CORPORATE GOVERNANCE AND DEBT TO EQUITY RATIO

Themistokles Lazarides 1 , Elektra Pitoska 2

Abstract

Capital structure, especially in the cases of the countries that belong in the Continental Europe system of Corporate Governance has a
significant impact on the way that the firm is structured, organizationally, strategically and functionally. The decision to use the capital
market or debt in order to obtain the necessary capital to finance firms’ operations is a critical factor for the formulation of corporate
environment, because it contributes to the ownership concentration or diffusion and to corporate risk exposure level. Debt aggravation
is measured by the ratio “Debt to Equity”. Panel data methodology is used. The hypothesis that are tested: a) is debt aggravation
affected by the quality of corporate governance, the structure and composition of the Board of Directors, firm’s size, and other factors,
b) are the factors that affect debt aggravation in Greece the same with the ones that are delineate in the literature for the Anglo-Saxon
countries.
Debt aggravation is statistically affected by performance, organizational structure and firm size. These findings are compatible with
the literature. The innovative finding is that variables like Corporate Governance Index (CG), Mergers and Acquisitions (Merger),
Major shareholder is the CEO (OWNCEO) and den dismissal or resignation of, executive, non executive (BDIS_P) and independent
members of the Board of Directors are not statistical important. Corporate Governance does not seem to have any statistical important
impact on capital structure and this conclusion is the opposite of the relevant studies of Shleifer and Vishny (1997) and Vilanova
(2007). Greek firms seem to favor debt as a mean of finance, instead of capital-share issues.

Keywords: Corporate governance, Debt aggravation, Greece

JEL Classification: G32, G34, G39

1. Introduction

Empirical surveys that studied ownership concentration and performance investigate debt aggravation as a substitute
or complement to equity ownership or as a fundamental element of capital structure (i.e. Jensen and Meckling, 1976
for the basic theory 3 ). Aguilera and Jackson (2003) argue that lack of liquidity in capital markets in countries that
have the characteristics of the Continental Europe system of corporate governance have the tendency to depend
more on debt.
Debt aggravation and capital structure affects the decision making process. If the firm depends on its profits to
finance its growth, then in short-term the expected growth should not be a great one, due to the large amount of time
needed to raise the necessary capital, to invest it and to obtain profits. If the firm can raise capital through issuing
new shares for current stockholders, then this increases the commitment or risk of the current shareholders on the
firm. If the firm can raise capital through issuing new shares for new stockholders, then the percentage of equity
holdings of the old shareholders is decreased and the possibility of power and control loss is increased (this option
has the same effects as the Mergers and Acquisitions (MA)).
As Harris et al. (1988) argue “Debt reduces the expected benefits of control for several reasons. First, it
increases the probability of bankruptsy, an event that implies the loss of all benefits of control. Second, debt
contracts often include restrictive covenants that limit management's ability to reap the benefits of control. Third, as
Jensen (1986) points out, the commitment to pay out future cash flows entailed by the debt constitutes a constrain on
the control exercised by management and, hence on its benefits”. So, why Greek firms rely more on debt that own
capital?
Debt – liability increase does not create directly monitor and control rights on management or limitations for the
decision making process. Hence, the dominant group can select and implement the strategy, organizational scheme
and asset allocation that they see fit to their expectations and goals. Furthermore, debtors don’t have the same legal

1
Department of Applied Informatics in Administration and Economy, Technological Institute of West Macedonia,
Grevena, Greece, themis@themis.gr, tlazarides@teikoz.gr
2
Department of Financial Applications, Technological Institute of West Macedonia, Koila, Kozani, Greece,
ilpitoska@yahoo.gr
3
See as well Schauten and Blom (2006); Piot and Missonier-Piera (2007); Chan-Lau, Jorge A., (2001); Jiraporn and
Kitsabunnarat (2007).

Electronic copy available at: http://ssrn.com/abstract=1408408

mechanisms to influence or to determine the decisions made by the board of directors or other managerial
mechanisms.
The hypothesis the paper tests are: a) is debt aggravation affected by the quality of corporate governance, the
structure and composition of the Board of Directors (BoD), firm’s size, and other factors? b) are the factors that
affect debt aggravation in Greece the same with the ones that are delineate in the literature for the Anglo-Saxon
countries?

