**2. Conceptual framework and hypotheses development**

#### **2.1. Corporate governance and financial performance**

held corporations trading in US markets, as well as the performance of firms operating under a more rigorous governance environment in other developed countries [8–11]. However, the relationship between corporate governance and the performance of firms operating in the emerging markets has drawn little attention [12–15], while the comparison of crosslisted emerging market (EM) firms issuing American Depository Receipts (ADRs), that are required to abide by SEC restrictions, and non-cross-listed EM firms have received even less [16–19]. In this study, we address the governance – performance relationship for crosslisted (ADR) firms trading on US markets and non-cross-listed EM firms. To do this we use the corporate governance score of companies that is provided by the *Bloomberg Professional* database and corporate governance rules mandated by the *New York Stock Exchange* (NYSE) or the *National Association of Securities Dealers Automated Quotations* (NASDAQ) for firms trading on their exchanges; the rules are identified in Section 303A of the NYSE's Listed

Investors have shown an increasing interest in emerging market countries in recent years. Despite the many evident problems associated with political instability, lacking infrastructure and uncertain property rights protections, the latent potential for substantial growth in these untapped markets is clearly present. Both corporate leaders and politicians have begun to signal their recognition that the influx of capital is the key to sustained economic development and growth. To attract this requisite capital in a competitive global economy, more robust corporate governance standards are beginning to evolve; either by government mandate or through self-imposed corporate standards. To examine the impact of enhanced governance standards on corporate performance, we focus on firms operating in countries identified by Bloomberg's 2014 Emerging Market rankings for which there are available data. In this study we apply a two-step Generalized Least Squares (GLS), random effects model and

Given that emerging market countries are endeavoring to compete for a slice of the global economic pie, this study provides both theoretical insight and practical relevance related to international corporate governance practices and the impact it has on creating and maintaining investor confidence. We find that stronger governance is associated with higher financial performance among the non-cross-listed EM firms, but we were unable find any significant evidence for the cross-listed ADRs. Furthermore, CEO duality has a negative impact on financial performance only for ADR firms, while none of the other governance standards have a significant effect on firm performance. Finally, among cross-listed firms, it appears to be important to separate the chief executive's position and authority from that of the chairman of the board, so that the authority of the board of directors (BOD) is not usurped or mitigated. This is important because it strengthens the mechanisms used to monitor management, which leads to enhanced financial performance. A CEO lacking appropriate oversight by the BOD may have the incentive and certainly the ability to accept investments that self-benefitting, but prove harmful to the firm in the long run [20, 21]. Finally, the findings also reveal that market risk negatively moderates the governance-performance relationship in the emerging markets. As a firm's market risk increases, the positive effect on financial performance associated with strengthening corporate governance significantly declines. The results indicate that strong corporate governance is an important element toward improving

company specific data on a large sample of firms over the 2008–2014 period.

Company Manual.

150 Financial Management from an Emerging Market Perspective

SOX (2002) was established in an effort to mitigate, if not completely eliminate, major corporate scandals. The SEC implemented the new law in 2006 in the form of enhanced corporate governance standards, which are codified in Section 303A of the NYSE's Listed Company Manual and the NASDAQ's Rule 4000 and apply to cross-listed ADRs (in particular to level 2 and 3 ADRs) as well as US domiciled firms. Bonding Theory provides an explanation for the voluntary adoption of these rather rigorous, "best practice" governance rules among EM firms. EM firms have an incentive to "bond" to a regulatory regime with higher standards than their own markets in an attempt to signal a commitment to these standards [22]. From this perspective, US governance directives serve as a global model of "best practices," providing a codified benchmark of corporate transparency, which restrains the self-serving behavior of all stakeholders as well as management [23].

Global investors typically are skeptical when EM firms exhibit good performance, because they are concerned about the accuracy and consistency of their financial reports. In order to provide confidence and attract investors, some emerging markets companies have made impressive strides in their governance over the last decade by "bonding" their companies to globally accepted best practice rules [24]. However, the impact of this improved corporate governance on firm performance remains ambiguous in the extant literature. For example, Brown and Caylor [9] create a corporate governance measure for US firms based on 51 firm-specific provisions over the 2003–2005 period and show that the governance score is significantly and positively related to a firm's value. Chhaochharia and Grinsten [3] run an event study over the post-SOX (2002) announcement period across US firms and, in contrast to Brown and Caylor [9], observe that firms that are less compliant with the new corporate governance rules earn positive abnormal returns compared to firms that are less compliant. Similarly, Aebi et al. [8] examine corporate governance mechanisms and firm performance for the US banking industry during the crises 2007–2008 and show that corporate governance factors (i.e., board independence and board size) are not statistically significant and/or are negatively related to performance. Among cross-listed ADRs, Litvak [18] also finds similar findings to that of Aebi et al. [8]. By comparing the stock price reaction of SOX-exposed ADRs to SOX-unexposed foreign firms, Litvak [18] observes that the impact of SOX on ADRs is negative and that firms that rigorously apply the governance standards experience the greatest declines in their stock prices.

