Abstract
China Journal of aCC ounting StudieS , 2016 Vol . 4, no . 4, 379–405 http://dx.doi.org/10.1080/21697213.2016.1251770 Why do companies appoint independent directors having professional legal expertise?* a b Weifeng He and Wei Liu a b School of a ccounting, Zhongnan university of e conomics and law, Wuhan, China; School of economics and Management, t singhua university, Beijing, China ABSTRACT KEYWORDS Corporate governance; Understanding the role of the independent director is an important independent director; branch of corporate governance study, and the analysis of the professional legal expertise independent director system from the perspective of a professional background constitutes an important part of recent theoretical research. This paper attempts to uncover the underlying motivations for Chinese listed companies to engage independent directors having professional legal expertise and to analyse the associated economic consequences. We find that Chinese listed companies engage independent directors mainly for consulting rather than for supervisory purposes; if a company is bound up in such activities as a lawsuit, dividend distribution, equity transfer or asset acquisition, it would be more likely to hire independent directors of legal expertise; and when a company is considering hiring independent directors, it would prefer those independent directors reputed to have professional legal expertise and extensive practical experience. We further find that the listed companies which hire independent directors having professional legal expertise generally have a higher market value. This paper not only contributes to the literature of the professional background of independent directors but also extends the literature of law and finance. In addition, it provides new inspiration on how to improve listed companies’ governance efficiency. 1. Introduction As an integral part of a corporate governance structure, the independent director is an independent third party who has no material relationship with company. Although an independent director neither directly interferes with a company’s day-to-day operating decision nor is directly accountable for the company’s performance, (s)he is responsible for protecting the interests of outside investors, mitigating a company’s operational risks and improving the board’s decision-making. The independent director system stems from the United States and was introduced to China over a decade ago. But the reasons for, and effectiveness of, appointing independent directors remain controversial in the fields CONTACT Wei liu liuw2719@163.com t his article was originally published with errors. t his version has been corrected. Please see Corrigendum (http://dx.doi.org/ 10.1080/21697213.2017.1294837). *Paper accepted by heng Yue. © 2017 a ccounting Society of China 380 W. HE AND W. LIU Table 1. Variable definitions. Variable Definition LawD an indicator variable equal to 1 if the company has at least one independent director having legal expertise in a given year LawN t he number of independent directors having legal expertise in a given year LawP t he proportion of independent directors having a legal expertise to all the independent directors in a given year Salary t he sum of the top three managerial salaries Legint When divestitures, lawsuits, dividends, transfer of equity or asset purchase happens, we assign value 1 to legal density index (l egint), and 0 otherwise Size t he natural logarithm of company total assets at the end of the year Lev d ebt-to-asset ratio = total debt/total assets Roa t he total return on assets = net profit/total assets Firth t he largest shareholder’s share proportion State an indicator variable equal to 1 if the company’s ultimate control shareholder is government-related Divestitures an indicator variable equal to 1 if the company has divestitures in a given year Law an indicator variable equal to 1 if the company has lawsuits in a given year Dividend an indicator variable equal to 1 if the company distribute dividends in a given year Equity an indicator variable equal to 1 if transfer of equity happens in a given year Asset an indicator variable equal to 1 if the company has asset purchase in a given year LawS an indicator variable equal to 1 if an independent director of legal expertise does not belong to the college LawM an indicator variable equal to 1 if an independent director of legal expertise holds the same position in two or more companies Ind industry dummy variable Year Year dummy variable Mid an indicator variable equal to 1 when the company is registered in provinces such as Shanxi, Jilin, heilongjiang, anhui, Jiangxi, henan, hubei, hunan West an indicator variable equal to 1 when the company is registered in provinces such as Sichuan, Chongqing, guizhou, Yunnan, t ibet, Shanxi, g ansu, Qinghai, n ingxia, Xinjiang, guangxi, i nner Mongolia Lfirm an indicator variable equal to 1 if the company has at least one independent director having legal expertise Tyear an indicator variable equal to 1 after the company hired at least one independent director having legal expertise TobinQ t he company's market value Incor g overnment incorruptibility index Judic Judicial justice and efficiency index CEOturnover an indicator variable equal to 1 if the company dismissed a Ceo after two consecutive years of decline in performance of theory and practice. On the one hand, regulators mandate that listed companies appoint a set number of independent directors, but those independent directors may fail to exert their due functions in corporate governance as expected, due to institutional limitations; on the other hand, some researchers find that independent directors play a positive role in improving the corporate governance for Chinese listed companies (He, Sun, Zhu, & Liu, 2014). The reason is that the selection of independent directors and their routine work are rarely investigated, and it is impossible to directly quantify their roles and economic consequences in the course of research studies. Nevertheless, independent directors fea- ture stable background traits and psychological structures, which provides a good starting point for investigation of the independent director. For this reason, there have been many papers reporting recently on the influence of hiring independent directors having pro - fessional expertise in financial accounting, security, banking or technical aspects of cor - porate governance (He et al., 2014; Liu, Tang, & Lou, 2012). But few prior studies have investigated the underlying motivations for listed companies to engage independent directors having professional legal expertise or analysed the associated economic consequences. CHINA JOURNAL OF ACCOUNTING STUDIES 381 Since the law topic was introduced to the research field of corporate governance by La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998), scholars have found that law is weighing on corporate agency and equity structure in that it inu fl ences not only corporate governance but also the State’s capital market. But most previous studies have probed the influences of law on corporate governance at the macro level, especially the influences of inter-state or inter-regional differences of legal institutions on the governance behaviour of listed com- panies. Such research provides an important theoretical basis for improving listed companies’ governance and driving the development of the capital market, but it cannot examine the legal acts of listed companies at the micro level. Meanwhile, plenty of data reveals that listed companies are apt to employ increasingly more senior executives having legal expertise. Linck, Netter, and Yang (2009) reported that after the SOX Act was passed, the proportion of directors having legal expertise to all directors in the boards of American listed companies increased from 5.6% in 2001 to 8.6% in 2004; and according to Krishnan, Wen, and Zhao (2011), 36% and 37% of company audit committees had at least one member having legal expertise in 2003 and 2005 respectively. It is found that around 47% of Chinese listed com- panies engaged independent directors having legal expertise in the period 2004–2011. It is not mandated by relevant Chinese laws and regulations that listed companies engage independent directors having legal expertise. It is a listed company’s own voluntary behav- iour to hire independent directors, which creates a good object of study for uncovering the motivations underlying a listed company’s act of hiring independent directors having legal expertise. Therefore, we first investigate the motivations for the actions of listed companies in engaging independent directors having legal expertise. We find that listed companies engage independent directors having legal expertise primarily for consulting purpose. Especially when the companies are bound up in such activities as lawsuit, dividend distri- bution, equity transfer and asset acquisition, they would be more likely to hire independent directors having legal expertise. Zhao, Tang, Zhou, and Zou (2008) claimed that the academic background of independent directors could significantly enhance corporate value. Ferris, Jagannathan, and Pritchard (2003) and Field, Lowry, and Mkrtchyan (2013) demonstrated that independent directors having a rich experience in serving several listed companies concurrently could exert their consulting functions more effectively and contribute more to enhancing corporate value. Ye, Zhu, Lu, and Zhang (2011) found that independent directors of high repute are more likely to query the decisions made by managers. It is evident that independent directors of different types may have different impacts on the corporate governance. Under the system where the appointment of independent directors having legal expertise is deemed as a voluntary act of listed companies, which types of independent directors would be preferred by Chinese listed companies? To investigate this problem, we further examine the types of independent directors that would be preferred by listed companies and find that when a company is considering hiring