2. Corporate Governance status in Greece

Greek firms are mainly family or controlled by a group of stockholders. Free float is relatively small in percentage
(20-50%) and the ability to achieve control through capital market is limited. The members of the family or the
controlling group are actively involved in management and normally, there is no distinction between management
and ownership. The Board of Directors can be characterized as one tire. Managers, that are not members of the
family or the controlling group, are closely connected with these groups and their decisions are subjected to their
control and monitor. Institutional investors, although they were the catalyst for the adoption of CG mechanisms,
have not actively been involved in management or in controlling and monitoring the decisions and actions of the
controlling group.
Spanos (2005) argues that “the majority of medium and small capitalization (family-owned) companies have
adopted the minimum mandatory requirements and lack further efficient CG mechanisms. Such as the competition
for capital is increasing, the listed companies have to realize that proper CG is a prerequisite in order to attract
international capital. Moreover, corporate governance may meet one of the most significant challenges that family-
run businesses face: management succession”. The need for CG mechanisms is identified by all market participants
as a substitute for trust (as a bonding and problem solving element) among the major stockholders or family
members, but they cannot agree on what the mechanisms / processes are going to be. Also, there are strong resistive
forces, mainly by the major stockholders / family members who are not willing to pass power and information to
non “trust worthy” stock holders or professional executive managers. As a result the governing / administrative
bodies do not function according to statutes or laws and the processes that they provide, but according to the
common will of the family members. Furthermore, a market for corporate control and a market for board members
and executives are effective.
The Board of Directors is mostly acting as a passive body in the company where it follows the decisions of the
management. Non-executive board members should be acting as shareholders’ agents, but, in reality, they do not
efficiently supervise managers (Schulze et al., 2003). This is the case for the majority of the (family or not) public
companies in Greece, where significant costs are the result of bias in favoring family interests over the firm’s
interests (such as non-family shareholders), due to the loyalty toward the family (Schulze et al., 2003). Even though
rules mandate specific requirements regarding board independence, it’s difficult in practice to identify whether the
board meets these rules (Spanos, 2005). Countries with concentrated ownership structure (continental Europe, Japan
and other OECD countries) and large dominant shareholders, usually control managers and expropriate minority
shareholders, in order to extract private control benefits. The agency problem of CG is therefore posed as how to
align the interests of strong blockholders and weak minority shareholders (Spanos, 2005, p. 16; Becht, 1997). CG
mechanisms and processes should be directed to address this issue and not the agency problem. If the mechanisms
that are proposed or enforced do not address the real CG issue in Greece then the reaction will be to deny
compliance or to idle them, using pretexts and contra mechanisms.
On the other hand, investors usually use their exit options if they disagree with the management or if they are
disappointed by the company’s performance, signalling – through share price reduction – the necessity for managers
to improve firm performance (Spanos, 2005, p. 16; Hirschman, 1970). The lack of market liquidity creates problems
in the effectiveness of the shareholders exit option and governing problems (since the main governing body is the
general shareholders meeting, but participation is not an easy task). The cost of involvement with management and
control for the minor stockholder is greater than the cost of exit and so they may easily choose to sell their stock
(“they vote with their feet”) if they are not content with the managements’ choices. The shareholders encirclement
does not necessarily mean participation in the company administration. Moreover, family firms disclose less
narrative information than non-family firms, where family-firms may disclose more information than non-family
firms in some selected areas of interest, such as data information about share price policy and number of diagrams
used in the interim report (Mavridis, 2002). In countries where business has traditionally been based on relationship
and trust, corporate information is thought of as secret; and it is accepted practice to keep different sets of books,
e.g. one for taxes, one for outside investors, and one for the majority shareholder (Fremond and Capaul, 2002, p.

Electronic copy available at: http://ssrn.com/abstract=1408408

18). There is a vicious circle whereby managers consider secrecy as imperative so that shareholders do not vote with
their feet and through it they can cover up their lack of efficiency or impotence; minority shareholders (major
shareholders already have the information because they are members of the BoD, management or the relevant cost
for them is not too high) do not actively demand information because the cost of acquiring and processing it is to
high for them.
As it seems, debt aggravation is a feasible and preferable option for the dominant shareholders. It minimizes the
possibility of power and control loss and furthermore, remarkably, it facilitates the decision making process. Lack of
external mechanisms of CG, the inefficiencies of internal mechanisms and the lack of dynamic and participative
institutional investors, gives manoeuvring space to block holders to gain power and control over firms assets and
decision making process.

