A. Shleifer. 2000. “Tunneling.” American Economic Review 90: 22-27.
5. Dyck, A. and L. Zingales. 2004. “Private benefits of control: An international comparison.” Journal of Finance 59: 537-600.

6. La Porta, R., F. Lopez-de-Silanes, and A. Shleifer. 2006. “What works in securities laws?” Journal of Finance 61: 1-32.

7. Guedhami, O. and J. A. Pittman.2006. “Ownership concentration in privatized firms: The role of disclosure standards, auditor choice, and auditing infrastructure.” Journal of Accounting Research, forthcoming.

8. Pittman, J. A. and S. Fortin. 2004. “Auditor choice and the cost of debt capital for newly public firms.” Journal of Accounting and Economics 37: 113-136.

9. Attig, N., W. M. Fong, Y. Gadhoum, and L.H.P. Lang. 2006. “Effects of large shareholding on information asymmetry and stock liquidity,” Journal of Banking and Finance, forthcoming.