independent directors, it would prefer those independent directors of high repute, having legal expertise and extensive practical experience. The findings reveal that listed companies engage independent directors having legal expertise for exerting their consulting functions and mitigating company’s legal risks. But it remains unclear whether hiring independent directors is helpful for enhancing corporate value. In Chinese listed companies, the proposals for engaging independent directors having legal expertise are generally raised by controlling shareholders or managers, calling into question whether independent directors can act for maximisation of corporate value. We 382 W. HE AND W. LIU have found that independent directors having legal expertise help listed companies to mit- igate legal risks, leaving it open as to whether such independent directors do this for pro- tecting the company’s interests or managers’ personal gains. Thus, the influences of independent directors having legal expertise on corporate value remain unknown. For this reason, we further explore the influences of independent directors on listed corporate value and find that the companies which hire more independent directors having legal expertise generally have higher market value than those which hire less independent directors having legal expertise. The potential contributions of this paper include: (1) It studies the independent director system of Chinese listed companies from the perspective of professional background. There have been many prior research papers discussing independent directors having expertise in financial accounting, security, banking or technical professional services, while this paper discusses the independent director system from the angle of legal background. It is a sup- plement to prior literature on the study of independent directors. (2) It investigates the influence of law on listed companies at the micro level using available data on independent directors having legal expertise, extending the contents of prior studies on law and finance theories. Prior studies on law and finance have focused more on the macro level, and the studies conducted at the micro level have focused primarily on company laws and regula- tions, with little concern over people. In this paper, based on the increasing common phe- nomenon that Chinese listed companies may engage independent directors having legal expertise of their own accord, we examine the influences of law on corporate governance at the micro level, which extends the content of prior studies on law and finance theories. (3) It analyses the characteristics specific to the listed companies engaging independent directors having legal expertise and the different types of such independent directors pre - ferred by listed companies, making a supplement to prior literatures in the field. Krishnan et al. (2011) investigated the influences of audit committee members having legal expertise on the quality of financial reporting, while this paper further analyses the characteristics of the listed companies engaging independent directors having legal expertise and the types of independent directors that would be preferred by listed companies. This paper is organised as follows: Section 2 presents the literature review and hypothesis development. Section 3 introduces the study design, including sample selection and data source, model design and variable definitions, and descriptive statistics. Section 4 contains the results of empirical analysis. We run further analysis and a robustness test in Section 5, and conclude in Section 6. 2. Literature review and hypothesis development 2.1. Literature review As an integral part of corporate governance, the functions of the independent director system have always been the subject of serious attention in the theoretical and academic cycles ever since the system was introduced to China (Liu et al., 2012; Tang, Du, & Shen, 2010; Wei, Xiao, Nick, & Zhou, 2007; Ye et al., 2011). Previous studies have identified the main functions of an independent director, i.e. supervision and consulting. Fama and Jensen (1983) argued that managers may conspire with the board, so independent directors can be intro- duced to supervise managers’ behaviour with the intention of protecting the managers’ own reputations. Subsequently, there have been a great number of research papers addressing CHINA JOURNAL OF ACCOUNTING STUDIES 383 independent directors’ supervision in terms of the appointment of the CEO, managerial compensation and mergers and acquisitions. For instance, Borokhovich, Parrino, and Trapani (1996) proposed that independent directors are inclined to employ CEOs from outside the company instead of hiring from within, making it easier to supervise the behaviour of CEOs; Hermalin and Weisbach (1998) analysed independent directors’ supervision from the per- spective of the removal of incompetent CEOs, claiming that independent directors could intensify the competition for the CEO post by increasing the mobility of CEOs so as to achieve the aims of supervision over CEOs; and Coles, Daniel, and Naveen (2012) found that inde- pendent directors having no relationship with CEOs are more effective in supervising CEOs’ behaviour. Hall and Murphy (2003) examined the influences of independent directors on managerial compensation and pointed out that independent directors make for positive functions of managerial compensation. Similarly, Coles et al. (2012) found that independent directors could influence managerial compensation. Bebchuk and Weisbach (2010) and Dominguez-Martinez, Swank, and Visser (2008) found that independent directors play an active role in mergers and acquisitions in that they may control managers’ moral conduct. However, there have been more and more researchers questioning independent directors’ supervisory functions on the grounds that most independent directors might be appointed by managers or controlling shareholders and thus they are losing the motivation to supervise managers. Moreover, independent directors’ supervision relies on the company information in hand. But the reality is that the independent directors with company information in hand usually maintaining a good relation with managers while those independent directors who have no relationship with managers have limited access to the information necessary for supervision (Liu et al., 2012; Tang et al., 2010). Therefore, many scholars have argued that independent directors fail to perform their due functions in supervision and their votes serve as little more than a rubber stamp (Jensen, 1993; Mace, 1986). Ye et al. (2011) analysed the data regarding independent directors’ comments and voting on the proposals raised by the board in Chinese listed companies, and found that the independent directors did not perform their due functions in supervision, which is consistent with the findings reported by Tang et al. (2010). On that basis, scholars proposed the consulting function of independent direc- tors. The main researches in this regard include the following. Ferris et al. (2003) found that the independent directors who have ever served many companies are more likely to perform their consulting function effectively. Coles, Daniel, and Naveen (2008) found that the more complex a company organisation is, the greater the consulting function of independent directs will be Fahlenbrach, Low, and Stulz (2010) noted that the independent directors employed by a company who concurrently serve as CEOs in other companies can perform their consulting functions; while Liu et al. (2012) pointed out the independent directors having professional banking expertise in Chinese listed companies perform the consulting function to some extent. It can be seen that few prior research papers have specially discussed independent direc- tors having legal expertise; instead, this topic has been mentioned only in the researches regarding the audit committee and the board of directors. For example, Krishnan et al. (2011) investigated the influences of audit committee members having legal expertise on the qual - ity of financial reporting and found that the audit committees composed of more members having legal expertise tend to prepare financial reports of higher quality. This finding sug- gests that audit committee members having legal expertise play the supervisory role. They do far more than delivering signals to the market, and their supervisory role became more 384 W. HE AND W. LIU significant after the SOX Act was passed in the USA (Johnson, 2004; Linck et al., 2009). Litov, Sepe, and Whitehead (2013) found that listed companies appoint increasingly more directors having legal expertise who play a vital role in mitigating the company’s legal risks and increasing corporate value. Along with the development of rule-by-law in China, the legal environment in which listed companies operate is changing greatly. On the other hand, the macro legal environment is ever changing, exerting a profound impact on the behaviour of stakeholders including independent directors of listed companies; on the other hand, in Chinese listed companies, the number and proportion of senior executives having legal expertise, especially independent directors, are increasing. Although it has been shown by many prior research papersthat the law has critically affected the sustainable development of Chinese listed companies and even the capital market, there have been few researches addressing the influences of independent directors having legal expertise on company per - formance (Li & Liu, 2012; Wei et al., 2007; Zhao et al., 2009). 