The results reported regarding the governance-performance relationship for US firms as well as ADRs reveal that countries with more developed financial markets do not react significantly to a change in the governance regime. This is partly related to the fact that the costs of complying with these rules outweigh the benefits in markets that are already heavily regulated [3, 18, 19]. In comparison to developed markets, financial markets in emerging countries are relatively inefficient and incomplete. However, in order to compensate for the negative perception of their riskier market conditions, the emerging markets have provided incentives in an effort to strengthen corporate governance so that the interests of all stakeholders are protected (i.e., investors and creditors) [25]. It follows then that we expect that stronger governance to have a positive effect on financial performance among EM firms. Also, based on the evidence in the extant literature, we do not expect to find a significant relationship between governance and performance among cross-listed ADRs. Therefore, we hypothesize the following:

**H1:** Stronger corporate governance will increase financial performance in the emerging markets over time.

#### **2.2. The individual corporate governance standards and their impact on financial performance**

In addition to examining firms' overall corporate governance score with respect to financial performance, in this study we further investigate the impact of four individual governance standards. Three of these standards (i.e., board independence, establishing a formal ethics policy and three committees) are compulsory for all public US firms as well as cross-listed ADRs trading on the NYSE or NASDAQ. While US governance standards are not mandatory for the EM firms, in an effort to minimize the potential for conflicts of interest between major and minority shareholders and to build trust among potential foreign investors, voluntary adoption of these standards has increased during the last decade [26, 27].

While SOX (2002) mandates that listed firms have a majority of independent directors, US governance rules do not require the CEO and the chairman of the board to be held separately. Nonetheless, over the last 10 years, it appears as though American companies began providing a clearer distinction between the responsibilities of management and the board [28, 29]. The academic literature seems to support the distinction: CEOs simultaneously holding the position of chairman of the board are more likely to select board members who fail to qualify as independent [30–32]. Furthermore, separating the CEO role from that of the chairman also separates the interests of the CEO from that of the shareholders [33].

The emerging markets literature is mixed with regard to the impact of Independent Directors and CEO Duality on firm performance. Black et al. [34] examines the relationship between board independence and performance, as measured by Tobin's Q, and finds a positive association between the two variables in Korea, a negative association in Brazil and no association in India. Similarly, Mahadeo [35] uses survey data to test the impact of board diversity on the short-term performance of firms trading on the exchange of Mauritius and finds that a higher proportion of independent directors negatively impacts performance. Nonetheless, the results also provide evidence that companies in Mauritius have been employing "best practices" corporate governance since a mandated code change in 2005. In this case, "best practices" include increasing the number of independent directors and appointing independent board chairpersons to avoid CEO duality. Moreover, Ramdani and Witteloostuijn [36] examine the effect of board independence in addition to CEO duality on the performance of firms in Indonesia, Malaysia, South Korea and Thailand. They find that both having a greater percentage of independent directors on the board and CEO duality positively affects performance. The authors also observe that board size has a negative moderating impact on the positive relationship between CEO duality and performance.

inefficient and incomplete. However, in order to compensate for the negative perception of their riskier market conditions, the emerging markets have provided incentives in an effort to strengthen corporate governance so that the interests of all stakeholders are protected (i.e., investors and creditors) [25]. It follows then that we expect that stronger governance to have a positive effect on financial performance among EM firms. Also, based on the evidence in the extant literature, we do not expect to find a significant relationship between governance and

**H1:** Stronger corporate governance will increase financial performance in the emerging

In addition to examining firms' overall corporate governance score with respect to financial performance, in this study we further investigate the impact of four individual governance standards. Three of these standards (i.e., board independence, establishing a formal ethics policy and three committees) are compulsory for all public US firms as well as cross-listed ADRs trading on the NYSE or NASDAQ. While US governance standards are not mandatory for the EM firms, in an effort to minimize the potential for conflicts of interest between major and minority shareholders and to build trust among potential foreign investors, voluntary

While SOX (2002) mandates that listed firms have a majority of independent directors, US governance rules do not require the CEO and the chairman of the board to be held separately. Nonetheless, over the last 10 years, it appears as though American companies began providing a clearer distinction between the responsibilities of management and the board [28, 29]. The academic literature seems to support the distinction: CEOs simultaneously holding the position of chairman of the board are more likely to select board members who fail to qualify as independent [30–32]. Furthermore, separating the CEO role from that of the chairman also

The emerging markets literature is mixed with regard to the impact of Independent Directors and CEO Duality on firm performance. Black et al. [34] examines the relationship between board independence and performance, as measured by Tobin's Q, and finds a positive association between the two variables in Korea, a negative association in Brazil and no association in India. Similarly, Mahadeo [35] uses survey data to test the impact of board diversity on the short-term performance of firms trading on the exchange of Mauritius and finds that a higher proportion of independent directors negatively impacts performance. Nonetheless, the results also provide evidence that companies in Mauritius have been employing "best practices" corporate governance since a mandated code change in 2005. In this case, "best practices" include increasing the number of independent directors and appointing independent board chairpersons to avoid CEO duality. Moreover, Ramdani and Witteloostuijn [36] examine the effect of board independence in addition to CEO duality on the performance of firms in Indonesia, Malaysia, South Korea and Thailand. They find that both having a greater percentage of independent directors on the board and CEO duality positively affects

performance among cross-listed ADRs. Therefore, we hypothesize the following:

**2.2. The individual corporate governance standards and their impact on financial** 

adoption of these standards has increased during the last decade [26, 27].

separates the interests of the CEO from that of the shareholders [33].

markets over time.

