A separate monitoring organ and disclosure of firm-specific information

Abstract

As the economy is recovering from the recent financial crisis, we explore the appropriateness of a corporate monitoring organ, which is a component separate from the board of directors, to enhance firm-specific information disclosure. Findings of this study, rooted in the evidence from China's stock markets, confirm that having a separate and effective monitoring organ results in a higher level of idiosyncratic risk, as long as the legal environment is sufficiently strong and the functionality of this separate monitoring organ is clearly defined. Effects of regulatory changes and ownership characteristics are addressed to help better understand the corporate governance–idiosyncratic risk relationship. Moreover, this study sheds light on timely global issues about information transparency and supervision, the lack of which becomes one of the major causes of the ongoing financial crisis, and presents an important challenge before corporate governance.

Keywords:

• idiosyncratic risk
• information disclosure
• monitoring
• corporate governance

JEL Classification:

• D82
• G30
• G34
• G38
• M41

Notes

1. One may question whether idiosyncratic risk serves as a valid proxy for disclosure quality in China's markets since it is highly dependent on the CAPM, which measures the expected return–risk relationship in efficient market (Bai et al. 2004). China is among the five fast-growing emerging markets in the world, Brazil, Russia, India, China, and South Africa (BRICS), and should be considered semi-strongly efficient (Barnes and Ma 2001). Cui (2007) tests the CAPM using information from Shanghai Stock Exchange, one of the two major stock exchanges in China, and replicates the Fama and French three-factor model (Fama and French 1993); whereas one-factor CAPM is rejected with a R² of 42.99% (p. 23, Tables 1 and 2), the three-factor model is not (Cui 2007). Nevertheless, CAPM works in China at least as good as it does in more developed markets, and therefore, the idiosyncratic risk may be viewed as a reasonable proxy for disclosure quality in China in more recent years.

2. Note that another important event occurred in 2005 was the split share structure reform (SSSR), which, like the new Corporate Law, may have similar impacts on information disclosure. This is mainly because of shareholders’ improved incentives of monitoring managers. If SSSR were successful, shareholders’ wealth would have become more closely tied to share prices because previously non-tradable shareholders also concerned capital gains or losses when share price fluctuated. Additionally, as shareholders have their representatives on both boards of directors and supervisory boards, they have more observable measures to time their monitoring behaviors, since informational asymmetry between management team and shareholders is significantly reduced by the SSSR. However, according to the Administrative Policies of Split Share Structure Reform of Publicly Listed Companies announced by the State Council of the People's Republic of China on September 4, 2005, the newly liquidated shares were subject to lock-up provisions; they could not be traded in the stock exchanges within 12 months, and no more than 5% of the newly liquidated shares could be traded within 12 months after that and no more than 10% within 24 months. Therefore, the impacts of SSSR on information disclosure of companies listed in China's stock exchanges are expected to be minimal during our sample period.

3. According the GTA's data description file, the total risk is estimated as , where R_t−ln (1+r_t), n is the total number of trading days within a year, and r_t is a stock's daily return including capital gain and dividends at date t.

4. Since it is hard to measure quality of board activities, we follow these previous studies and use their quantities as proxies for board activities.

5. Following the approaches proposed by Chen and Xiong (2002), we calculated Tobin's Q by taking into consideration the existent of non-tradable shares in China's stock exchanges, and used it to retest the models. No qualitative change was found.

6. Such negative association before 2005 may be interpreted by a reverse causality. Corporate Law requires listed firms to disclose certain information to the public, and if this rule is violated, a firm may be punished by the CSRC, and as a result, its supervisory board needs to meet more as a passive reaction (Ding et al. 2010b). Thus, this finding indicates that government-controlled firms tended to disclose less information before the legal environment was improved.

7. Wang, Liu, and Wu (2009) find that, in China's listed firms, more transparent information disclosure leads to lower idiosyncratic volatility, but Xu et al. (2011) do not find such negative relationship. While the relationship between idiosyncratic risk and information disclosure in Chinese stock market has not been concluded, Wang, Liu, and Wu (2009) also report that institutional holdings mitigate the negative relationship between them. In the sample period this study considers, the institutionalization in China's stock exchanges was significantly improved with a great development in mutual funds (Ding et al. 2013). This is confirmed by the negative relationship between supervisory board activities and idiosyncratic risk before 2005 and their positive relationship after 2005.