2.1.2. Hypothesis development Since the separation of ownership and management rights in companies, how to solve the agency problem has become a core issue of corporate governance. In this regard, to set up a board of directors that works is considered an important institutional arrangement. Theoretically, the board is not only the decision-making body of a company’s major events but also the supervisory body over managers’ behaviour. But in a company characterised by dispersed ownership, managers may attempt to manipulate and control the board. In this context, regulators advocate introduction of independent directors to protect share- holders’ interests and improve company’s governance efficiency. The independent director system originated from the conflicts between shareholders and managers over the agency problem (Fama & Jensen, 1983). In a company characterised by dispersed ownership, inde- pendent directors can supervise managers’ behaviour through appointment, removal and assessment of managers so as to curb conspiracy within company. From the findings of worldwide research on corporate governance, it has been found that the controlling share- holder agency problem has become a major issue in the corporate governance of Asian companies (Claessens, Djankov, & Lang, 2000; La Porta, Lopez-de-Silanes, & Shleifer, 1999); But in addition to procuring that independent directors perform their supervisory duties, companies also expect independent directors to oe ff r advice and perform consulting duties as an expert so as to improve companies’ decision-making ( Wei et al., 2007). So, in a company having either dispersed or concentrated ownership, independent directors should, in theory, perform both supervisory and consulting duties. As the business environment in which a company operates is becoming more and more complex, companies are exposed to greater legal risks during operations, making it necessary for companies to increase their legal knowledge to cope with increasingly complex legal risks. Companies can reduce their legal risks by hiring independent directors having legal expertise to perform their supervisory and consulting duties. In listed companies, managers’ behaviour is subject to strict regulation and supervision by corporate governance structure and the capital market. However, it is still possible that managers exploit loopholes in com- pany rules to seek personal gains in such arrangers as business mergers and acquisitions, insider transactions, critical transactions and asset acquisition. If the board has independent directors having legal expertise, such directors can use their expertise to supervise managers’ legal acts made in these arrangements more effectively and monitor the agreements reached CHINA JOURNAL OF ACCOUNTING STUDIES 385 between managers and third parties, which helps to reduce companies’ legal risks. Taking financial reporting for example, Palmrose and Scholz (2004) found that the listed companies with poor-quality financial reporting are prone to suffer law suits. Enron, WorldCom and Yunnan Greenland cases all demonstrate that poor-quality financial reporting would trigger legal exposure to litigation. If a company’s independent directors have legal expertise, their legal knowledge can make the board members more sensitive to the legal risks associated with inaccurate and radical financial reporting so as to urge the supervisory management to act in compliance with established accounting standards, prevent earnings management and reduce companies’ legal exposure to litigation. By fulfilling consulting duties, independ - ent directors having legal expertise can help companies establish a better understanding of laws and regulations and minimise legal risks. Compared with non-listed companies, listed companies are subject to more stringent legal regulation and control in terms of information disclosure, insider transactions, related party transactions, stock equity management and share redemption, exposing companies to greater legal risks. When independent directors having legal expertise are involved in deliberation over such high-risk arrangements, they may offer more advice consistent with legal implications and thus reduce the losses and additional expenditures incurred to companies resulting from legal risks. So, independent directors having legal expertise in listed companies have supervisory and consulting functions. Along with the development of rule-by-law in China, the legal environment in which listed companies operate is changing greatly. On the one hand, regulators issue many laws and regulations to regulate the behaviour of listed companies; on the other hand, the oper- ational activities and conducts of listed companies become more and more complex, espe- cially the international competition resulting from economic globalisation, increasing companies’ legal risks. Unlike American regulators, Chinese regulators do not mandate that listed companies appoint legal advisers and other professionals, but they do require listed companies to elect independent directors, making it possible for listed companies to actively engage independent directors having legal expertise to cope with increasing legal risks. The Guideline for Introducing Independent Directors to the Board of Directors of Listed Companies (the “Guideline”) issued by China Securities Regulatory Commission (CSRC) in 2001 stipulates that listed companies shall introduce independent directors to their boards of directors and at least one third of board shall be independent directors. Except for the requirement that at least one of the independent directors should be an accounting pro- fessional, the Guideline does not provide further specific requirements on the professional background of independent directors, giving listed companies many choices in appointing independent directors. Nevertheless, Chinese listed companies do not engage independent directors out of the motive of performing their supervisory function. Liu et al. (2012), Tang et al. (2010) and Ye et al. (2011) did not identify the supervisory function of independent directors in Chinese listed companies. Similarly, listed companies do not engage independ- ent directors having legal expertise for supervisory purposes. Instead, they expect the direc- tors to perform consulting duties so as to cope with increasing legal risks. The reason is that under the corporate governance background in which listed companies generally have majority shareholders, the appointment of independent directors is mainly determined by majority shareholders and their spokes person managers. Hiring independent directors having legal expertise not only guarantees compliance with regulators’ requirements on corporate governance but also enables the independent directors to give advice on legal 386 W. HE AND W. LIU affairs using their expertise. In fact, if the board members or managers of a listed company lack legal knowledge or the company expends a great deal of cost in dealing with legal affairs, legal risks and law compliance, to introduce independent directors having legal exper - tise to the board might be an effective solution. In conclusion, in Chinese listed companies, hiring independent directors having legal expertise not only guarantees compliance with regulators’ requirements but also enables the independent directors to perform consulting duties using their expertise so as to mitigate legal risks. Thus, based on the foregoing analysis, we propose our first hypothesis. H1: Chinese listed companies engage independent directors having professionallegal expertise for a consulting purpose. Organisational behaviour shows that managers’ characteristics formed by psychological structure such as cognitive competence, perception and values and their social relations are comparatively stable, and their impacts on and causal relationship with company’s deci- sion-making are clear (Li & Liu, 2012). In the scenario where regulators mandate that listed companies engage independent directors while the appointment of independent directors is subject to the decisions of companies’ actual controllers, then which types of independent directors having legal expertise would be preferred by listed companies to better perform a supervisory function? Based on the prior researches and independent directors’ consulting function, we mainly analyse whether listed companies intending to hire independent direc- tors having legal expertise take the candidates’ practical experience and reputation into account. Independent directors from colleges and universities possess a wealth of theoretical knowledge which enables them to come up with creative ideas and solutions as an outsider to address legal risks encountered during business development. But these independent directors lack practical experience and are less advantageous in giving advice on addressing legal risks. So, a listed company might prefer professionally experienced independent direc- tors. The reasons include: firstly, the legal environment in which listed companies operate them compels them to choose experienced independent directors. Through years of devel- opment, China has basically established a sound socialistic legal system. But since the law itself cannot be perfect and China’s market economy is in the transition and emerging phase, the current development of rule of law in China is characterised by selective law enforcement and weak force of law. As China’s market economy advances further, listed companies are facing more and more legal issues and are exposed to greater litigation risks. To this end, they are in need of directors having legal expertise capable of giving directions relating to legal issues rather than those possessing a wealth of theoretical knowledge. Secondly, resource support theory has demonstrated that independent directors tend to help get companies out of various crises by taking advantage of their good external relationship network (Zahra & Pearce, 1989). Relatively speaking, experienced independent directors having legal expertise might provide more critical external connections relating to legal affairs in mitigating company’s legal risks, consolidate and enhance the win-win relationship between company and capital market, strengthen the coordination with other companies and control the legal risks encountered during business development. Ferris et al. (2003) and Field et al. (2013) claimed that independent directors holding concurrent posts in several listed companies are usually of high repute. It remains disputed as to whether the independent directors holding