152 Financial Management from an Emerging Market Perspective

**performance**

An application of Bonding Theory leads us to expect that EM firms will likely converge toward a corporate governance structure consistent with that of the US, thereby voluntarily subjecting themselves to a rigorous set of "best practices" rules. Moreover, in this study, we scrutinize the governance – performance relationship over a longer term. Although the short-term effect of these standards on performance might diverge, we expect that, given enough time, EM firms will converge toward a US governance structure, regardless of any compulsory standard. Given that CEO duality is negatively associated with strong corporate governance structure, while board independence is positively associated with strong governance among US firms, we expect to find a positive relationship between strong governance and performance in the emerging countries, and hypothesize the following:

**H2:** A higher proportion of independent directors on the board will increase the financial performance of EM firms over time.

**H3:** CEO duality will result in decreased financial performance for EM firms over time.

In accordance with SOX (2002), listed companies in NYSE and NASDAQ must have nomination, compensation and audit committees to identify potential courses of action for the board of directors [37]. The nomination committee directs the process governing board appointments and provides recommendations regarding candidates for directory positions [38]. The compensation committee exists to oversee the process by which bonuses and salaries are awarded to senior executives or other employees to prevent gratuitous compensation. The board of directors relies on audit committees to manage internal controls, risk management and financial reporting. In general, committees are assigned specific roles and responsibilities with the intention of improving a firm's governance and enhanced governance should increase investor returns through higher stock prices. Research suggests that there is a positive association between the committee structure of boards and firm performance among US firms [39]. Still, studies also reveal that as the percentage of outsiders on these boards increases, financial performance decreases [40]. On the whole, there remains a considerable gap in the governance literature and therefore little guidance for policymakers regarding the importance of board committees for effectively enhancing firm performance [41].

According to SOX (2002), listed firms also are required to establish a well-defined ethics policy and code of conduct for directors, officers and employees that clearly identifies the applicable rules of behavior as well as the various responsibilities of every employee in the organization. Donker et al. [42] examines the relationship between the corporate ethics behavior of firms and the performance of Canadian firms listed on the Toronto Stock Exchange. They find that by establishing a code of ethics, a company increases profitability. If a firm applies a code of ethics effectively, individual and organizational dilemmas can be resolved promptly. This, in turn, increases the efficiency of the decision-making process. Furthermore, corporations that effectively apply an ethics policy improve their image and reputation, which likely produces a positive effect on financial performance. Overall, we expect that EM firms will adopt a bonding strategy and subject themselves to a more robust governance structure, resulting in the establishment of a greater number of committees that support the board of directors. Additionally, firms will forge formal ethics policies to enhance the decision-making process as well as their market image. In line with the findings in the extant literature, and following Bonding Theory, we hypothesize the following:

**H4:** EM Firms with a greater number of committees will exhibit better financial performance over time.

**H5:** EM firms with formal ethics policies will exhibit better financial performance over time.

#### **2.3. The moderating effect of risk on governance-performance relationship**

Prior literature documents a negative relationship between contemporaneous risk and governance; perhaps because establishing an effective corporate governance regime protects shareholders and creditors and serves to reduce the expropriation of power by managers and controlling shareholders [43–45]. Earlier studies also document risk as an important determinant of a firm's financial performance [46, 47]. For firms in the emerging markets, however, identifying an appropriate measure of risk can present problems when estimating the cost of capital because of the time-varying nature of the integration of these markets into the global economy. Nonetheless, the exposure of a firm to the risks inherent in its local market remains an important element of the overall risk assessment [48–50]. Although, research has demonstrated that both market risk and governance have a significant impact on the financial performance of firms, it remains necessary to develop a more complex and dynamic theoretical model than has been previously considered; a model that reflects how market risk moderates the governance-performance relationship in the emerging markets. We therefore posit the following hypotheses for each of the aforementioned governance indicators:

**H6:** Greater market risk negatively moderates the relationship between an EM firm's governance score and its financial performance over time.

**H7a:** Greater market risk negatively moderates the relationship between an EM firm's independent directors and its financial performance over time.

**H7b:** Greater market risk positively moderates the relationship between CEO Duality and financial performance among EM firms over time.

**H7c:** Greater market risk negatively moderates the relationship between number of committees and financial performance among EM firms over time.

**H7d:** Greater market risk negatively moderates the relationship between the presence of an ethics policy and financial performance among EM firms over time.
