Pledge of Stock and Firm Value: Evidence from the...

Proceedings of the Third Asia-Pacific Conference on Global Business, Economics, Finance

and Banking (AP15Singapore Conference) ISBN: 978-1-63415-751-3

17-19 July 2015 Paper ID: S535

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www.globalbizresearch.org

Pledge of Stock and Firm Value: Evidence from the Amendment

of the Company Act of Taiwan

Yu-Chun Wang,

Department of Finance,

Ming Chuan University, Taiwan, ROC.

E-mail: [email protected]

___________________________________________________________

Abstract

This study investigates stock market reactions to the amendment of the 2011 Company Act of

Taiwan. Shares pledged for bank loans created by top management are regarded as having high

expropriation risk for outside investors. To improve minority shareholder protection, the

regulations were changed and the exercise of voting rights on pledged shares exceeding one half

of the shares held by a director upon election (excess pledged shares) became limited. Our

empirical evidence shows that firms with high pledge ratio experience positive abnormal stock

returns, and this situation is pronounced in firms with low shareholdings of the board and in

those with a chairman who pledges excess shares for bank loans. These findings are consistent

with the alignment hypothesis stating that firms that are less compliant with the new rule benefit

more from the legislation changes. Relations between pledged shares and firm value also

demonstrate how investors evaluate weakened corporate governance practices. The effect of

regulation changes on firm value has an important implication for law makers and

policymakers who could improve corporate governance by ameliorating the legal system.

_____________________________________________________________________

Keywords: pledge of stock, firm value, corporate governance, regulation

JEL classification: G14, G34, K22

mailto:[email protected]




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1. Introduction

The use of collateral in loan contracts is usually required to help lending banks mitigate the

risk of information asymmetry between banks and borrowers. When banks are uncertain on

whether borrowers would engage in moral hazard activities, the collateral would serve as an

insurance against such unfavorable conditions. Prior studies indicate that collateral is most

often associated with high-risk borrowers (Berger and Udell, 1990; Coco, 2000; Menkhoff et

al., 2006). Regarding the top management of a firm, their pledged shares for bank loans indicate

that they are high-risk borrowers and that their behavior may increase agency costs of outside

investors; thus, these pledges are referred to as the weak corporate governance practices in

Taiwan (Kao and Chiou, 2002; Lee and Yeh, 2004). However, limited evidence shows how

investors evaluate such poor corporate governance. This study addresses this issue by

examining the reaction of the Taiwan stock market to the Company Act amendment in 2011 on

regulating the pledge behavior of directors.

Beginning the passage of the Sarbanes–Oxley Act (SOX) of 2002 in the US, improving

corporate governance has been one of the most important challenges for all governments.

Taiwan is no exception. Until recently, pledged shares of directors for bank loans have become

a long-standing problem among corporate governance issues in this emerging market. To

improve the protection for minority shareholders, regulators advocated implementing

additional rules on the behavior of directors pledging stocks in 2011.1

Law makers argued that pledged shares for bank loans reflect the degree to which firm

directors increase leverage, specifically in using less personal funds, to fight for control rights.

When operating concessions are expected to change because of potential variation in the

ownership structure, incumbent directors could apply high leverage to increase share holdings

and defend operating concessions.2 Thus, pledged shares resemble a tool by which directors

could entrench positions. In addition, when directors create a pledge on shareholdings for bank

loans, they are subject to a required maintenance margin similar to mortgage loans. If the

market value of pledged stocks falls below the maintenance requirement, directors will be

informed through a margin call. If the required margin is not met, banks can sell the pledged

stocks. Thus, regulators also argue that directors who pledge shares when the stock price is high

may engage in riskier operations for higher returns to boost security price (the value of the

collateral), and further magnify the volatility of firm value. The most severe situation is when

1 Note that the “first reading” of this law amendment was on December 31, 2010, but the first publication

of the discussion in an official Committee in newspapers was on June 8, 2011. 2 See Stulz (1988) for discussions about managerial entrenchment through stock holdings. He suggests

that management can change the fraction of the votes they control by capital structure changes. See

Shleifer and Vishny (1989) for a model that describes how managers can reduce the probability of being

replaced and obtain more latitude in determining corporate strategy by making manager-specific

investments.




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directors who intend to tunnel3 the companies do not pay back the loan and leave “a shell

company” along with a decreasing stock price.4 Minority stockholders consequently suffer

from this expropriation of directors. Thus, the exercise of voting rights of excess pledged shares

(pledged shares that exceed one half of the shares held by a director upon election) is suggested

to be limited.5

However, the dissentient view of the limitation argues that a pledged share differs from a

transfer of property rights to lending banks. Voting rights, therefore, should not be restricted

until the pledged shares are settled. After a five-month debate, as the voice of strengthening

capital market and improving corporate governance outweighs that of opponents, the

Legislative Yuan (the Taiwanese Congress equivalent) passed the amendment of Article 197–1

of the Company Act on October 25, 2011. This amendment aims to limit the voting rights of

excess pledged shares. The goal of this study is to investigate the relationship between pledges

of shares and firm value by examining the stock market reaction to this event.

Although previous research argues that the pledge of shares of the management deteriorates

corporate governance, our knowledge on whether such behavior affects shareholder wealth is

limited. Recent regulatory changes have led to an exogenous shock to the behavior of the top

management. Thus, the stock market reaction to recent regulation is a novel research

opportunity to examine the relation between corporate governance and firm value that is less of

a concern of endogeneity. If existing behaviors of pledging stock are, on the average,

characterized by poor corporate governance, we expect regulatory changes to increase the value

of shareholders.

