Relationship between Corporate Governance and Financial Distress: An Empirical Study of Distressed Companies in China

Abstract

Because of the effects of the internal and external environment on companies, it is argued that the way in which a company governs itself should make a difference to its susceptibility to financial distress. It is argued that companies with appropriate corporate governance should be less likely to suffer from the costs of financial distress than companies whose governance is inappropriate. Within this framework, we examined the relationships between selected aspects of corporate governance and the indirect costs of financial distress, using panel data of 193 financially distressed listed companies in China from 2000 to 2006. We find that ownership balancing at the governance level reduced the indirect costs of financial distress, while each of the following three aspects of corporate governance-the proportion of the company's shares that were held by the state, the percentage of independent directors on the board, and the proportion of total costs that were overhead costs-increased the indirect costs of financial distress. The results suggest that companies benefit from better corporate governance and that such improvements can help the companies to become financially healthy. 1. Introduction It is common for companies to experience financial distress before and after running smoothly. Financial distress is usually regarded as the embarrassing situation of not being able to pay mature debts or expenses, which involves liquidity problems, insufficiency of equity, default debts and lack of current assets. Financial distress is the cost of falling into financial distress and some opportunity losses, and it can be easily divided into direct costs and indirect costs. Direct costs of financial distress include the diminishing of assets caused by quarrels between owners and creditors, the fees for lawyers, legal costs and other administrative costs. Indirect costs refer to the potential losses due to bankruptcy, which include decreasing clients or increasing costs caused by financial distress, and the decreasing of company's value caused by managers' actions to protect themselves. Some scholars (Branch, 2002) also regard the losses of creditors and stakeholders as indirect costs, as well as part of companies' losses. Recent studies on financial distress have been concerned with the prediction of distress and calculation of indirect costs, but there has been little analysis of the factors and mechanisms involved, nor of the influence of corporate governance characteristics on indirect costs. Theoretically, good corporate governance should effectively prevent financial distress, and also be able to get rid of bankruptcy. However, the internal and external environment may change a lot due to financial distress, so some corporate governance characteristics may have a positive effect on value when the firm is healthy and opposite effects when the firm is distressed. Especially in China, some characteristics like having an unbalanced shareholder structure, governmental interference and insider control, constitute significant 'opposite' influences. This paper will analyze the relationship between corporate governance characteristics and the indirect costs of financial distress of 193 listed companies in 2000-2006. 2. A Review of the Literature In the study of the costs of financial distress, we should clarify the idea of financial distress first. However, there has not been an agreed definition until now. For example, Beaver (1966) defines bankruptcy, default preferred dividends and default debts as financial distress. Deakin (1972) believes companies with financial distress should only include those who have already been bankrupt, debt insolvent, or have made to liquidate for the creditors. It is difficult to give a clear definition of financial distress; with different classifications influencing how it is measured. It is common to measure financial distress from two aspects: operating performance and market value of equity. …

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