3. Methodology - Model.

Panel data methodology is used. Three stratification variables (FIN, INDEX and LAW) and the time variable
(YEAR) are taken into consideration. A relatively large number of variables are used to construct the model (see
Table 1). The model is:
DEit = α + β1ROAit + β2TQit + β3CGit + β4MERGERit + β5INVPit + β6HERFit + β7OWNCEOit + β8ΒODit
+ β9BEXECit + β10BPSit + β11BDIS_Pit + β12BDISI_Pit + β13PROSPAGit + β14TAit + β15EMPLit +
β16SMCAPit + β17OC_Sit + β18OC_S2it + β19YEARFit + uit
Where: i = 1 … Ν, t = 1 … T
Table 1. Variables
Variable Type Description
Own Percentage Sum of ownership percentages of the biggest five shareholders
Herf Percentage Square of the sum of ownership percentages of the biggest five shareholders
ROA Continuous Return on Assets
TQ Continuous Tobin’s Q
CG Ordinal Quality of CG
MERGER Binary M-A (1), no M-A (0)
INVP Continuous Investments as a percentage of assets
DE Continuous Debt Ratio (Debt / Equity)
OWNCEO Binary Main shareholder is the CEO (1), No (0)
CEOCHAIR Binary CEO is the President of the Board of Directors – duality of roles (1), No (0)
AUDITC Binary An Audit Committee exists (1), No (0)
BOD Ordinal Number of members in the Board of Directors
BEXEC Ordinal Number of executive Board members
BPS Ordinal Number of firms that Board members participate as Members of their BoD
BDIS_P Percentage Secessions – Resigns of board members to the total number of board members
BDISI_P Percentage Secessions – Resigns of board independent members to the total number of board members
TA Continuous Total assets
SMCAP Continuous Stock market capitalization
EMPL Continuous Number of employers
OC_S Continuous Own Capital to Sales
OC_S2 Continuous Square of Own Capital to Sales
YEARF Continuous Foundation year

4. Expected relation of independent variables with the dependent variable

High financial performance may lead to a decision to finance firm’s activities mainly or exclusively through its
profits. Financial performance variables (TQ, ROA) are expected to be negatively related with DE. The sign can be
positive if the hypothesis that high financial performance may lead to even greater need for working capital, in order
to sustain the growth of sales and profits.
High quality of corporate governance (CG) can attract investors and debtors. If the fact that own capital has a
relatively lower cost than debt or liabilities, then the relation of debt to own capital should be negative, since the
firm can obtain capital from outsiders at a lower cost. The attractiveness of good CG will increase equity demand
and so the price of these equity capital. This mechanism makes public offerings of shares even more attractive than
debt.
 Dummy variable MERGER is positively related with debt aggravation if MAs are realized or followed by
(working capital increase) with liability increases, then the relation between the two variables should be positive.
The same sign and explanation is expected for the INVP variable. At a first glance this may seem like a paradox.
Investments, as long term capital allocations shouldn’t be positively related with short term liabilities. There are two
main reasons that can explain the negative sign. The first reason is that large public offerings of equity have been
reported during 1999-2000 and he corresponding investments (with the raised capital) have been realized in the
following years. The second reason is related with the dominant’s group decision to select the financing mix for the
firm. A negative sign is an indication that the dominant group does not wish to loose power and control.
Management tries to realize two goals simultaneously by selecting debt as the main finance source. The first
goal is to achieve a higher firm growth and the second to maintain the status quo of power and control. Higher
financial growth increases the attractiveness of the equity shares, share prices increase and hence current
shareholders have to give up a smaller part of the firm to raise the capital they need. This way the balance of power
and control in maintained. The newly raised capital is then used to pay out firm’s liabilities and to plan new
investments. This mechanism can achieve both goals if other affecting external factors (i.e. interest rates, stock
market cycle, etc.) remain constant.
Ownership concentration variables are expected to be positively related to debt aggravation. The dominant
group is unwilling to surrender power and control to executive managers or to other shareholders. If the role of the
dominant shareholder (with the largest equity holdings) and the role of CEO (OWNCEO variable) in one person,
then concentration of power and control is the aftermath, due to the fact that this person controls the monitoring and
executive power. Strong leadership, through concentration of power is expected to mitigate the risk of debt
aggravation and hence the sign is expected to be negative.
The BoD’s size (BoD variable) and the selection of members that seat in other BoD (BPS) are administrative
decisions that may affect or be affected by external and internal factors. A logical assumption is that the quality of
monitoring and supervising provided by the BoD is relevant to its size and its members’ knowledge and experiences
(negative signs). If this hypothesis is true then large in size BoD should shield the firm form the risks of debt
aggravation.
The number of executive board members (BEXEC) expresses the will of the firm to increase effectiveness is
formulating strategy and monitoring firm’s processes. The large number of board executives is antagonistic to the
effectiveness of the board to monitor executives. In Greece many of the executives even if they are not members of
the dominant group, are closely related and they do not have the same bargaining power as the executives in the
Anglo-Saxon countries. The expected sign for the BEXEC variable is positive or negative according to which
hypothesis of leadership-concentration or control is validated.
Secessions – Resigns of board members (BDIS_P) and independent board members (BDISI_P) are negatively
related with debt aggravation. Secessions – Resigns may cause lack of monitor and control effectiveness or be the
cause of an effective monitoring and controlling board.
Younger firms (variable YEARF) may not have the capability to have as much access to low cost credit as older
firms do. Hence, the expected sign is negative.