This study examines the response of investors to the prohibition of voting of excess pledged

shares of directors by the following aspects. First, we assess whether stock price reactions to the

new rule differ with levels of expropriation. Prior studies suggest that regulation benefits firms

that are less compliant with provisions of rules (Chhaochharia and Grinstein, 2007; Berkman et

al., 2010; Cai and Walkling, 2011). Thus, we hypothesize that firms experience positive

abnormal returns if they have higher levels of pledged shareholdings of directors than others.

To address this issue, we employ both firm- and director-level data on pledged shares to analyze

the extent of agency costs of minority shareholders. While director-level pledged share

3 Prior studies (e.g., Johnson et al., 2000b) use the term “tunneling” to describe the transfer of assets and

profits from firms for the benefit of those who control them. In an emerging market such as Taiwan,

which features family-controlled firms and directors participating in management, dominant insiders are

more likely to take risks in entities where their cash flow rights are low and then siphon out proceeds to

entities where their cash flow rights are high. 4 See the study of Lee and Yeh (2004), which indicates that stock pledge is one of the key characteristics

of financially distressed firms in Taiwan. 5 For example, if a director held 10,000 shares of a firm when he (or she) was elected and pledged 6,000

shares for bank loans, the new rule would limit the voting rights to 1,000 (6,000 minus 10,000/2) shares.

In this paper, we use the term “excess pledged shares” to describe the situation when pledged shares

exceed half of the shares held by a director upon election to the position.




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holdings are the most direct measure to investigate the level of directors having “a slap in his

face”, we expect that firms with a high number of directors having excess pledged shares would

have positive abnormal returns. Meanwhile, firm-level pledged share holdings, which are

disclosed by month, are the most accessible information for investors. Accordingly, we expect

that firms with their board having a high percentage of pledged share holdings over the actual

board holdings (the pledge ratio) will experience positive abnormal returns.

Agency conflicts of management boards may subsequently be associated with the

ownership structure (Jensen and Meckling, 1976; Leland and Pyle, 1977; Jensen, 1993). If the

board only holds a few shares of a firm (i.e., the participation they can obtain from the firm’s

profits is low), but pledges a large proportion of their share holdings, they are more likely to

engage in activities of entrenchment. Thus, the hypothesis also predicts that firms with

directors who hold low share holdings and pledge their stocks for bank loans would benefit

more from the newly passed regulation.

Third, we examine whether firms with excess pledged shares created by the chairman of the

board of directors experience positive abnormal returns. In contrast to the role of a chairman in

U.S. firms, under the Company Act in Taiwan, a chairman is the legal representative of a

company. The chairman is also the highest authority in a firm and is responsible for overall

operations. If a chairman pledges shares, investors may perceive this action as a severe conflict

of interest compared with the pledges of other directors. Thus, we hypothesize that positive

abnormal returns are more pronounced in firms with a chairman who makes excess pledged

shares.

This study contributes to the literature on firm value and corporate governance, specifically

on stock market reactions to corporation governance regulations (Chow, 1983; Johnson et al.,

2000a; Bushee and Leuz, 2005; Greenstone et al., 2006; Carvalhal da Silva and

Subrahmanyam, 2007; Chhaochharia and Grinstein, 2007; Wintoki, 2007; Zhang, 2007;

Hochberg et al., 2009; Berkman et al., 2010; Iliev, 2010; Cai and Walkling, 2011; Larcker et al.,

2011; among others). The alignment hypothesis suggests that regulations can reduce rent

extraction of the management from minority shareholders, hence increasing shareholder value

(Chhaochharia and Grinstein, 2007; Berkman et al., 2010; Cai and Walkling, 2011, Black et al.,

2015). Some studies find that governance provisions do not improve firm value because the

observed governance practices have been the results of value maximization (e.g. Iliev, 2010;

Larcker et al., 2011). Mixed conclusions and countervailing effects of regulations provided in

previous studies emphasize the importance of such an empirical issue that we will address in

the current study.

The remainder of this paper is organized as follows. Section 2 reviews the related literature

and presents the empirical hypotheses. Section 3 describes the research design, empirical




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model, and data. Section 4 reports the empirical results, and then Section 5 states the

conclusion.

2. Literature Review and Hypotheses Development

2.1 Literature on Pledge for Loans

Without considering collateral, if a bank agrees on a higher loan rate when facing

asymmetric information, the expected return would decrease (Leland and Pyle, 1977) because

borrowers would take ex post high-risk projects (Stiglitz and Weiss, 1981). Thus, to avoid such

adverse selection effect, lending banks prefer rationing credit to opaque borrowers rather than

increasing loan rate because they do not have enough information to ensure payback from

borrowers. A collateral resolves credit rationing and assists borrowers in asking for a reduction

in loan rate (when loan size is held constant) or an increase in loan size (when loan rate is held

constant). When borrowers are not trusted by banks, they can use the collateral to ease financial

constraints (Boot et al., 1991; Inderst and Mueller, 2007).

When a director of a firm is required to pledge shares from banks for personal loans, such

activity signals the assessment of the bank that the director has higher tendency to engage in

high-risk investment projects. This situation also indicates the agency problem between

directors and outside shareholders (Jensen and Meckling, 1976). To mitigate information

asymmetry for outside investors on personally pledged borrowings of insiders, Taiwan’s

competent authority requires, under the Article 197–1 of the Company Act (see Appendix A),

listed companies to fully disclose the amount of pledged shares in a firm. Although this

regulation improves the transparency of pledged borrowing of insiders, the risk of managerial

rent extraction remains.

In Taiwan, loan contracts with pledged stocks include terms of collateral maintenance ratio.