concurrent posts in several listed compa- nies have enough time and energy to perform their duties effectively. But Fama and Jensen CHINA JOURNAL OF ACCOUNTING STUDIES 387 (1983), basing on agency theory, argued that independent directors holding concurrent posts in multiple companies can deliver the information on the quality of independent directors to the market because the more companies that an independent director serves concurrently, the more competent (s)he will be. Therefore, listed companies also want to hire independent directors holding concurrent posts in multiple companies. Based on the above analysis, we are of the opinion that listed companies might prefer well-regarded independent directors having legal expertise who hold concurrent posts in multiple com- panies on the grounds that, in the capital market, managers of listed companies need to communicate and deal with a range of organisations and interested parties including insti- tutional investors, media, financial analysts and regulators. Meanwhile, listed companies may be involved in mergers and acquisitions and refinancing arrangements, and under the circumstance where the environment is highly uncertain and information highly asymmetric, listed companies are exposed to greater legal risks. In addition, by appointing independent directors holding concurrent posts in multiple listed companies, the company can convey favourable messages to the capital market. Bugeja, Rosa, and Lee (2009) and Coles and Hoi (2003) reported that the more competent an independent director is, the more likely (s)he will be hired by many listed companies. These independent directors who hold concurrent posts in multiple listed companies tend to contribute more to improving corporate govern- ance, appointing a more competent CEO or arriving at a more successful M&A arrangement. It can also explain why Chinese listed companies prefer well-regarded independent directors having legal expertise who hold concurrent posts in multiple listed companies. Thus, based on the foregoing analysis, we propose the second hypothesis. H2: when a listed company is considering hiring independent directors having legal expertise, it would prefer those well-known independent directors having extensive practical experience. 3. Research design 3.1. Sample selection and data source Chinese listed companies are required to disclose the personal particulars of senior execu- tives from 2004, so our samples consist of the listed companies in the period from 2004 throughout 2011. The financial data and personal particulars of independent directors are mainly obtained from the China Stock Market & accounting Research (CSMAR) database. After obtaining the personal particulars of independent directors, we collect by hand their legal background information and complement the data by retrieving the annual reports of sample listed companies and searching their names using Baidu. Following prior empirical studies, we exclude the following samples: the listed companies operating in the banking and insurance industries and those whose relevant variables are not available. 3.2. Model design and variable definitions We estimate the following model (1) to test the hypothesis 1: Law = + Salary(Legint) + Control + (1) 0 1 In model (1), Law is the explained variable representing independent director having legal expertise. Following Krishnan et al. (2011), we define a person having professional legal 388 W. HE AND W. LIU expertise as one who has received an academic degree in law, holds a lawyer’s practising licence or is a faculty member in a law school. In this paper, we measure independent direc- tors having professional legal expertise (Law) from three aspects and analyse their influences on companies. LawD is a dummy variable equal to 1 when a listed company has independent directors having legal expertise, and 0 otherwise; LawN is the number of independent direc- tors having legal expertise in the listed company; LawP is thee proportion of independent directors having legal expertise to total independent directors. In model (1), Salary and Legint are explanatory variables representing the supervision and consulting functions of independent directors having legal expertise respectively. Regarding the supervision variable, shareholders in a company can avoid specific risks through diversification, but managers cannot readily spread the risk of human capital invest - ment by means of diversified investment and are thus exposed to greater risks than share - holders. When the company is in a recession, managers’ personal reputation and human capital might be affected. The separation of the two rights makes shareholders have the ownership of the company and mangers master the management rights. Under the condition of information asymmetry, because of the difference of objective function, managers don’t follow the rule of maximum interest of stockholders. On the one hand, the board which is the trust institution of shareholders needs to motivate managers to work for the company, and on the other hand the board should set up effective mechanisms to restrict the managers to seek private interests. When the company raises debt financing too frequently, managers will receive limited returns but suffer huge potential losses, while shareholders can receive unlimited returns within the range of limited losses. For this reason, manager incentives plus restraints form the basis of the board’s most important decisions, and managerial compen- sation is established as a critical measure of the board’s supervisory effectiveness. Hall and Murphy (2003) found that independent directors would supervise managerial compensation; Adams et al. (2010) noted that independent directors exert their supervisory function mainly through the appointment of the CEO and compensation assessment; Liu et al. (2012) also identified managerial compensation as a supervision variable when exploring the influences of independent directors having professional banking expertise on a company’s credit financ - ing. Thus, we use managerial compensation as the alternative variable of supervision. To be specific, we use the sum of three highest managerial compensations as the variable of man - agerial compensation (Salary) to measure the supervisory function of independent directors. Regarding the consulting variable, Litov et al. (2014) pointed out the reasons why independ- ent directors having legal expertise are introduced to company boards include: (1) it is deter- mined by the company size and whether it is listed or not; (2) companies are compelled to seek more professional legal support in the face of external legal risks, such as more and more lawsuits and other legal activities that are beyond companies’ control. The second reason is more important. Thus, we use litigation intensity (Legint) to signal the demand for legal consulting. Following Krishnan et al. (2011) and in light of the actualities of Chinese listed companies, we measure the following activities of listed companies closed related to legal practice. Dummy variables are used to measure the events of asset divestiture (Divestitures), lawsuit (Law), dividend distribution (Dividend), equity transfer (Equity) and asset acquisition (Asset) occurring during a company’s operation in a year; and we assign the value 1 to indicator (Legint) if one of these events occur, and 0 otherwise. Based on prior studies (Litov et al., 2014), we include the following control variables: size captures the company size and is expressed as the natural logarithm of listed company’s CHINA JOURNAL OF ACCOUNTING STUDIES 389 closing assets; lev represents the company’s asset-liability ratio and is expressed as the ratio of closing total liabilities to total closing assets; roa represents the company’s return on assets; firth represents the stock proportion of the company’s largest shareholder; and state captures the company’s ownership characteristics divided by ultimate controller, which equals 1 if the ultimate controller is the Government, and 0 otherwise. Industry and Year variables are included to control for the impact of industry and year. According to CSRC’s Industry Codes, except that the manufacturing industry is coded 02, the remaining industries are all coded 01; and agriculture is taken as the benchmark to produce 20 Industry dummy variables. r the Year variable, the year 2004 is taken as the benchmark year to produce seven Year dummy variables. We estimate the following model (2) to test the hypothesis 2: LawL = + Legint + Size + Lev + Roa + Firth + State + Control + 0 1 2 3 4 5 6 (2) In model (2), LawL is a dummy variable representing the source (LawS) and reputation (LawM) of an independent director having legal expertise. We assign the value 1 to LawS if the independent director having legal expertise is not a faculty member in colleges, and 0 oth- erwise; and we give the value 1 to LawM if the independent director is well regarded and of high repute, and 0 otherwise. The independent director who holds a concurrent post in two or more companies is deemed as well-regarded and of high repute. The definitions of the remaining variables are same with those in model (1). 3.3. Descriptive statistics Table 2 presents descriptive statistics of all relevant variables. The mean value of LawD is 0.466, suggesting that nearly 47% of Chinese listed companies in our sample engage inde- pendent directors having legal expertise. The minimum value of LawN is 0 and the maximum value 4, indicating that the sample listed companies appoint 4 independent directors having legal expertise at most and some companies have no independent director having legal expertise. The mean value of LawP is 0.153; given that the appointment of independent directors having legal expertise is not mandated by laws and regulations, this mean value indicates that independent directors having legal expertise make up a large proportion on the boards of Chinese listed companies. Moreover, the maximum value of LawP is 1 because independent directors having legal expertise meanwhile possess a variety of other expertise Table 2. d escriptive statistics of variables. Variable Obs. Mean Median SD Min Max LawD 13,030 0.47 0.00 0.50 0.00 1.00 LawN 13,030 0.50 0.00 0.57 0.00 4.00 LawP 13,030 0.15 0.00 0.18 0.00 1.00 Salary 13,041 13.45 13.50 0.87 3.37 17.13 Legint 13,023 1.67 2.00 0.98 0.00 5.00 Size 13,030 21.44 21.32 1.22 18.59 23.18 Lev 13,030 0.51 0.50 0.32 0.05 2.40 Roa 13,030 0.03 0.04 0.08 −0.43 0.24 Firth 13,030 0.37 0.35 0.16 0.09 1.00 State 13,023 0.56 1.00 0.50 0.00 1.00 note: all the variables are defined in t able 1. 