5. Statistical Analysis

AR1 models and Whites method (to mitigate heteroscedasticity problems) were used. LM statistic (see Table 2) is
relatively small (where time is not used) and this is an indication that the classical OLS econometric model is more
suitable (Greene, 2000), which means that the selected stratification variables do not have statistically significant
impact on the dependent variable. On the contrary when time is used the LM statistic rises significantly.
In the case where stratification is used, the selection between Fixed and Random Effects is made with the use of
the H statistic (Hausman test). The H statistic in all cases is zero, which is in favor of the Random Effects (REM).
Table 2. Model statistics
Stratification variable, Time LM H R2 R2 Adj. F statistic
None – AR1 0,3638 0,3352 12,71 (0,00)
INDEX 0,73 0,00
INDEX - YEAR 2,95 0,00 0,3668 0,329 9,71 (0,00)
FIN 0,50 0,01
FIN - YEAR 2,64 0,00 0,3668 0,329 7,11 (0,00)
LAW 0,78 0,00
LAW - YEAR 2,89 0,00 0,3668 0,329 8,73 (0,00)
OWN_G 0,99 0,00
 OWN_G - YEAR 3,09 0,00 0,3624 0,3244 8,82 (0,00)
HERF_G 0,87 0,00
HERF_G - YEAR 2,75 0,00 0,3624 0,3267 8,91 (0,00)
R2 coefficient and Adjusted R2 coefficient of fitness in all six cases is about 0,36 which is sufficiently good.
Heteroscedasticity test has been done with the use of Breusch-Pagan-Godfrey (B-P-G) method. LM X2 statistic for
the B-P-G method took the value 563,32 (13 degrees of freedom; 0,00 possibility of homescedasticity) To correct
the problem White’s method has been used. Autocorrelation test has been done using two statistics (d of Durbin –
Watson and Spearman’s correlation r statistic for the residuals). Both statistics (d=1,24; r=0,37) show that there is
autocorrelation problem. AR1 method has been implemented to correct the problem (d=2,0293).
Table 3 shows that only a small number of the independent variables are statistically significant. All statistically
significant variables have the expected sign. The variables that do not are the ones which describe important external
and internal mechanisms of monitoring and control.
Table 3. Model Results (Stratification: none, AR1 model)
Variable β Stand. Error β/Stand. Error Statistical significance Expected sign verification
TQ 1.04260 .17685591 5.895 .0000* Yes
CG -.19741 .36549840 -.540 .5891 Yes
MERGER -.02731 1.45366 -.019 .9850 No
INVP -4.0985 4.958392 -.827 .4085 No
HERF 2.056263 3.84461 .535 .5928 Yes
OWNCEO -3.0385 1.7744 -1.712 .0868*** Yes
BOD -.681651 .29244 -2.331 .0198** Yes
BEXEC -.26331 .35955 -.732 .4640 Yes
BPS .12882 .20896 .617 .5376 Yes
BDISI_P 3.15795 6.9685 .453 .6504 No
BDIS_P .17171 2.26498 .076 .9396 No
YEARF -.07683 .03528 -2.178 .0294** Yes
TA .00050 .0001 5.049 .0000* Yes
* p < ,05
** p < ,01
*** p < ,001
Previous statistical analysis has shown that the stratifying variables did not have any significant impact on the
model’s behavior. The model was refined to incorporate only the statistical significant variables. Only four variables
were found to be statistical significant (see Table 4).
Table 4. Final model variables
Variable Pooled OLS REM
β Statistical significance β Statistical significance
TQ 0,7594 0,0004*** 0,7594 0,0003***
BOD -0,3918 0,0825* -0,3918 0,0789*
YEARF -0,1562 0,0000*** -0,1562 0,0000***
SMCAP 0,0009 0,0103* 0,0009 0,0092***
Intercept 315,284 0,0000*** 315,284 0,0000***
* p < ,05
** p < ,01
*** p < ,001
Due to the fact that the REM model has better statistical behavior (i.e. heteroscedasticity and autocorrelation) ,
this model is preferable to Pooled OLS model. Model fitness is adequate, as R2 coefficient is 0.2356 and Adjusted
R2 coefficient of fitness is 0.2253.