For example, if a director borrows 1 million New Taiwan Dollars (NTD) with pledged stocks

valued at NTD 2 million, then the collateral maintenance ratio is 200% (2/1*100%). If the

maintenance ratio drops below 140% (i.e., the stock price falls 30%) for three successive

trading days, the bank will deliver a notice of margin call, and the director should post a margin

to raise the maintenance ratio to 170%. If the borrower does not meet this requirement, the bank

can terminate the loan contract and sell the pledged stocks as part of the recovery. Therefore, to

increase the collateral value, directors have incentives to engage in high-risk investment

projects for higher returns, which results in high volatility in firm value. In this context, a

conflict of interest between directors and outside investors exists when directors pledge on

shareholdings.

Prior research has investigated the role of pledged shares in agency problems and presented

evidence consistent with the authority’s consideration that pledged shares are indicative of

agency problem. For example, Kao and Chiou (2002) find the correlation between earning




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information and stock price decreases when the pledged shareholdings of the board increases.

This situation indicates that the pledged shareholdings of boards induces earning management,

reduces information quality, and worsens the problem of information asymmetry between

management executives and minority stockholders. Lee and Yeh (2004) examine the

determinants of financial distress and find that pledge ratio is an essential attribute of firm-level

governance to increase the probability of financial distress or even boost bankruptcy cost. Chen

and Kao (2011) indicate in their study that directors who have financing need and hold high

turnover stocks prefer to pledge their stocks at private banks for loans. In sum, the literature

shows that the behavior of the board to pledge on their shareholdings lowers the common

interest between the management group and outside investors. Such a weak governance

mechanism would be harmful for firm value (Mitton, 2002; Gompers et al., 2003; Lemmon and

Lins, 2003; Cremers and Nair, 2005).

2.2 Hypotheses Development

A growing body of literature assesses the effects of regulations on firm-level governance

attributes (Atanasov et al., 2010; Bruno and Claessens, 2010) and on shareholder wealth (e.g.,

Greenstone et al., 2006; Chhaochharia and Grinstein, 2007; Berkman et al., 2010; Cai and

Walkling, 2011). Evidence suggests that rules aimed at improving governance mechanisms to

protect outside investors from expropriation are likely to create firm value. For example,

Chhaochharia and Grinstein (2007) examine the effect of the 2002 U.S. new governance rules

on firm value. During the announcement period of one year, portfolios of firms with insider

trading, related party transactions, and restated financial statements earned positive abnormal

returns compared with portfolios of firms that were more compliant with the rules. Cai and

Walkling (2011) investigate the announcement effect of Say-on-Pay Bill of 2007 on

shareholder wealth and find that stocks of firms with positive abnormal CEO pay and low CEO

pay-for-performance sensitivity reacted positively to the passage of the bill. In the Chinese

security market, Berkman et al. (2010) study three regulatory changes in 2000 and find firms

with minority shareholders facing greater expropriation benefit from new regulations,

especially for private firms rather than state-owned enterprises. In sum, these findings are

consistent with the notion that laws can eliminate the severity of expropriation from managers

and lead to higher maximization of shareholder value.

If investors perceive that the 2011 Company Act amendment would benefit firms with

high levels of pledged shareholdings of boards, these firms would have positive abnormal

returns upon the passage of the amendment.6

6 In Taiwan, information about pledged shareholdings is required to be disclosed publicly, and thus is

relatively transparent. The eased expropriation from insiders may be accompanied by legal convergence

(La Porta et al., 2000; Glaeser et al., 2001), and investors are likely to have rare doubts whether the rule

will be enforced effectively. From the view of cost–benefit analysis, given that extra auditing or filing




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H1a: Firms with high pledged shareholdings of boards exhibit positive abnormal returns upon

the passage of the Company Act amendment.

H1b: Firms with high pledged shareholdings of boards exhibit negative abnormal returns upon

the passage of the Company Act amendment.

In addition, when the board of directors controls a firm using a low fraction of

shareholdings, agency problems exacerbate because of inconsistent interests between the

management group and minority shareholders (Jensen and Meckling, 1976; Leland and Pyle,

1977; Jensen, 1993). Thus, firms with directors who hold low shareholdings and pledge their

shares for bank loan are expected to suffer from severe agency problems. These directors are

more likely to engage in rent-seeking activities, relationship-based transactions, and risky

investment projects, given that the costs of expropriation are low. Firms with such directors are

particularly benefited upon the amendment of the Company Act.

H2a: Firms with directors who hold low shareholdings and pledge their shares for bank loans

lead to positive abnormal returns upon the passage of the Company Act amendment.

H2b: Firms with directors who hold low shareholdings and pledge their shares for bank loans

have negative abnormal returns at the passage of the Company Act amendment.

Risk incentive of top managers affects equity prices (Yermack, 1997; Malmendier and

Tate, 2008; Wei and Yermack, 2011). Accordingly, we expect that the effects of legislation are

stronger for firms with top managers pledging their shares than for those without such top

managers. In Taiwan, the chairman of a firm is its legal representative under the Company Act,

and he (she) is also the highest authority in a firm and is responsible for overall operations.

Thus, the hypothesis predicts that positive abnormal returns are more pronounced in firms with

a chairman who makes excess pledged shares.

H3a: Positive abnormal returns at the passage of the Company Act amendment are stronger for

firms with a chairman who pledges excess shares.

H3b: Positive abnormal returns at the passage of the Company Act amendment are weaker for

firms with a chairman who makes excess pledged shares.