390 W. HE AND W. LIU Table 3. Summary of correlation coefficients. Panel 2A LawD LawN LawP Salary LawD 1.000 0.987*** 0.954*** 0.029*** LawN 0.940*** 1.000 0.966*** 0.028*** LawP 0.928*** 0.966*** 1.000 0.000 Salary 0.025*** 0.021*** −0.009 1.000 Panel 2B LawD LawN LawP Legint LawD 1.000 0.986*** 0.952*** 0.054*** LawN 0.938*** 1.000 0.964*** 0.055*** LawP 0.928*** 0.965*** 1.000 0.046*** Legint 0.067*** 0.067*** 0.057*** 1.000 notes: Correlation coefficients of Pearson are presented in the lower left of the table, and correlation coefficients of Spear - man in the upper right of the table. *, ** and *** indicate statistical significance at 10, 5, and 1% levels respectively. such as accounting. The mean value of Salary is 13.454, the minimum value 3.367, and the maximum value 17.120, suggesting that the compensation varies greatly with managers. The mean value of Legintis 2, showing that Chinese listed companies in our sample have certain demands for litigation. From the minimum and maximum values of the indicator we can see that different listed companies have significantly different demands for litigation. As to the control variables, the mean value of levis 0.512 and that of roa is 0.032, indicating that the profitability of Chinese listed companies needs improving; firth represents the stock proportion of the company’s largest shareholder and its mean value is relatively high (0.373). The variable state represents the company’s ownership characteristics, and around 56% listed companies in our sample are controlled by the Government. Table 3 summarises the correlation coefficients of major variables. The Salary variable is significantly associated with LawD and LawN variables and insignificantly associated with LawP, suggesting that independent directors having legal expertise might affect managerial compensation. But since a correlation coefficient merely measures the relation between two variables in the absence of relevant control factors, further analysis has to be done using multiple regression for more accurate results. However, the Legint variable is significantly positively associated with LawD, LawN and LawP variables. This result might suggest that the listed companies involved in increasing legal affairs would be more likely to engage independent directors having legal expertise mainly for consulting purposes. 4. Empirical analysis 4.1. Functions of independent directors having legal expertise Table 4 reports the regression results of model (1). Columns (1), (3) and (5) present the regression results of the Salary variable, and columns (2), (4) and (6) the regression results of the Legint variable. As can be seen from the regression results presented in columns (1), (3) and (5) of Table 4, the regression results of LawD, LawN and LawP are not significant, demonstrating that Chinese listed companies do not engage independent directors having legal expertise for the purpose of controlling the management’s improper conduct relating to compensation. From the regression results presented in columns (2), (4) and (6) we can see that the Legint variable is significantly positive in the three regression models, which means that the listed companies having greater demands for litigation are more willing to CHINA JOURNAL OF ACCOUNTING STUDIES 391 Table 4. empirical analysis of the functions of independent directors having legal expertise. LawD LawN LawP (1) (2) (3) (4) (5) (6) Constant 0.795** 0.338 0.798*** 0.634*** 0.395*** 0.326*** (1.96) (0.93) (6.80) (5.90) (10.91) (10.12) Salary 0.025 0.010 −0.002 (0.93) (1.29) (−0.57) Legint 0.098*** 0.026*** 0.008*** (5.17) (4.92) (4.61) Size −0.053*** −0.024 −0.017*** −0.005 −0.010*** −0.008*** (−2.78) (−1.40) (−3.15) (−1.08) (−5.86) (−5.26) Lev 0.227** 0.215*** 0.096*** 0.090*** 0.030*** 0.028*** (3.51) (3.34) (4.70) (4.41) (4.68) (4.42) Roa 0.649** 0.655*** 0.154** 0.172*** 0.042* 0.040* (2.53) (2.59) (1.96) (2.23) (1.70) (1.65) Firth −0.644*** −0.633*** −0.190*** −0.199*** −0.047*** −0.046*** (−5.19) (−5.09) (−5.53) (−5.75) (−4.34) (−4.31) State 0.192*** 0.180*** 0.051*** 0.047*** 0.010*** 0.009*** (4.78) (4.48) (4.51) (4.12) (2.70) (2.41) Year Yes Yes Yes Yes Yes Yes Industry Yes Yes Yes Yes Yes Yes 2 2 Adj-R /Pseudo-R 0.014 0.017 0.021 0.024 0.024 0.025 N 13,036 13,023 13,036 13,023 13,036 13,023 notes: t he table reports the regression results of model (1). in Columns 1, 3 and 5, the independent variable is Salary. in columns 2, 4 and 5, the independent variable is Legint. all the variables are defined in t able 1. t his table reports the results of the model 1 and the model 2. all continuous variables are winsorized at 1 and 99% level. T-statistics used to signal the robustness of standard errors with the White heteroscedasticity correction are reported in parentheses. ***, ** and * indicate statistical significance at 1, 5, and 10% levels respectively. engage independent directors having legal expertise mainly for consulting purposes. As the business environment in which a company operates is becoming increasingly complex, companies are exposed to greater legal risks during operations, making it necessary for companies to increase their legal knowledge to cope with increasingly complex legal risks. Meanwhile, the State’s regulators provide that listed companies should appoint a set number of independent directors, but companies’ actual controllers do not expect independent directors hired to play their substantial role of supervision. Hiring independent directors having legal expertise not only guarantees compliance with regulators’ requirements but also enables the independent directors to mitigate a company’s legal risks using their exper- tise. As to control variables, the regression coefficients of size and r fi th variables are significant and negative, suggesting that the companies with larger size and stock proportion of largest shareholder are less likely to engage independent directors having legal expertise. The coef- ficients of lev, roa and state are significantly positive, showing that the listed companies with a higher asset-liability ratio, return on assets and stated-controlled listed companies are more likely to engage independent directors having legal expertise. Krishnan et al. (2011) found that American listed companies hire lawyers only when they are bound up in formal legal contract arrangements or financial activities mandated by law, but it is not clear which types businesses would lead to an increase of legal expertise. Choudhary et al. (2013) noted that the companies with greater exposure to legal risks, more complex financial reporting issues and higher demand for patents and intellectual property rights are more likely to hire a senior legal adviser and other professionals. Prior research has demonstrated that Chinese listed companies with higher litigation intensity are more willing to engage independent directors having legal expertise to give full access to their 392 W. HE AND W. LIU expertise. However, litigation intensity is measured by such businesses as asset divestiture, lawsuit, dividend distribution, equity transfer and asset acquisition, and different businesses may spur different legal risks, so the legal consulting services required might vary to some extent. Will Chinese listed companies hire independent directors having legal expertise based on the differences in legal affairs? To investigate this problem, we estimate the fol- lowing equation: LawD = + LawI + Size + Lev + Roa + Firth + State + Control + 0 1 2 3 4 5 6 (3) In model (3), LawD is a dummy variable as defined in model (1) and equals to 1 if the listed company has independent directors having legal expertise on board, and 0 otherwise; LawI means the specific legal affairs the company deals with and represents the above-mentioned five variables of litigation intensity. If the company is involved in the events of asset dives- titure (Divestitures), lawsuit (Law), dividend distribution (Dividend), equity transfer (Equity) and asset acquisition (Asset), the value 1 is assigned to each of these five variables, and 0 otherwise. The definitions of the remaining variables are same with those in model (1). Table 5 reports the regression results of model (3). From Table 5 we can see that the regression coefficients of lawsuit (Law ), dividend distribution (Dividend), equity transfer Table 5. f ive specific legal affairs and independent directors having legal expertise. LawL (1) (2) (3) (4) (5) Constant 0.233 0.057 0.450 0.202 0.309 (0.64) (0.15) (1.22) (0.55) (0.84) Divestitures 0.059 (1.43) Law 0.171*** (3.20) Dividend 0.158*** (3.75) Equity 0.069* (1.70) Asset 0.066* (1.72) Size −0.012 −0.004 −0.026 −0.011 −0.016 (−0.71) (−0.23) (−1.49) (−0.63) (−0.92) Lev 0.236*** 0.193*** 0.284*** 0.237*** 0.240*** (3.65) (2.92) (4.37) (3.68) (3.73) Roa 0.805*** 0.813*** 0.543** 0.803*** 0.766*** (3.19) (3.24) (2.09) (3.19) (3.04) Firth −0.680*** −0.680*** −0.730*** −0.663*** −0.690*** (−5.48) (−5.49) (−5.87) (−5.31) (−5.58) State 0.171*** 0.171*** 0.190*** 0.174*** 0.177*** (4.25) (4.24) (4.68) (4.31) (4.39) Year Yes Yes Yes Yes Yes Industry Yes Yes Yes Yes Yes 2 2 Adj-R /Pseudo-R 0.016 0.016 0.016 0.016 0.016 N 13,023 13,023 13,023 13,023 13,023 notes: t his table reports the results of the specific legal affairs on independent directors of legal expertise. f rom columns 1 to 5, the independent variables are Divestitures, Law, Dividend, Equity, Asset, respectively. all the variables are defined in t able 1. all continuous variables are winsorized at 1% and 99% level. T-statistics used to signal the robustness of standard errors with White heteroscedasticity correction are reported in parentheses. ***, ** and * indicate statistical significance at 1, 5, and 10% levels respectively. CHINA JOURNAL OF ACCOUNTING STUDIES 393 (Equity) and asset acquisition (Asset) are signic fi antly positive, while the regression coec ffi ient of asset divestiture (Divestitures) is not significant, suggesting that the companies involved more in lawsuits, dividend distribution, equity transfer and asset acquisition activities are more likely to engage independent directors having legal expertise. The regression coeffi- cient of Divestitures is not a significant possibly because such business rarely occurs, so the board tends to be rather prudent in decision-making in this regard by consulting external law firms separately. In a word, the above results show that companies manage to mitigate legal risks by engaging independent directors having legal expertise to offer advices on legal issues. 