5. Discussion - Conclusions

The existence of heteroscedasticity is an indication that there groups with different behavioral patterns. Stratifying
variables like ownership concentration, sector, law and index ranking do not seem to have any statistical impact on
the model. Economically this means that debt aggravation is not dependent on these stratification variables and its
formulation is dependent more on other variables.
Random Effects Model (REM) appropriateness denotes that every firm has its own policies and principles and
that latent variables (which are a large proportion of the total) are not related with the ones that are recorded in the
model. Finally, the suitability of REM shows that the subjects of the sample are representative of a larger
population.
 An interesting point is that variables that are directly related with Corporate Governance (CG) are not
statistically significant (MERGER, OWNCEO, BDIS_P, BDISI_P) regardless the fact that all variables have the
expected sign. Corporate Governance quality (CG) itself doesn’t have the any statistically significant impact on
debt aggravation. This phenomenon is contrary to the theoretical propositions and empirical studies of Shleifer and
Vishny (1997) and Vilanova (2007).
The basic determinants of debt aggravation in Greece are firm performance, organizational structure and size.
Financial performance measured by Tobin’s Q (TQ) is critical to debt aggravation because a successful needs more
capital to finance its growth. It is peculiar that financial performance does not mitigate debt. This paradox can be
solved if ownership structure and main shareholders’ behavior is taken into account. High ownership concentration
and main shareholders’ reticence to issue new capital or to reduce their equity holdings is understandable because
these shareholders are not willing to share the benefits of high financial performance with new shareholders that
have not taken any risk (free riders). These benefits, in countries like Greece (weaker investor protection, lower tax
compliance, less independent press and poorer accounting rules), are larger than in Anglo-Saxon country and
therefore the incentive to preserve the status quo even greater (Dyck and Zingales, 2004). Incumbents use capital
structure to maintain control
The hypothesis that a larger Board of Directors (BoD) can contribute to debt decrease is confirmed by the
model. Large BoD can monitor, theoretically, better the processes and decisions made by executives.
Younger firms (variable YEARF) do not seem to have the capability to exploit low cost financing sources.
Younger firms retain the family control status quo and hence there is no need to create a complex system of
monitoring and control or to adopt corporate governance mechanisms. In this case these mechanisms only create
costs. Younger firms choose to finance its activities more with debt than with equity issues, in order to keep the
balance of power and control. Moreover, younger firms do not have the capital market’s trust and so equity issues
may not be successful. Finally, younger firms are focusing more on keen product competition and choose to be
flexible in their decision making process. Ownership dispersion and the adoption of complex monitoring and
controlling mechanisms and processes reduce flexibility. As Franks et al. (2008) argue, “the family’s decision to
dilute its ownership stake depends critically on the costs and benefits of control”.
Debt is not free of consequences; it creates obligations and responsibilities to creditors and banks and has bigger
cost. Creditors and banks have the right to monitor and control firm’s activities. Due to the fact that monitoring and
controlling may demand significant amounts of time, resources and costs, creditors are not willing to undertake this
activities and so they undertake a risk. This is the case in Greece. Banks to mitigate the risk in financing a firm
demand collaterals – guarantees or securities and they do not practice any control over the firm’s activities as
stakeholder theory suggests. Dominant or incumbent shareholders are willing to pay a premium for capital that does
not challenge their position in the firm.
Main dominant shareholders often don’t have the necessary capital to participate in issues of equity capital and
to retain their power and control over the firm. On the other hand creditors and potential shareholders do not have
the capability, through capital market, to obtain control because dominant shareholders own the majority of equity.
Even after the IPO’s (1998-20020 or equity issues that have been recorded no firm has reported ownership
concentration below 52%. All the above arguments lead to the conclusion that debt, for some firms in Greece, may
not be a real choice but rather a coercive solution. As the paper has shown debt aggravation hasn’t the same
determinants as in the Anglo-Saxon countries, where external and internal mechanisms like stock market and
corporate governance provisions play crucial role.

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