This article is excerpted from Professor Luo Jinhui from the Accounting Department/Accounting Development Research Center of Xiamen University School of Management and Dr. Yao Yue from the Accounting Department of Xiamen University School of Management, entitled "Does the reputation mechanism apply to independent directors in emerging markets? Evidence from China”, which was published in the first issue of Volume 16 of China Journal of Accounting Research in 2023.

01

introduction

In the past 20 years, a large number of emerging market countries have asked listed companies to hire independent directors as an important part of corporate governance structure with reference to the practices of developed countries. In developed countries, a good reputation will bring more job opportunities to independent directors, and reputation constraint is usually considered as the most important factor to promote independent directors to perform their duties. However, unlike developed countries, in emerging market countries such as China, on the one hand, due to the weak legal protection of investors, the controlling shareholders of the company are likely to infringe on the interests of small and medium-sized investors through tunnel behavior, and the market lacks independent directors with good reputation; On the other hand, listed companies generally have controlling shareholders, who usually choose independent directors themselves. So in emerging market countries, can independent directors with good reputation also effectively improve corporate performance and corporate governance?

02

The Influence of Independent Directors' Reputation on Corporate Performance and Corporate Governance

This paper holds that, first of all, paying attention to reputation will encourage independent directors with good reputation to supervise the management behavior of the company more effectively and limit the encroachment of controlling shareholders on the interests of minority shareholders, so as to reduce the agency problem of the company and improve the company's performance. Secondly, independent directors with good reputation usually have excellent professional knowledge and skills and a wide social network, which can help companies improve their operational capabilities, obtain government support or bank loans, and win additional business investment opportunities, thus improving the company's performance. In addition, in order to cover up their opportunistic behaviors, company managers tend to provide financial reports with low transparency, and independent directors with good reputation can help companies improve the quality of their financial reports, so as to release positive information about good corporate governance to external stakeholders. Therefore, this paper predicts that the reputation of independent directors is positively related to the company's performance, but negatively related to the agency cost of the company.

Referring to previous literature, this paper uses the number of independent directors as independent directors to measure the reputation of independent directors. At the company-annual level, this paper measures the reputation of independent directors of a company by the average number of positions held by all independent directors of the company. In terms of corporate performance, this paper uses three indicators to measure the return on net assets, total assets turnover rate and total factor productivity. This paper also uses the first kind of agency cost, the second kind of agency cost and cash dividend to measure the supervision effect of independent directors. At the same time, this paper also measures the quality of the company's financial report by using whether the auditor issues non-standard opinions and whether the company has financial information disclosure violations, so as to provide evidence. The empirical results show that companies with independent directors with good reputation will have better corporate performance, lower the first and second kinds of agency costs, provide more cash dividends, receive non-standard opinions and have lower probability of financial information disclosure violations.

03

What kind of company will hire reputable independent directors?

Because the choice between independent directors and listed companies is two-way, this paper expects that independent directors with good reputation will prefer the services of large companies and state-owned enterprises that provide them with more visibility and benefits. At the same time, this paper also expects that enterprises in a competitive environment will be more eager to hire independent directors with professional knowledge, extensive contacts and good reputation. In addition, companies with larger board of directors naturally increase the probability of hiring independent directors with good reputation. In line with the expectation of this paper, this paper finds that companies with large board of directors, state-owned enterprises, large-scale companies with more free cash flow, and companies in highly competitive industries or areas with high degree of marketization are more likely to hire independent directors with good reputation.

04

The influence of document No.18

On October 19th, 2013, the Central Organization Department issued "Opinions on Further Standardizing Part-time Jobs of Party and Government Leading Cadres in Enterprises" (referred to as "Document No.18"), stipulating that party and government leading cadres who are currently serving or not serving but have not gone through retirement procedures are not allowed to take part-time jobs in enterprises, which triggered a wave of resignation of independent directors of A-share listed companies. Therefore, this paper further examines whether this policy will affect the main findings of this paper. The results show that the policy will lead to the resignation of independent directors who hold multiple independent directors' positions and are more concerned about their reputation, so the influence of independent directors' reputation on company performance is basically effective only before the policy is introduced. This result further supports the main point of this paper, that is, reputation concern will encourage independent directors to effectively play their governance role and improve corporate performance.

05

Cross section analysis

In this paper, a series of cross-sectional analysis are carried out. Firstly, this paper explores whether the reputation mechanism of independent directors is related to the unique institutional environment in China. This paper selects three factors related to China's institutional environment: (1) market-oriented environment; (2) the nature of property rights; (3) Political ties. The results show that the reputation of independent directors will be able to play a more positive role, that is, to make up for the lack of institutional environment, when the formal or informal institutional environment in China is relatively weak.

Another set of cross-sectional analysis aims to explore how independent directors, as an internal governance mechanism, will interact with other external governance mechanisms. This paper selects three variables of external governance mechanism: (1) the degree of product market competition; (2) Number of analysts tracking; (3) The shareholding ratio of institutional investors. The results show that when the external governance level of the company is weak, the reputation mechanism of independent directors will play an important role, that is, there is a substitution effect between the internal governance mechanism and the external governance mechanism.

06

conclusion

This paper explores whether independent directors with good reputation can effectively perform their duties in emerging market countries with weak legal protection for investors. The results show that independent directors with good reputation will improve the company's operating performance and corporate governance. Further cross-sectional analysis shows that when the formal or informal institutional environment is weak and the external governance level of the company is low, the reputation mechanism of independent directors plays a stronger positive governance role, showing a substitution effect.

The conclusion of this paper shows that even in emerging market countries, reputation mechanism can make independent directors actively perform their duties. Moreover, the reputation mechanism of independent directors can make up for the lack of formal or informal institutional environment in emerging markets and the lack of external corporate governance mechanism, and play a more effective role. The conclusion of this paper will provide important enlightenment for investors looking for high-quality investment opportunities and policy makers eager to improve the quality of corporate governance.