3. Research Design and Data

3.1 Research Design and Models

When assessing the link between corporate governance and firm value, researchers often

encounter problems of endogeneity, as corporate issues can be jointly determined. We use the

standard event–study methodology of portfolio time-series regression by Sefcik and Thompson

(1986), Campbell et al. (1997), Chhaochharia and Grinstein (2007), Berkman et al. (2010), and

Cai and Walkling (2011). The methodology aims to reduce potential shortcomings of clustering

costs are not generated when the board reduces their shared pledges, less compliant firms will benefit

from legislation improvement, as evidenced in this study.




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in the specification of cross-sectional regression analysis and to avoid endogeneity of firm

value and corporate governance in static analysis. This method diversifies from the

cross-sectional correlation among sampling stocks arising from the shared event window. We

investigate whether the amendment of the Company Act creates value for firms with high

pledge ratios by using the following portfolio time-series regressions.

(1) H

0 1 2RET_PLEG D_Event RET_MKTt t t

(2) L

0 1 2RET_PLEG D_Event RET_MKTt t t

(3) H L

0 1 2RET_PLEG - RET_PLEG D_Event RET_MKTt t t t

Where, HRET_PLEGt

and LRET_PLEGt

denote the equal-weighted portfolio returns of

firms with high and low levels of board pledge variables. In this study, we determine the high

and low levels of pledge-related variables by terciles, such that variables are nearest to zero.

H LRET_PLEG RET_PLEGt t denotes the return of a portfolio that had a long position in

high pledge-related firms and a short position in low pledge-related firms. D_Event is a dummy

variable of event time that takes a value of 1/n in the event window of length n, and zero

otherwise. The coefficient of D_Event β1 is the estimated CARs (cumulative abnormal returns,

Equations 1 and 2) of the concerned portfolio or the difference in CARs (Equation 3 between

the concerned portfolios during the event window). RET_MKTt denotes equal-weighted

market portfolio returns of sample firms listed in the Taiwan Stock Exchange (TWSE) at time t.

Following Cai and Walkling (2011), we set a three-day event window as (-1, +1) that centers on

the day of the passage of the new law. The coefficient of D_Event, β1, is the CARs of the stock

market during the event window. We perform the model with a sample period of a 250 trading

days that started from October 28, 2010.

3.2 Sample and Data

Our sample firms are listed companies in the TWSE. The initial sample contains 727 listed

firms at the time of the 2011 Company Act amendment. The exclusion of one foreign firm and

34 financial firms (regulated industry) results in our final sample of 692 firms. We collect the

data of pledged shares of the board from two sources. The Company Act requires listed

companies to disclose monthly the creation or cancelation of pledges of stocks held by board

members. Thus, we can obtain the data of firm-level board pledge ratios in September 2011 (the

first month prior to the amendment passage) from the database of the Taiwan Economic Journal

(TEJ). TEJ is the most comprehensive financial data vendor of Taiwanese financial market

because it gathers information from the TWSE filings of public companies. In addition, the

laws require listed firms to disclose detailed ownership structure (including pledged shares of

board members) in the annual financial reports. We also collect director-level data of pledged

shares at the end of 2010 from the TEJ database. With such information, we can identify




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whether the chairman of a firm made excess pledges on his (or her) shareholdings. Data on

stock prices and other firm characteristics also come from the TEJ database.7

4. Empirical Results

4.1 Descriptive Statistics

Table 1 presents the summary statistics of our sample. The average pledge ratio at the end of

September 2011 is about 10.3% with a median of 0, indicating that not more than half of firms

have a board with members pledging their stocks for bank loans. For director-level data,

approximately 6.6% of the directors in the firms made excess pledged shareholdings. About 9%

of the firms have chairmen who made excess pledged shares for bank loans, and 16.2% of the

firms have at least one director, who is not the chairman, making excess pledged shares. About

a quarter (9% + 16.2%) of the firms has at least one director pledging over half of his shares for

bank loans. The average shareholding ratio of the board is 18.7%.

4.2 Empirical Results for Hypothesis Testing

To examine whether firm-level compliance with the new rule affects market valuation, we

examine Equations 1 to 3 based on the high and low terciles of pledge ratio. Table 2 presents the

estimation results of portfolio CARs over the window (-1, +1). With almost 40% of the firms

having a positive pledge ratio, Panel A of Table 2 compares the CARs of groups of firms with

the highest third and highest fourth of pledge ratios with those without pledged shares of the

board. The CAR of portfolio consisting of firms with highest fourth of pledge ratios, whose

pledge ratio is greater than 12.65% with a mean of 38%, is 0.37% and is statistically significant

at 1% level. This portfolio outperforms that containing firms without pledged shares of the

board, whose CAR is -0.23%, by 0.6% at 1% statistical significance. The portfolios of firms

with the highest third of pledge ratio and firms with positive pledge ratio exhibit a similar

pattern. Their CARs are significantly positive and greater than the CAR of the portfolio of firms

without pledged shares of the board. Thus, the results support H1a.

Panel B of Table 2 presents the CARs when the 2011 Company Act amendment was passed

for groups based on board shareholding and then pledge ratio. For both groups with high and

low board shareholdings, the portfolios of firms with a positive pledge ratio have positive

CARs. However, for the low-board shareholding group only, the portfolio of firms with a

positive pledge ratio significantly outperforms that of firms without pledged shares of the

board. The difference in CARs at the onset of the new provision is 0.77%, which is statistically

significant at the 1% level. This outperformance is the largest among all portfolios based on

pledge ratio. This result indicates that minority shareholders of firms with low board

7 See Appendix B for the summary statistics of these variables. These firms have a median market

capitalization of NT$ 6.7 billion, an average book-to-market ratio of 0.68, and a one-year stock return of

14.9% on average prior to the legislation. The average leverage is 34.2% and the average return on assets

(ROA) is about 10%.




