Do corporate governance, independent boards, and auditors affect market and financial performance? An application to the Istanbul Stock Exchange.

Introduction

The ongoing process of globalization and liberalization has led to significant changes in the relationships between the participant groups and corporate structures. Among the most remarkable reasons for change is the increasing ownership of equity shares by institutional investors. Increases in international portfolio investments and other progresses accomplished in the privatization processes have boosted the number of investors. As they gained experience participating in the market, these investors became well informed, and the conditions for acquiring information on the operations, financial position, performance and development phases of companies on a regular basis, began to improve. Market participants began to demand a voice in corporate governance to protect their rights.

The relationship among the company's participants, which is dependent on certain principles and standards, is defined as "principles of corporate governance." The principles of corporate governance are based on a new structural process that enables profitability, development and compatibility that the companies target in their main sectors. The principles and standards of corporate governance set the nature of the relationship among shareholders, members of board of directors, managers, employees and other corporations and persons with whom the company has business links. They mainly protect the rights of the company and its participant groups, and specify their obligations. Therefore, corporate governance principles are important in terms of establishing the rights and obligations of the said groups, and ensuring investor confidence. Such principles also ensure the establishment of a mutual supervision system between the company managers and the shareholders.

Analysis of the Relationship between Corporate Governance Principles and Performance

Purpose of the Survey. The purpose of the survey is to determine the extent to which the corporate governance principles are practiced by the ISE traded companies and the ISE member firms.

Method. The questionnaire was prepared on the basis of corporate governance principles developed by the OECD. The questionnaire forms were sent by mail to the companies traded on the ISE and the member brokerage firms of the ISE. For ease of assessing the questionnaire forms, questions related to the governance principles were gathered under five sections and the responses to the questions were evaluated under two groups, denoted as "1" or "0". The responses were accepted as "1" if the company stated that it practices corporate governance principles; otherwise the response was denoted "0". A company's responses to each question and each group of questions revealed the degree to which it was applying corporate governance principles.

In the analysis of the questionnaire, the relationship between corporate governance principles and standards and the financial structure and performance of the companies were determined. For this purpose, five subgroups were created in accordance with the responses to questions gathered under each group.

* The rate of corporate governance principles practiced 100% -- (Group 5)

* The rate of corporate governance principles practiced at high level -- 75 % and above (Group 4)

* The rate of corporate governance principles practiced at upper middle level -- between 50% and 75% (Group 3)

* The rate of corporate governance principles practiced at less than middle level -- between 25% and 50% (Group 2)

* The rate of corporate governance principles practiced at low level -- below 25% (Group 1)

The relationship between the level of corporate governance principles practiced, financial performance, financial liquidity, profitability and dividend policies were examined. Financial ratios of total debt/total assets, current ratio and net profit margin, gross profit margin and return on equity were used as criteria for financial structure, liquidity, and profitability, respectively.

Sample size. The level of participation in the survey by the ISE traded companies and the ISE member brokerage firms was quite high, as 358 out of the total of 513 companies gave responses to the questionnaire. Accordingly, the responses of 56% of the ISE member brokerage firms and 79% of the ISE traded companies were evaluated. The total sample size corresponds approximately to 70% of the ISE traded companies and ISE member firms. We can assume that the analysis of the survey results reflects the entire market, in general.

Findings

General. The questionnaire responses of the ISE traded companies and member firms are summarized in Exhibit 3. The analysis shows that 52% of the sample were aware of the corporate governance principles. However, the level of practicing such principles is quite low.

The governance principles implemented by the ISE traded companies at high levels are as follows: re-election of members of board of directors (61%), General Assembly's approval of legal auditors' financial rights (57%), disclosure of relevant information to the shareholders and having responsibilities in other companies belonging to the same group (56%). The corporate governance principles implemented by the ISE member firms at high levels include: re-election of members of board of directors (92%), establishment of employee foundations/ funds (69%), disclosure to shareholders (69%) and existence of an inspection unit (77%).

Independence of the Management. The results of the questionnaire reveal that it is a common practice for the members of board of directors to be re-elected. Executing other functions within the company and at the other related companies of the group impedes the application of principles on independence of the management.

On the other hand, the structure of the board of directors tends to be more centralized due to the existence of kinship among the board members.

Inter-Company Inspection and Auditing

Maintaining an inspection and an auditing system has a crucial importance on the company's performance. However, companies must further comply with the issues related to this principle. The application of such principles should be widespread due to the lack of inspection units or auditors appointed on a temporary basis for auditing specific issues and the very low number of lawsuits filed against the board members by the legal auditors. (See Exhibit 2.)

The Link between Corporate Governance and Performance: The Role of Independent Management and Auditors

In this part of the study the link between corporate governance and performance, the role of independent management and auditors are examined. One of the questions asked most often about corporate governance--and one of the hardest to answer--is how such activities affect the level of corporate performance. In many studies accounting and market data are used for performance measures. Also ROE, ROA and Tobin's Q are primary measures. Below there is list of corporate governance and performance studies.

The link between corporate governance and firm performance was examined in manufacturing industry for being a sector having the greatest number of firms. Before evaluating the link between corporate governance and performance, we used the hypothesis tests to find whether the firms applying corporate governance are bigger in terms of average market capitalization.

The results indicate that the average market capitalization of group 3 that apply corporate governance principles at a higher level is statistically different and bigger than that of the group 2. Thus we can declare that as firms get bigger in terms of market capitalization, they apply corporate governance principles at a higher level.

Corporate Governance and Market Performance Analysis.

Market performances of the groups 2 and 3 were calculated due to adjusted and cumulative adjusted returns, where;

[AR.sub.t] = 1/n [n.[summation]][ar.sub.it] [ar.sub.it], is the adjusted return and,

[CAR.sub.1,s] = [s.summation over (t=1)][AR.sub.t] is the cumulative of the AR.

Financial Structure and Profitability in the Manufacturing Industry. In the analysis of the financial situation of the firms, the total liabilities and the ratio of the total liabilities to total assets representing, to a certain extent, the long-term financial risk, as well as the share of short-term liabilities in total liabilities was calculated. In addition, return on equity, return on assets, and net profit margin ratios were used for assessing the profitability performance criteria of firms.

Corporate Governance and Financial Structure. The debt ratio is defined as the ratio of total debt over equity. As 2000 and 2001 were the years of a financial crisis in Turkey, after that period, with the increasing growth, the firms began to use more debt to finance their investments. Group 3, which represents firms implementing corporate governance principles, has a higher debt ratio than group 2, which indicates that the firms in the first group (group 3), have a greater opportunity to obtain a loan. The financial leverage of group 3 is smaller than the financial leverage of group 2. Considering that the debt ratio of group 3 is greater, we can say that the asset quality of group 3 is better than group 2.