4.2. Types of independent directors having legal expertise Table 6 reports the regression results of model (2). The regression results presented in column (1) of Table 6 show that the regression coefficient of independent director source (LawS) is significantly positive, suggesting that companies having demands for the treatment of legal affairs are more likely to engage experienced independent directors having legal expertise. China’s market economy is now in the transition and emerging phase when relevant laws and regulations still need improving, which creates much room for experienced independent directors having legal expertise to use their expertise. Meanwhile, Djankov, Glaeser, La Porta, Lopez-de-Silanes, and Shleifer (2003) reported that judicial procedures of the civil law system are much more complicated than those of common law system in that the entire course from filing to closure of a case has a large time span, resulting in poor judicial efficiency. It is evident that the independent directors having abundant practical experience can better accommodate listed companies’ demands for counselling than those of academic back- ground. The regression results presented in column (2) of Table 6 show that the regression Table 6. t ypes of independent directors having legal expertise. LawS LawM (1) (2) Constant −4.552*** 3.107*** (−8.30) (4.96) Legint 0.073*** 0.082*** (2.70) (2.65) Size 0.222*** −0.122*** (8.57) (−4.13) Lev 0.111 0.167* (1.32) (1.77) Roa 1.113*** −0.391 (3.06) (−0.93) Firth −0.199 0.199 (−1.09) (0.98) State 0.067 −0.003 (1.11) (−0.04) Year Yes Yes Industry Yes Yes Pseudo-R 0.260 0.025 N 6,064 5,606 notes: t his table reports the results of litigation intensity on two types of independent directors having legal expertise. all the variables are defined in t able 1. all continuous variables are winsorized at 1% and 99% level. T-statistics used to signal the robustness of standard errors with White heteroscedasticity correction are reported in parentheses. ***, ** and * indicate statistical significance at 1, 5, and 10% levels respectively. 394 W. HE AND W. LIU coefficient of the independent director’s reputation (LawM) is significantly positive, suggest - ing that companies having demands for treatment of legal affairs are more likely to engage well regarded independent directors having legal expertise. China’s market economy is now in the transition and emerging phase, and the legal environment in which listed companies do business needs further improvement. In such context, the independent directors having legal expertise who hold concurrent posts in multiple listed companies tend to possess rich legal experience and resources. Such independent directors hired can not only guarantee compliance with regulators’ requirements but also offer advice as to how to mitigate legal risks. 5. Further analysis and robustness test 5.1. Relation between independent directors having legal expertise and corporate value Prior research has demonstrated that listed companies want to engage independent direc- tors having legal expertise because they are exposed to greater legal risks as the business environment in which they operate is getting more and more complex, and such independ- ent directors hired may help mitigate their legal risks to some extent. But it remains unclear whether hiring independent directors having legal expertise is helpful for enhancing cor- porate value. The reason is that prior studies have not identified the motives driving inde - pendent directors having legal expertise to mitigate legal risks, i.e. to protect company interests or managers’ personal gains. From the perspective of an independent director, independent directors having legal expertise might help increase corporate value but might also impair corporate value. The reasons why independent directors having legal expertise might contribute to an increase of corporate value include: firstly, the independent directors possessing legal expertise make them more sensitive to the changes in law so as to serve the board and the management better; secondly, the independent directors can use legal knowledge to give advice as an expert in mergers and acquisitions, intellectual property and other businesses and facilitate closure of deals with third parties; thirdly, the independent directors who uphold professional ethics can encourage companies to comply with laws and regulations and urge companies to disclose misconduct, which makes companies more prudent and conservative and in turn reduces legal risks. However, independent directors having legal expertise may also impair corporate value because in Chinese listed companies, the appointment of independent directors having legal expertise is mainly determined by the majority shareholders, which ties the two together. So, independent directors having legal expertise may be partly engaged to mitigate the company’s legal risks, but more importantly, they could be intro- duced to the board to reduce the legal risks associated with the majority shareholders’ tunnelling behaviour. Under such circumstances, independent directors tend to interfere with a company’s information disclosure and accounting at the direction of the majority shareholders rather than maximisation of company interests. In this case, independent direc- tors having legal expertise may cause a loss of corporate value. Therefore, in the following section, we conduct empirical studies to analyse whether independent directors having legal expertise in listed companies may contribute to an increase of corporate value. We estimate the following equation: CHINA JOURNAL OF ACCOUNTING STUDIES 395 Table 7. independent directors of legal professional and corporate value. TobinQ (1) (2) (3) Constant 8.708*** 8.701*** 8.690*** (44.29) (44.28) (44.32) LawD 0.028* (1.82) LawN 0.035*** (2.50) LawP 0.101*** (2.19) Size −0.368*** −0.368*** −0.367*** (−36.81) (−36.84) (−36.88) Lev 0.606*** 0.603*** 0.603*** (10.32) (10.31) (10.30) Roa 1.780*** 1.777*** 1.780*** (8.91) (8.92) (8.92) Firth −0.430*** −0.427*** −0.429*** (−8.44) (−8.38) (−8.43) State 0.056** 0.056*** 0.057*** (3.31) (3.29) (3.33) Year Yes Yes Yes Industry Yes Yes Yes Adj-R 0.399 0.399 0.399 F-value 163.463 163.720 163.677 N 12,727 12,727 12,727 notes: t his table reports the results of independent directors of legal expertise on corporate value. f rom columns 1 to 3, the independent variables are LawD, LawN, LawP, respectively. all the variables are defined in t able 1. all continuous variables are winsorized at 1 and 99% level. T-statistics used to signal the robustness of standard errors with White heteroscedastici- ty correction are reported in parentheses. ***, ** and * indicate statistical significance at 1, 5, and 10% levels respectively. Q = + Law + Size + Lev + , Roa + Firth + State + Control + (4) 0 1 2 3 4 5 6 In mode (4), Q represents a company’s market capitalisation and is measured as the ratio of the sum of equity value and book value of liabilities to book value of assets. The definition of Law is same as that defined in model (1) and it measures the influences of independent directors on corporate value from three aspects. LawD is a dummy variable equal to 1 when a listed company has independent directors having legal expertise, and 0 otherwise; LawN is the number of independent directors having legal expertise in the listed company; LawP is the proportion of independent directors having legal expertise to total independent direc- tors. The definitions of the remaining variables are same with those in model (1). Table 7 reports the regression results of model (4). From Table 7 we can see that the regression results of LawD, LawN and LawP are all significant and positive, suggesting that independent directors having legal expertise contribute to increase of corporate value to some extent. It means that the independent directors having legal expertise hired by listed companies play an active role in offering advices on companies’ legal affairs and also in reasonable evaluation of companies’ legal risks, assessment of the consistency between company behaviour and regulatory policies and third-party transactions. 5.2. Robustness test We conducted the following two robustness tests. 