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shareholding and high pledge ratio face higher entrenchment risk. Therefore, improvement of

legislation may help them overcome the previously mentioned disadvantage. This finding

supports H2a.

Table 3 presents the portfolio CARs based on the number of directors with excess pledged

shares in a firm. In Panel A, we compare the portfolio of firms that have the highest sixth and

the highest fourth of directors having excess pledged shares with that of firms without any

directors conducting pledges. The portfolio of firms whose number of directors with excess

pledged shares in a firm is greater than 16.6% (more than 1/6 of the board members) exhibits a

positive CAR of 0.3%, and the CAR is statistically significant at 1% level. This portfolio

outperforms that of firms without any directors having excess pledged shares by 0.35% at the

1% level.

In Panel B of Table 3, we focus on the firms with at least one director making excess pledged

shares. We further split this subsample into two groups based on whether the chairman makes

excess pledged shares or not. The CAR of the portfolio of firms whose chairman creates excess

pledged shares is 0.78%, which is statistically significant at 1% level. This portfolio

outperforms that of firms with at least one director, but not the chairman, having excess pledged

shares by 0.95%. The difference in CARs is the highest among all comparisons in this study.

The results indicate that whether the chairman of a firm makes excess pledged shares for bank

loans is important in determining the levels of agency conflicts between the board and outside

investors. Hence, the market perceives that the new regulation is an attempt to improve the

credibility of investor protection, and such firms would be affected mostly. Our H3b is

therefore largely supported by the evidence presented.

Overall, our results suggest that the stock market considered the new regulation to be

effective in improving investor protection of Taiwanese listed firms. We find that firms with a

high pledge ratio experience greater abnormal stock returns than those without pledged shares

for bank loans of the board. This relation is more profound in firms with low shareholdings of

the board. The director-level evidence indicates that, among firms with at least one board

member with excess pledged shares, those with a chairman pledging excess shares for bank

loans exhibit higher stock returns than others (chairmen without excess pledged shares). These

findings support the hypothesis that firms that are less compliant with the new rule will benefit

more from the legislation.

4.3 Robustness Tests

4.3.1 Multivariate Analysis of Stock Returns and Pledge of Stock

In addition to the standard event study methodologies, we perform regressions to test the

relationship between pledged shares and stock returns. While the stock returns may cause

cross-sectional correlation problems in a regression, which can bias the ordinary least squares




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standard errors, we estimate robust standard errors adjusted for industry clustering and then

calculate t-statistics based on these robust standard errors. Furthermore, we use a bootstrap

methodology similar to that performed by Chhaochharia and Grinstein (2007) and Cai and

Walkling (2011) to estimate the p-value of the regression coefficients. The p-value is obtained

by benchmarking our test results against those obtained on randomly selected non-event days.

Comparing the estimations between event and non-event days alleviates the possibility that the

statistical relations are a general phenomenon and not specific to the market’s reaction to the

regulatory change.

Table 4 presents the regression results of the relations between CARs by the time the new

rule was passed and the pledge ratio of firms. In Column 1, the coefficient of the pledge ratio is

0.14, which is statistically significant at the 5% level. The bootstrapped p-value confirms the

significance of the pledge ratio variable in this regression. Hence, a positive relation exists

between pledge ratio and abnormal returns, and this relation is unique to the concerned

regulatory event and not a general phenomenon.8

4.3.2 Effects of Other Corporate Governance Variables

While the new regulation aims to improve investor protection, one may suspect that, in

addition to firms with excess pledged shares, weakly governed firms would benefit from the

legislation. The market seems to consider that the new regulation will improve corporate

governance regardless of the governance attributes. In this context, the increment to the value

of firms examined with board pledges on stocks would not determine the relationship between

pledge of stock and firm value. Instead, this increment is an increase in value for all weakly

governed firms. We subsequently investigate the relations between abnormal stock returns and

seven corporate governance proxies by the regression analysis described in the previous

section. The attribute variables include excess control board (percentage of board seats

occupied by the controlling shareholders less the cash flow rights of the controlling

shareholders, see Young et al., 2008), cash flow rights (proportion of net profits that controlling

shareholders can claim through all their direct and indirect shareholdings, see La Porta et al.,

2002), deviation of cash flow rights from control rights (difference between control rights9 and

cash flow rights of controlling shareholders, see Claessens et al., 2000), institutional holdings

(shareholdings held by institutional investors, see Ferreira and Matos, 2008), foreign holdings

(shareholdings held by foreign investors, see Leuz et al., 2008), government holdings

(shareholdings held by the government, see Berkman et al., 2010), and CEO duality (a dummy

that takes a value of one if the CEO is also the chairman of a firm, and zero otherwise, see

8 In this regression analysis, the natural log of market capitalization, book-to-market ratio, and past year

stock return are significant. However, from the bootstrapped p-value, their significance appears as a

general phenomenon and not unique to the event being examined. 9 “Control rights” is the voting right that the controlling shareholders have through their direct and

indirect shareholdings.




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Donaldson and Davis, 1991).

Columns 2 to 8 of Table 4 report the regression results. The significance of pledge ratio

remains consistent across the regressions of CARs on other corporate governance variables.

However, we find no evidence suggesting that any of the seven governance variables is

important in explaining abnormal stock returns as a result of the new legislation. Although

institutional holdings seem to correlate positively with the CARs, the bootstrapped p-value

(:0.22) fails to reject the null hypothesis that the relationship between institutional holdings and

abnormal stock returns is a general phenomenon instead of a specific relation during the event.

Hence, among all the corporate governance variables we have examined, only the relations

between pledge ratio and abnormal stock returns are specific to the time when the Company

Act amendment was passed.

