The relation between the corporate governance evaluation and abnormal returns: the role of company financial performance

ABSTRACT

This research investigates the association between the upgrade/downgrade of rankings in corporate governance evaluation exercises and stock price reactions. Using Taiwan equities as the research setting, this study finds that firms receiving an upgraded (downgraded) ranking from corporate governance evaluation exercises do not experience significantly positive (negative) abnormal returns, but there is actually a positive (negative) correlation between such an upgrade (downgrade) after these evaluation exercises as well as abnormal returns under the condition of better company financial performance. This study contributes to the extant literature by shedding additional light on the correlation among corporate governance evaluation exercises, abnormal returns, and company financial performance.

KEYWORDS:

• Corporate governance evaluation
• upgrade/downgrade
• abnormal returns
• financial performance

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1. TWSE is the abbreviation for Taiwan Stock Exchange Corporation, and TPEx is the abbreviation for Taipei Exchange Corporation.

2. SFI is a non-profit organization established on 29 May 1984 by the Taiwan government. This organization operates in conjunction with national economic growth policies to guide investment activities, promote academic and practical research in the domains of securities and futures, strengthen services for investors, provide a comprehensive array of information, and enhance the sound development of financial markets domestically.

3. FSC was established on 1 July 2004 as the competent authority responsible for the development, supervision, regulation, and examination of financial markets and financial service enterprises in Taiwan. FSC seeks to ensure safe and sound financial institutions, maintain financial stability, and promote the development of the country’s financial markets. Since its establishment, its main goals have been to create a sound, fair, efficient, and internationalized environment for the financial industry, strengthen safeguards for consumers and investors, and help the financial industry achieve sustainable development.

4. However, a listed company shall be excluded from the evaluation rankings if any of the following circumstances happened within the period under evaluation and before the announcement of the evaluation results: (1) A company was listed for less than 1 year during the period evaluated. (2) A company’ securities have been placed under an altered trading method. (3) A company’s securities are subject to a suspension of trading. (4) A company’s securities have been delisted. (5) Other grounds for exclusion from evaluation as resolved by a meeting of the Corporate Governance Evaluation Committee.

5. The purpose of this study is to explore the correlation between the upgrade/downgrade of ranking in the corporate governance evaluation exercises and abnormal returns (AR), and so I have to use the evaluation exercise’s announcement of all evaluated companies. For instance, if firm A is not in the top 20% of the best TWSE/TPEx-listed companies in the first year’s evaluation, then firm A ranks between 21% to 100% in the first year’s evaluation. However, if firm A is in the top 50% of the best TWSE/TPEx-listed companies in the second year’s evaluation, then firm A may be one firm that receives an upgrade, downgrade, or no change of ranking, meaning the study cannot correctly define firm A. As a result, the study only utilizes the data from 2016 to 2017, because in the years 2016 and 2017, the FSC publicized its ranking of all evaluated companies.

6. In 2018, FSC combined the dimension of protection of shareholders’ equity and the dimension of equitable treatment of shareholders into one dimension: protection of shareholders’ equity and equitable treatment of shareholders. Therefore, considering the comparison of each year, it is not suitable for the paper to extend the research period to 2018.

7. The findings from Taiwan studies built upon the efficient market hypothesis (EMH) are inconsistent due to different research methods and different sample periods. In particular, many studies conducted in Taiwan do not fit the weak form of EMH (Chen, Chen, and Cheng 2006). Furthermore, several studies have asserted that the Taiwan stock market fits the semi-strong form of EMH; for instance, Hsiao et al. (2014). Therefore, this study assumes Taiwan exhibits this semi-strong form of EMH, and so stock prices reflect all publicly-available information. As a result, I use abnormal returns (AR) of evaluated companies on announcement day, 2018/4/30, to explore my hypotheses. In addition, I calculate cumulative abnormal returns (CAR), including event windows; i.e., (0, +1), (−1, 0), (−1, +1), (−2, +2), and (−5, +5); and I find that H1 and H2 are not supported for all aforementioned windows. The results support my assumption that the Taiwan stock market fits the semi-strong form of EMH again, meaning the Taiwan stock market has the semi-strong form of EMH, and that stock prices in Taiwan reflect all publicly-available information. Hence, using cumulative abnormal returns (CAR) of longer event windows do not support my hypotheses. Taken together, using abnormal returns (AR) of evaluated companies on announcement day to examine H1 and H2 is an appropriate way.

8. The evaluation results in the third and fourth evaluation exercises are announced by SFC, which lists the evaluation results into seven grades: (1) above 5%; (2) 6%~20%; (3) 21%~35%; (4) 36%~50%; (5) 51%~65%; (6) 66%~80%; and (7) 81%~100%. If the movement of the firm is upgrade (downgrade), for example, from grade 2 (1) in the third evaluation exercise to grade 1 (2) in the fourth evaluation exercise, then I set ‘RANK’ to 1 (0).

9. This paper does not consider the endogeneity problem that the dependent variable and the independent variable exhibit mutual causality, because the announcement of corporate governance evaluation rankings occurs before the investors react to stock prices.