396 W. HE AND W. LIU 5.2.1. Supervisory function of independent directors having legal expertise When studying the functions of independent directors, it is difficult to distinguish the direc - tors’ supervisory and consulting functions, so there has been little prior research discussing the two separately (Liu et al., 2012). Nevertheless, for independent directors having legal expertise which are the object of our study, their legal consulting function is closely related with their expertise, making it easier to distinguish from the supervisory function. But man- agerial compensation only may not reflect the directors’ supervisory function completely. So, based on the previous research of Adams et al. (2010), Hall and Murphy (2003), Liu et al. (2012) and Wang (2007) we examine the independent directors’ supervisory function by selecting the pay-performance sensitivity, vetoes by the independent directors, earnings quality and CEO turnover as the supervised objects. We develop the following regression model to observe the influences that independent directors having legal expertise have on pay-performance sensitivity: Salary = + Law ∗ Roe + Law + Roe + Size + Lev + Mid 0 1 2 3 4 5 6 (5) + West + Firth + State + Year + Industry + 7 8 9 i j In the model (5), roe represents the company’s return on equity; mid and west represent the company’s location, denoting central China and western China respectively; the definitions of the remaining variables are the same as those in model (1). Table 8 presents the regression results of independent directors having legal expertise and managerial pay-performance sensitivity. As shown in Table 8, the regression results of three variables LawD, LawN and LawP signaling independent directors having legal expertise are all insignificant, indicating that Chinese listed companies do not engage independent directors having legal expertise for the purpose of controlling the management’s improper conducts relating to compensation. Earnings quality is another important object of supervision by independent directors in listed companies (Adams et al., 2010; Wang, 2007). Following them, we also select earnings quality as an object of supervision by independent directors having legal expertise. We use the modified Jones Model as the measure of earnings quality, and the regression results are summarized in Table 9. From Table 9 we can see that the regression results of LawD, LawN and LawP are not significant, demonstrating again that Chinese listed companies do not engage independent directors having legal expertise for the purpose of supervising the management’s conduct. Table 10 summarises the statistics relating to the vetoes by independent directors having legal expertise and other independent directors. The table shows that no matter the inde- pendent directors having legal expertise are introduced to the current or next session of the board, they submit fewer vetoes than other independent directors, indicating that inde- pendent directors having legal expertise show little willingness to veto the behaviour of majority shareholders or managers and thus cannot perform their due supervisory functions. Following Liu et al. (2012) to test the influence of independent directors having legal exper - tise on CEO turnover, we identify the following as alternative variable of CEO turnover: CEO turnover under the circumstance where company performance (ROE) declines in two con- secutive years. Table 11 reports the regression results of independent directors having legal expertise and CEO turnover after the company operates at a loss in two consecutive years. The regression results of three variables LawD, LawN and LawP signaling independent CHINA JOURNAL OF ACCOUNTING STUDIES 397 Table 8. independent directors having valegal expertise and pay-performance sensitivity. Salary (1) (2) (3) Constant 6.075*** 4.757*** 6.011*** (21.57) (13.5) (20.90) LawD 0.032 (1.44) LawD × Roe 0.022 (0.74) LawN 0.032 (1.52) LawN × Roe 0.036 (1.32) LawD 0.055 (0.84) LawD × Roe 0.079 (0.92) Roe 0.040** 0.032** 0.039** (2.53) (2.01) (2.51) Size 0.338*** 0.399*** 0.342*** (25.44) (23.59) (25.10) Lev −0.542*** −0.540*** −0.542*** (−8.61) (−8.33) (−8.56) Mid −0.209*** −0.219*** −0.211*** (−5.94) (−6.11) (−5.96) West −0.284*** −0.297*** −0.285*** (−8.05) (−8.28) (−7.99) Firth −0.409*** −0.361*** −0.424*** (−4.83) (−4.17) (−4.94) State 0.008 −0.002 0.006 (0.29) (−0.09) (0.21) Year Yes Yes Yes Industry Yes Yes Yes Adj-R 0.413 0.399 0.412 F-value 123.802 115.604 120.400 N 12,727 12,727 12,727 notes: t his table reports the results of independent directors of legal expertise on pay-performance sensitivity. in column 1, the independent variables are LawD and the interaction term of LawD and roe. in column 2, the independent variable are LawN and the interaction term of LawN and roe. in column 3, the independent variable are LawP and the interaction term of LawP and roe. all the variables are defined in t able 1. all continuous variables are winsorized at 1 and 99% level. T-statistics used to signal the robustness of standard errors with White heteroscedasticity correction are reported in pa- rentheses. ***, ** and * indicate statistical significance at 1, 5, and 10% levels respectively. directors having legal expertise are all insignificant, implying that independent directors having legal expertise in Chinese listed companies perform few functions in supervising CEO turnover. 5.2.2. Possible endogeneity between independent directors having legal expertise and corporate value Companies of higher values may happen to have engaged independent directors having legal expertise. We use the following four methods to solve the possible endogeneity problem. First and foremost, following Bertrand and Schoar (2003), we use the manager fixed effects model to test the influence of independent directors having legal expertise on corporate value. Bertrand and Schoar (2003) created manager-company matching panel data to track the work experience of managers holding concurrent posts in two or more listed companies, and employed the time fixed effects model to investigate the influence that managers have 398 W. HE AND W. LIU Table 9. independent directors of legal expertise and earnings quality. DA (1) (2) (3) Constant 0.259 0.626*** 0.798*** (0.68) (5.56) (6.80) LawD 0.061 (0.37) LawN 0.046 (0.96) LawP 0.021 (1.31) Size −0.006 −0.001 −0.007*** (−0.32) (−0.26) (−4.79) Lev 0.197*** 0.088*** 0.027*** (3.32) (4.44) (4.34) Roa 0.587** 0.161** 0.041* (2.37) (2.06) (1.67) Firth −0.670*** −0.202*** −0.050*** (−5.20) (−5.60) (−4.45) State −0.059** −0.010 −0.002 (−2.43) (−1.37) (−0.99) Year Yes Yes Yes Industry Yes Yes Yes 2 2 Adj-R /Pseudo-R 0.015 0.022 0.025 N 12,148 12,148 12,148 notes: t his table reports the results of independent directors of legal expertise on earnings quality. f rom columns 1 to 3, the independent variables are LawD, LawN, LawP, respectively. all the variables are defined in t able 1. all continuous variables are winsorized at 1 and 99% level. T-statistics used to signal the robustness of standard errors with White heteroscedastici- ty correction are reported in parentheses. ***, ** and * indicate statistical significance at 1, 5, and 10% levels respectively. Table 10. Vetoes by independent directors of legal expertise and other independent directors. Vetoes by independent directors of Vetoes by other directors T-test/Wilconxon test legal expertise *** t Mean 0.000221 0.000820 −5.339 *** t Median 0.000000 0.000000 −6.871 *** t + 1 Mean 0.000233 0.000921 −5.310 *** t + 1 Median 0.000000 0.000000 −6.880 notes: t his table reports the statistics relating to the vetoes by independent directors of legal expertise and other inde- pendent directors. all the variables are defined in t able 1. ***, ** and * indicate statistical significance at 1, 5, and 10% levels respectively. on corporate financing, investment, mergers and acquisitions, and other major decisions. In this method, the external environment’s influences on company decisions are measured based on the control of company-specific effects and company decision changes are attrib - utable to managers, thus the endogeneity problem existing in empirical studies is solved. We identified 217 independent directors having legal expertise documented in the CSMAR database who have ever served two or more companies, and then used the method pro- posed by Bertrand and Schoar (2003) to test the influences that independent directors having legal expertise have on corporate value. The regression results presented in Tables 12–14 show that after the endogeneity problem is controlled, the independent director having legal expertise becomes significantly associated with corporate value, suggesting that the foregoing findings are reliable. Second, we use the differential model. Krishnan et al. (2011) used the differential model to assess the endogeneity produced by audit committee members having legal expertise CHINA JOURNAL OF ACCOUNTING STUDIES 399 Table 11. independent directors of legal expertise and Ceo turnover. CEOturnover (1) (2) (3) LawD 0.002 (0.10) LawN 0.007 (0.46) LawP 0.013 (0.25) Size 0.008 0.008 0.008 (0.86) (0.87) (0.87) Lev −0.048 −0.049 −0.048 (−1.22) (−1.25) (−1.23) Roa −0.828*** −0.829*** −0.828*** (−6.32) (−6.34) (−6.33) Firth 0.163** 0.165** 0.164** (2.50) (2.52) (2.51) State 0.046** 0.046** 0.046** (2.22) (2.24) (2.22) Constant 0.035 0.031 0.031 (0.17) (0.15) (0.15) Year Yes Yes Yes Industry Yes Yes Yes Observations 2,091 2,091 2,091 Pseudo-R 0.040 0.041 0.041 F 3.671 3.680 3.674 notes: t his table reports the results of independent directors of legal expertise on Ceo turnover. f rom columns 1 to 3, the independent variables are LawD, LawN, LawP, respectively. all the variables are defined in t able 1. all continuous variables are winsorized at 1 and 99% level. T-statistics used to signal the robustness of standard errors with White heteroscedastici- ty correction are reported in parentheses. ***, ** and * indicate statistical significance at 1, 5, and 10% levels respectively. Table 12. f ixed effects of independent directors of legal expertise on corporate value. Effects (1) (2) (3) (4) (5) (6) Control 81.361 116.771 14.155 39.330 41.485 38.282 (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) YEAR 77.492 115.692 104.960 (0.00) (0.00) (0.00) FIRM 3.251 4.683 4.650 (0.00) (0.00) (0.00) MANA 2.311 3.870 (0.00) (0.00) 2_ R adjust 20.78% 38.70% 53.05% 31.62% 71.22% 74.33% 2_ R adjust increase 17.92% 32.27% 10.83% 50.43% 53.55% 2_ R adjust percent increase 86.21% 155.26% 52.13% 242.68% 257.67% Vuong-Test 5.732 p-value (0.00) note: t his table reports the results of fixed effects of independent directors of legal expertise in corporate value. all the var - 2_ iables are defined in t able 1. t he table above presents F-statistics, and P-statistics are reported in parentheses. R adjust 2_ increase is the increase of variables contained in columns 2 throughout 6 relative to column (1) values. R adjust increase ratio is the percent increase of variables contained in columns 2 throughout 6 relative to column (1) values. Vuong-Test 