Does the Reputation of Independent Non-executive Directors Matter: Evidence from Hong Kong

1. Does the Reputation of Independent Non-executive Directors Matter: Evidence from Hong Kong Roger King and Winnie Qian Peng, HKUST NTUICF, December 2006

2. Outline • Motivation • Literature Review • Hypotheses Development • Scoring and ranking • Data Sources • Findings • Conclusion

3. Motivation • Post Enron - Shareholders and regulators are demanding greater corporate transparency. • Literature suggests that Independent Non-executive Directors (INED) play an important role in monitoring management and enforcement of transparency, then does INED’s personal reputation matter? • This paper examines shareholders’ response to appointments of INEDs in Hong Kong – a society where corporate ownerships are concentrated and personal reputations are highly valued.

4. Motivation - Continued More specifically, the paper examines the market’s reaction to the appointments of prestigious INEDs at specific events: • IPO – certification • Change in regulatory requirement – CAR • Unexpected resignation with replacement - CAR

5. Motivation - Continued Background of Hong Kong • Its basic culture philosophy follows the traditional Chinese Confucian values where personal reputation and relationship are highly valued. • High legal protection for investors. • Stock exchanges are globally recognized (ranked 4th by equity fund raised for the year 2005 and ranked 9th by market capitalization). • High transparency - the Security Exchange of Hong Kong, SEHK, has mandated that all firms, after March 31, 2004, must have at least 3 INEDs. • Other major capital markets have similar characteristics

6. Literature Review – INEDs • Fama (1980) states that INEDs can play an important role in monitoring management actions • Shivdasani (1993) suggests that the number of additional board seats held by the appointee as a measure of an individual director’s reputation. • Mace (1986) claims that board directorship can be a source of prestige and business contact and induce CEOs to accept outside directorships.

7. Literature Review – information asymmetry • Rock (1986) posits a model that investment bankers will maintain an equilibrium level of underpricing. • Beatty and Ritter (1986) extended Rock’s model and show that underpricing should be related to the level of ex ante uncertainty. • Carter and Manaster (1990) provide empirical evidence that prestigious underwriters are associated with marking of low risk IPOs and have lower IPO returns.

8. Literature Review - signaling • Fich (2005) suggest that appointment of outside CEOs as outside directors signal the market that the prospect of the appointing firms are favorable – certification of future prospect of the firm. • Allen and Faulhaber (1989), Grinblatt and Hwang (1989), and Welch (1989) suggest that firms with good future prospects use underpricing to signal quality in which bad quality firms would not mimic.

9. Hypotheses At IPO • H1a: There is negative relationship between the prestige of individuals appointed as INEDs at the time of IPO and the perceived risk of the firms. • H1b: The appointment of prestigious INEDs signal firm quality thereby reduces IPO underpricing.

10. Hypotheses - continued At Regulatory Change • H2a: Better performing and less risky publicly listed firms (seasoned stocks) are positively related to prestigious INEDs • H2b: The market reacts positively whenever prestigious, non-busy individuals are appointed to the board

11. Hypotheses - continued At Replacement • H3: The market reacts negatively (positively) when a prestigious (less prestigious) INED resigns prematurely from the firm and is replaced by a less (more) prestigious INED.

12. Scoring and Ranking • INEDs • Auditing firms • Underwriters

13. Scoring and Ranking - INEDs • INED database of current 2,411 INEDs (61.4% of the total number), and past 1,515 INEDs (38.6% of the total number), of Main Board listed firms of the HKSE as of December 31, 2005. • Identify each (executive and non-executive) position held by these INEDs. Of 3,926 INEDs, there are a total of 148 different position descriptions or job titles. From this job title list, we consolidated the various position descriptions to 14 titles and assigned weight factors to each (see Table 1).

14. Scoring and Ranking – INEDs (continued) • Table 1

15. Scoring and Ranking – INEDs (continued)

16. Scoring and Ranking – INEDs (continued) The results of this scoring scheme are as follows. • The individual score ranged from a high of 118.5 to a low 0.5 with a mean of 6.00, median of 3.00 and a standard deviation of 7.23. • There are a total of 509 (12.7%) individuals with a score of 11.0 or better – Tier 1. • The next 1,194 (29.8%) individuals scored better than 3.0 – Tier 2 • Rest, 2,306 (57.5%), scoring 3.0 or less – Tier 3.

17. Scoring and Ranking - auditors • Similar to Michaely and Shaw (1995) – three tier scheme. • Assign the Big-Fours to Tier-1 (most prestigious) auditors. • To differentiate the Tier-2 auditors from the Tier-3 (least prestigious) auditors, ask 10 Hong Kong accounting professional to segregate all non-Big-Four IPO auditors,, into two distinct groups according to their perceived market reputation. • Calculate the auditors’ ranking based on the number of their IPO clients and total funds raised. • Combined the two approaches

18. Scoring and Ranking – auditors (continued)

19. Scoring and Ranking - underwriters • 76 separate lead underwriters involved in 348 new issues between the years 1998 and 2005. • Underwriters are separately ranked according to the number of leads and according to the amount of funds raised. • The two rankings are then combined to establish a score. • The subgroup with the lowest score is designated Tier-1 (25 firms) and the subgroup with the highest score designated as Tier-3 (25 firms).

20. Scoring and Ranking – underwriters (continued)

21. Data sources • Hong Kong Stock Exchange website (www.sehk.com.hk): • Company prospectuses (4/1/1999-2005) • Listing Matters and Listed Companies - Auditors' Reports with "Qualified Opinion" and/or Explanatory Paragraph - Main Board (financial year ending December 31, 1997 - May 31, 2005) • Listing Enforcement Notices/Announcements (2001-2005) • Status Report on Delisting Proceedings and Suspensions, New Listing Report - Main Board (1994-2005) • Investment Service Centre - Prolonged suspension status report (Main Board); • Datastream • Worldscope • David M. Webb (www.webb-site.com.hk)

22. Key findings: Firm-level descriptive statistics of IPO study

23. Key findings: Descriptive statistics of INED appointment study

24. Key findings: CAR for “required” and non-busy INEDs

25. Key findings: Descriptive statistics of INED replacement study

26. Key findings: Regression for the IPO study √ √ √ √ √ √ √ √

27. Key findings: Regression for INED appointment study

28. Key findings: Test of difference of means of CAR for INED replacement

29. Conclusions and limitations • Developed a method to score INEDs’ reputation • Prestigious INEDs on the board, the IPO underpricing is reduced – the key contribution of this study • Prestigious INEDs are positively correlated with high quality firms. • Market reacts positively to new appointments of non-busy, prestigious INEDs. • Hong Kong shareholders and investors are indifferent to the reputation INEDs replacing other INEDs.