4.4 Additional Tests

4.4.1 Market Response

Before 2011, the Company Act of Taiwan required listed companies to disclose the amount

of pledged shareholdings. Notwithstanding, the management entrenchment by pledged shares

for bank loans was not eased. The Company Act amendment of 2011 further limited the voting

rights of directors on excess pledged shareholdings. If investors perceive this effect to improve

investor protection (La Porta et al., 2000; Glaeser et al., 2001; La Porta et al., 2002), the market

would positively respond to the new rule.

Based on the theory predicting a positive relation between investor protection and firm

value, we also premised that the stock market would positively respond to the regulation. We

study the stock market reactions to the Legislative Yuan’s passage of the new regulation aimed

at improving investor protection. The following regression model is employed to examine the

stock market response to the amendment of Company Act of 2001 of Taiwan.

(4) 0 1RET_MKT D_Eventt t

Where, the variables are as mentioned earlier in this paper.

Table 5 shows the estimation results of Equation 4 in an attempt to investigate the market

response to the passage of the 2011 amendment of the Company Act. The stock market

positively reacted to the new legislation, with a statistically significant abnormal return of

2.96% during the three-day event window. This finding reveals that stock market participators

regard the new law as beneficial for investor protection; thus, the stock market appreciated in

line with the argument of La Porta et al. (2000). For comparison, Column 2 of Table 5 presents

the estimation results during the discussion of the provision in June. The abnormal stock market

return during the (-1, +1) window is 0.25%, which is not statistically significant, implying that

the stock market may not have considered the discussion in the Committee of the Legislative

Yuan as contributory to the increased probability of the passage of the rule. Only until the




13


Taiwanese Congress completed the legislation-making process did investors become convinced

of the eventual approval of the new rule. Thus, the stock market did not react strongly to the

committee discussion about this regulation.

4.4.2 Changes in Pledged Shares

Prior studies argue that the willingness of a firm to improve investor protection plays an

important role in determining whether shareholders benefit from the regulations. For example,

Berkman et al. (2010) find that state-owned enterprises, relative to private firms, are less likely

to comply with regulations of investor protection. Hence, minority shareholders of state-owned

enterprises are less benefited from new company rules. Cai and Walkling (2011) also point out

that worst-governed firms may be not willing to comply with new rules, and thus will not find

the provisions as beneficial. These findings suggest that the willingness to comply with

regulations is important in determining whether investors would benefit from new laws.

Based on such interpretation, one may expect that if the board of a firm responds to the

initiative of a Company Act amendment by reducing their pledged shares for bank loans, the

market will positively react to such compliance. When the board of a firm is willing to reduce

pledged shares, investors would consider the firm responsive to improve governance, and the

stock price would appreciate as a positive reaction. Thus, we examine whether firms with

directors who have decreased pledge ratio after the law amendment experience positive

abnormal returns. A decrease in pledge ratio is caused by either an increase in share holdings of

the board or a cancelation of pledged shares. Both movements tend to be more aligned with the

aim of the new regulation. In this part, we use the decrease in pledge ratio prior to the passage of

the Company Act as a proxy for a firm’s willingness to improve corporate governance.

Table 6 reports the CARs of groups based on changes in pledge ratio of firms between June

and September 2001 during the law-making process.10 While not more than 25% of the firms

had pledge ratios changing during the period, we focus on the groups of firms whose changes in

pledge ratios are in the top decile (> 0.3%) and those in the bottom decile (< 1.57%). The results

show that the portfolio of firms whose boards reduced pledged shares for bank loans exhibits a

positive and statistically significant CAR of 0.28%. However, this portfolio does not

outperform any other portfolios. Therefore, the evidence supporting the argument is weak.

5. Conclusions and Discussions

We show that pledged stocks of board members affect the wealth of investors based on the

evident positive reaction of the share prices of these firms to the passage of the 2011 Company

Act amendment that attempted to improve investor protection by restricting the exercise of

voting pledged shares of board members. However, the amendment does not benefit all

10 See Appendix B for the summary statistics of this variable. After the first discussion in the Committee

of Legislative Yuan in June 2011, the average change in pledge ratio until September 2011 was about

-0.02%.




14


companies, but only concerned entities. Our evidence shows that firms that are less compliant

with the new provision (having higher excess pledged shares) experience a greater increase in

shareholder wealth than firms that are more accordant with the spirit of the rule (having less

excess pledged shares). This result is supportive of the alignment hypothesis, which suggests

that regulations can reduce the rent extraction of the management from minority shareholders

(Chhaochharia and Grinstein, 2007; Berkman et al., 2010; Cai and Walkling, 2011).

Our results are consistent with the notion that pledged shares of the board are harmful for

shareholder value. Possible explanations can be borrowed from prior research that suggests the

presence of the pledged shares associated with earning management, financial failure,

management entrenchment, and information asymmetry between the management and outside

investors. Such agency conflicts are more severe when the chairman of a firm, as the highest

authority and responsible for the overall operations in a Taiwanese firm, makes excess pledged

shares. While governments all over the world are making efforts to propose more investor

protection regulations, this study adds to the understanding of the importance of the legal

environment by showing the relations between governance regulation changes and firm value.

While our results support the alignment hypothesis, some previous studies report that

governance provisions do not improve firm value possibly because the observed governance

practices have been the results of value maximization (e.g. Iliev, 2010; Larcker et al., 2011).