2_ assesses the difference in R adjust presented in columns 6 and 5. on the quality of financial reporting. Accordingly, we also use the differential model to exam- ine the endogeneity between independent directors having legal expertise and corporate value. The regression model used is estimated as follows: Δ Q = + ΔLaw + Δ Size + Δ Lev + Δ Roa + Δ Firth + State 0 1 2 3 4 5 6 (6) + Year + Industry + i j 400 W. HE AND W. LIU Table 13. Significant level statistics of the effects of independent directors of legal expertise. Significant level Proportion of significant effects Number of significant effects 10% 19% 42 5% 11% 24 1% 3% 7 num 217 73 Table 14. distribution of coefficients of independent directors’ effects. Manager Num 217 Mean Effect 1.225 Sdv 1.150 Max Effect 4.207 Min Effect −3.090 Median Effect 1.228 25th Percentile 0.499 75th Percentile 1.963 Difference between 25th and 75th 1.464 Table 15. independent directors of legal expertise and corporate value using differential model. ΔTobinQ (1) (2) (3) ΔLawD 1.976** (2.30) ΔLawN 1.503** (2.02) ΔLawP 5.979** (2.56) ΔSize −6.607*** −6.613*** −6.582*** (−9.01) (−9.02) (−8.98) ΔLev 17.547*** 17.580*** 17.510*** (10.49) (10.51) (10.46) ΔRoa 4.024 4.036 4.044 (1.44) (1.44) (1.45) ΔFirth 6.021 6.056 6.008 (1.40) (1.41) (1.40) ΔState −0.730 −0.722 −0.719 (−0.77) (−0.76) (−0.76) Constant −0.896 −0.889 −0.906 (−0.58) (−0.57) (−0.58) Year Yes Yes Yes Industry Yes Yes Yes N 10,232 10,232 10,232 F-value 7.480 7.442 7.520 R _adj 0.023 0.023 0.023 notes: t his table reports the differential model results of independent directors of legal expertise on corporate value. f rom columns 1 to 3, the independent variables are ΔLawD, ΔLawN, ΔLawP, respectively. all the variables are defined in t able 1. all continuous variables are winsorized at 1 and 99% level. T-statistics used to signal the robustness of standard errors with White heteroscedasticity correction are reported in parentheses. ***, ** and * indicate statistical significance at 1, 5, and 10% levels respectively. In model (6), all the variables are same with those described in model (1), while continuous variables are assigned differences of the values of two continuous years. Table 15 presents the regression results produced using the differential model. From Table 15 we can see that the regression results of ΔLawD, ΔLawN and ΔLawP are all significantly positive, which implies CHINA JOURNAL OF ACCOUNTING STUDIES 401 Table 16. independent directors of legal expertise and corporate value using did model. TobinQ (1) Lfirm*Tyear 0.340*** (4.73) Lfirm 0.075*** (2.89) Tyear −0.368*** (−5.46) Size −0.419*** (−52.38) Lev 0.809*** (26.29) Roa 2.166*** (18.34) Firth −0.416*** (−7.21) State −0.070*** (−3.75) Constant 9.780*** (55.61) Year Yes Industry Yes Observations 12,727 R _adj 0.396 F-value 239.701 notes: t his table reports the did model results of independent directors of legal expertise on corporate value. i n column 1, the independent variables are Lfirm, Tyear and the interaction term of Lfirm and Tyear. all the variables are defined in t able 1. all continuous variables are winsorized at 1 and 99% level. T-statistics used to signal the robustness of standard errors with White heteroscedasticity correction are reported in parentheses. ***, ** and * indicate statistical significance at 1, 5, and 10% levels respectively. that the influences that independent directors having legal expertise have on corporate value are robust. Third, we use the Difference—In—Difference model. We give the value 1 to the Lfirm var - iable if the company has independent directors having legal expertise, and 0 otherwise; and the Tyear variable is assigned value 1 and 0 respectively after and before appointment of independent directors having legal expertise. The regression model is estimated as follows: Q = + Lfirm ∗ Tyear + Lfirm + Tyear + Size + Lev + 0 1 2 3 4 5 6 (7) + Firth + State + Year + Industry + 7 8 i j In model (7), all the variables are the same as those described in model (1). Table 16 presents the regression results produced using the Difference—In—Difference model. As shown in Table 16, the coefficients of Lfirm and Lfirm*Tyear are both significantly positive, indicating that the changes of corporate value are directly related to the appointment of independent directors having legal expertise and that such independent directors contribute to an increase of corporate value. Fourth, we use the 2SLS instrumental variables method. Considering that there may exist bidirectional causality between independent directors having legal expertise and corporate value, we select the “government incorruptibility” index (Incor) and “judiciary justice and efficiency” index (Judic) as instrument variables, by reference to the Report on Business Environment Indexes for China’s Provinces 2013 compiled by Wang Xiaolu in 2013. Local 402 W. HE AND W. LIU Table 17. independent directors of legal expertise and corporate value using instrument variables method. TobinQ The second stage (1) (2) (3) LawD 1.610** (1.98) LawN 1.270** (2.23) LawP 4.010** (2.26) Size −0.404*** −0.262*** −0.243*** (−23.34) (−21.36) (−15.51) Lev 0.554*** 0.144*** 0.142*** (7.00) (2.57) (2.57) Roa 0.220** 0.070 0.073 (2.36) (1.08) (1.05) Firth −0.052 −0.080 −0.103 (−0.23) (−0.56) (−0.77) State −0.022 0.012 −0.010 (−0.32) (0.16) (−0.47) Year Yes Yes Yes Industry Yes Yes Yes N 4,826 4,826 4,826 ** ** *** F-value 64.547 68.204 69.379 Sargan Test 0.210 0.242 0.181 Underidentification test 9.693*** 9.693*** 10.187*** Huasman Test 29.600** 24.450* 28.170** notes: t his table reports the 2SlS model results of independent directors of legal expertise on corporate value. f rom col- umns 1 to 3, the independent variables are LawD, LawN, LawP, respectively. all the variables are defined in t able 1. all continuous variables are winsorized at 1 and 99% level. t -statistics used to signal the robustness of standard errors with White heteroscedasticity correction are reported in parentheses. ***, ** and * indicate statistical significance at 1, 5, and 10% levels respectively. government integrity and judiciary justice will encourage companies to engage more inde- pendent directors having legal expertise, while such independent directors can use their expertise to enhance the legitimacy of business activities and in turn blunt the companies’ motives for rent-seeking. These two variables have no direct eec ff t on corporate value (com - panies may operate at a loss even in a sound judicial environment and corruption-free busi- ness environment) but may inu fl ence corporate value through independent directors having legal expertise. We conduct the Sarganexogeneity test to verify the hypothesis that instru- mental variables are not associated with the disturbance and the original hypothesis is not denied, suggesting that the instrument variables selected for the “government incorrupti- bility” index and “judiciary justice and efficiency” index do not directly influence corporate value. In addition, in the first stage regression not presented here, these two variables have significant effects on independent directors having legal expertise. The above demonstrates that the instrument variables selected in this paper are suitable. We estimate models (8) and (9) for regression when applying the 2SLS instrumental variables method. The definitions of variables used in models (8) and (9) are same as those in model (1), and Incor and Judic represent the “government incorruptibility” index and “judiciary justice and efficiency” index respectively. Table 17 reports the results of the second stage regression. The regression results of 2SLS show that independent directors having legal expertise contribute to increase of corporate value. The regression models used for the 2SLS instrumental variables method are shown below: CHINA JOURNAL OF ACCOUNTING STUDIES 403 The first stage: Law = + Incor + Judic + Size + Lev + Roa + Firth 0 1 2 3 4 5 6 (8) + State + Year + Industry + 7 i j The second stage: Q = + Law + Size + Lev + Roa + Firth + State 0 1 2 3 4 5 6 (9) + Year + Industry + i j 6. Conclusion As an important institutional arrangement in corporate governance, independent directors’ supervisory and consulting functions have always been the subject of serious attention in academe, but there are no consistent conclusions as to which function is performed by independent directors in listed companies. In this paper, we use the data concerning Chinese listed companies to investigate the underlying motivations for listed companies to engage independent directors having legal expertise and analyse the associated economic conse- quences. We find that the main function of independent directors having legal expertise in Chinese listed companies is to offer advice. In addition, when the listed companies are bound up in such activities as lawsuits, dividend distribution, equity transfer and asset acquisition, they are more likely to engage independent directors having legal expertise to improve consultation. Independent directors having legal expertise generally vary in exper- tise and abilities possessed. We further find that when a listed company is considering hiring independent directors having legal expertise, it would prefer those well-regarded inde- pendent directors having extensive practical experience. Lastly, we also find that the listed companies which hire independent directors having legal expertise generally have high market value. Law not only influences corporate governance through establishment of the State’s legal institutions, court procedures and legalisation but also affects corporate governance through legal expertise in the companies. The research of this phenomenon, Engaging independent directors having legal expertise is voluntary behaviour for Chinese listed companies, con- tributes to understanding corporate governance mechanism in transition economics. 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Journal
China Journal of Accounting Studies
– Taylor & Francis
Published: Oct 1, 2016
Keywords: Corporate governance; independent director; professional legal expertise