Mixed conclusions in literature may be accounted for by certain governance practices

mandated by regulations that are not optimal contracts between the management and outside

investors (e.g., the number of block holders and the level of CEO compensation). Further, some

regulations are even costly to comply with (e.g., the requirement of management report for

small companies), whereas some would alleviate potential expropriation of self-dealing

managers (e.g., insider trading, excess compensation, excess pledges of shareholdings, and

relationship-based transactions). Thus, the effects of regulation change on shareholder wealth

are likely to depend on the effectiveness and efficiency of new rules that can be enforced to

increase investor protection.

Appendix A: Article 197-1 of Company Act

Article 197-1: Upon creation or cancellation of a pledge on the company's shares held by a

shareholder, a notice of such action shall be given to the company, and the company shall, in

turn and within 15 days after such pledge creation/ cancellation date, have the change of pledge

over such shares reported to the competent authority and declared in a public notice; unless

otherwise provided for in any rules or regulations separately prescribed by the authority in

charge of securities affairs.

In case a director of a company whose shares are issued to the public that has created pledge

on the company’s shares for more than one half of the shares being held by him/her at the time




15


he/she is elected, the portion of excessive voting power shall not be exercised, nor counted in

the number of votes of shareholders present at the meeting.

Appendix B: Summary statistics of the robustness tests

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Table 1: Summary statistics of the main variables

Variable Mean Median Std 25th 75th

Pledge ratio (%) 10.33 0.00 19.63 0.00 12.65

% of directors with excess pledged

shares

6.64 0.00 14.32 0.00 5.32

Board shareholding (%) 18.67 14.50 12.84 9.60 23.94

Dummy=1 if the chairman makes

excess pledges

0.0896 0.0000 0.2858 0.0000 0.0000

Dummy=1 if any non-chairman

director makes excess pledges

0.1618 0.0000 0.3686 0.0000 0.0000

Change in pledge ratio between

June and September 2011 (%)

-0.0178 0.0000 8.6932 0.0000 0.0000

Firm characteristics

Market capitalization (in millions

of NT$)

29,204 6,673 111,363 3,070 16,348

Book-to-market ratio 0.6832 0.6329 0.3040 0.4717 0.8584

Past year stock return (%) 14.91 5.49 46.86 -12.78 31.10

Leverage (%) 34.21 32.82 15.66 21.84 45.03

Return on assets (ROA) (%) 10.03 9.08 8.27 5.63 14.29

Note: This table presents the summary statistics of the main variables used in this study. The sample

contains 692 listed firms in TWSE in 2011. Pledge ratio is the percentage of pledged shares over total

shareholdings held by board members. Board shareholding is the shares held by the board divided by

total outstanding shares. Financial characteristics are figures at the year end of 2010.

Table 2: Cumulative abnormal returns (CARs) of portfolios by level of pledge ratio

Panel A. CARs sorted by pledge ratio

Portfolio CAR t-statistics

Difference

in CARs

with Low

t-statistics

(Diff.) N

Mean of pledge

ratio (%)

Highest Fourth

(pledge ratio > 12.65%)

0.37*** 6.86 0.60*** 4.09 172 38.0




19


Highest Third

(pledge ratio > 5.23%)

0.42** 2.50 0.65** 2.38 228 30.9

High

(pledge ratio > 0)

0.35** 2.17 0.58** 2.18 273 26.2

Low

(pledge ratio = 0)

-0.23** -2.17 419 0

Panel B. CARs sorted by board shareholding and pledge ratio

Portfolio CAR t-statistics N

Mean of pledge

ratio (%)

High board shareholding

High pledge

(pledge ratio > 0)

0.55* 1.75 120 23.5

Low pledge

(pledge ratio = 0)

0.07 0.87 226 0

Difference (High-Low) 0.48 1.22

Low board shareholding

High pledge

(pledge ratio > 0)

0.19*** 2.82 153 28.3

Low pledge

(pledge ratio = 0)

-0.58*** -4.19 193 0

Difference (High-Low) 0.77*** 4.06

Note: This table presents the portfolio CARs based on the levels of pledge ratios, as the 2011 Company

Act amendment was passed. The portfolio CARs are estimated using Equations (1) or (2), and the

difference in the portfolio CARs are estimated using Equation (3). Standard errors in OLS regressions are

calculated based on heteroskedasticity-consistent covariance matrix. *, **, and *** denote significance

at the 0.1, 0.05, and 0.01 levels, respectively.

Table 3: Cumulative abnormal returns (CARs) of portfolios by the excess pledged shares of

directors

Panel A. CARs by the excess pledged shares of directors

Portfolio CAR t-statistics

Difference

in CARs

with Low t-statistics N

Mean of pledge

ratio (%)

Highest Sixth

(# of directors with excess

pledged shares

> 16.6%)

0.30*** 3.52 0.35*** 3.60 116 37.0

Highest Fourth


pledged shares

> 0)

0.16** 2.27 0.22** 2.27 174 30.0

Low


pledged shares

= 0)

-0.06** -2.27

518 3.72

Panel B. CARs of portfolios of firms with at least one director having excess pledged shares




20



Mean of

pledge ratio

(%)

# of directors with excess pledged

shares> 0

and chairman with excess pledge

shares

0.78*** 6.77 62 40.32

# of directors with excess pledged

shares > 0

and chairman without excess

pledged shares

-0.17* -1.70 112 24.26

Difference 0.95*** 5.84

Note: This table presents the portfolio CARs based on whether any directors made excess pledged shares

(Panel A) and whether the chairman made excess pledged shares (Panel B), as the 2011 Company Act

amendment was passed. The # of directors with excess pledged shares is the number of directors creating

excess pledged shares divided by the number of board members. The portfolio CARs are estimated using

Equations (1) or (2), and the difference in the portfolio CARs are estimated using Equation (3). Standard

errors in OLS regressions are calculated based on heteroskedasticity-consistent covariance matrix. *, **,

and *** denote significance at the 0.1, 0.05, and 0.01 levels, respectively.

Table 4: Multivariate regressions

Variable [1] [2] [3] [4] [5] [6] [7] [8]

Ln(1+pledge ratio) 0.14** 0.14** 0.15** 0.15** 0.15** 0.14** 0.15** 0.14**

2.27 2.35 2.43 2.36 2.44 2.31 2.41 2.24

0.06 0.05 0.08 0.06 0.06 0.07 0.07 0.08

Excess control board 0.00

-0.70

0.30

Cash flow rights 0.01

1.57

0.22

Deviation of cash flow

rights from control rights

0.01

0.39

0.30

Institutional holdings 0.01**

2.11

0.22

Foreign holdings 0.00

0.41

0.38

Government holdings 0.03

0.92

0.14

CEO duality 0.42

1.18




21


0.09

Ln market capitalization 0.20** 0.22** 0.24** 0.19** 0.09 0.17 0.18* 0.21**

1.96 2.07 2.31 1.99 0.71 1.11 1.78 2.20

0.22 0.20 0.18 0.26 0.40 0.25 0.28 0.21

Book-to-market ratio -0.97** -0.90** -0.96** -0.98** -0.95** -0.98** -0.96** -0.97**

-2.13 -1.91 -2.14 -2.12 -2.15 -2.21 -2.10 -2.12

0.16 0.17 0.16 0.15 0.18 0.16 0.17 0.18

Past year stock return 0.01** 0.01** 0.01* 0.01** 0.01** 0.01** 0.01** 0.01**

2.15 2.14 1.93 2.15 2.09 2.15 2.11 2.13

0.14 0.09 0.12 0.13 0.13 0.14 0.14 0.11

Leverage 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

0.09 0.09 0.15 0.08 0.04 0.07 0.13 0.14

0.46 0.45 0.44 0.49 0.48 0.49 0.48 0.44

ROA -0.01 -0.01 -0.01 -0.01 -0.01 -0.01 -0.01 -0.01

-0.60 -0.62 -0.57 -0.59 -0.75 -0.65 -0.60 -0.56

0.36 0.33 0.35 0.34 0.32 0.33 0.38 0.38

Intercept -2.69* -2.94* -3.64** -2.56* -1.41 -2.23 -2.49 -3.05**

-1.75 -1.81 -2.05 -1.71 -0.80 -1.06 -1.59 -2.02

0.28 0.27 0.20 0.29 0.36 0.29 0.32 0.26

Overall R2 0.05 0.06 0.06 0.06 0.06 0.05 0.06 0.06

N 692 692 692 692 692 692 692 692

Note: This table presents the regression results with the CARs as the dependent variable, as the 2011

Company Act amendment was passed. “Excess control board” is the percentage of board seats occupied

by the controlling shareholders less the controlling shareholders’ cash flow rights. “Cash flow rights” is

the proportion of a firm’s net profits that the controlling shareholders can claim through their direct and

indirect shareholdings. “Deviation of cash flow rights from control rights” is the difference between the

control rights and cash flow rights of controlling shareholders. “Control rights” is the voting right that the

controlling shareholders hold through their direct and indirect shareholdings. “Institutional holdings” is

the shareholdings held by institutions. “Foreign holdings” is the shareholdings held by foreign investors.

“Government holdings” is the shareholdings held by the government. “CEO duality” is a dummy that

takes a value of one if the CEO is also the chairman of a firm, and zero otherwise. The coefficient

estimate, t-statistics, and bootstrapped p-value are provided in each cell of the table. t-statistics are

calculated based on standard errors adjusted for industry clustering. P-values are estimated by bootstrap

method with 1,000 replications. *, **, and *** denote significance at the 0.1, 0.05, and 0.01 levels,

respectively. The bold type denotes the significance for p-value at least at the 10% level.

Table 5: Stock market returns when the 2011 Company Act amendment was passed

Variable

[1]

Passage

October 25 2011

(-1, +1)

[2]

First Discussion

June 8 2011

(-1, +1)

Intercept -0.07 -0.06

(-0.89) (-0.75)

D_Event 2.96** 0.25

(2.29) (0.66)

Note: This table reports the market-wide cumulative abnormal returns (CARs) as the amendment in the

2011 Company Act of Taiwan was passed. CARs are estimated using Equation (4) with an




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equal-weighted portfolio consisting of all 692 sample firms. The first column presents the results for the

event window of the amendment passage, and the second column presents the results for the event

window of the first discussion on the amendment in the Committee of Legislative Yuan. ** denotes

significance at the 0.05 level.

Table 6: Cumulative abnormal returns (CARs) of portfolios by changes in pledge ratio between

June and September 2001


Mean of

pledge ratio

(%)

Highest Decile

(change in pledge ratio > 0.3%)

0.43 0.82 69 37.8

Mid

(-1.57% <= change in pledge ratio <= 0.3%)

-0.09 -1.38 554 5.10

Lowest Decile

(change in pledge ratio < -1.57%)

0.28* 1.66 69 24.8

Difference (Highest-Lowest) 0.15 0.26

Note: This table presents the portfolio CARs based on the changes in pledge ratio between June and

September 2011, as the 2011 Company Act amendment was passed. The portfolio CARs are estimated

using Equations (1) or (2), and the difference in the portfolio CARs are estimated using Equation (3).

Standard errors in OLS regressions are calculated based on heteroskedasticity-consistent covariance

matrix. *, **, and *** denote significance at the 0.1, 0.05, and 0.01 levels, respectively.

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