Financial constraints, board governance standards, and corporate cash holdings

• Date: 01 January 2016
• Author: Heungju Park,Choonsik Lee
• Published date: 01 January 2016
• DOI: http://doi.org/10.1016/j.rfe.2015.10.001

Financial constraints, board governance standards, and corporate

cash holdings☆

Choonsik Lee

a

, Heungju Park

b,

⁎

a

Departmentof Finance, Schoolof Business, QuinnipiacUniversity, Hamden, CT06518, United States

b

HSBC BusinessSchool, PekingUniversity, Shenzhen,China

abstractarticle info

Articlehistory:

Received27 January 2015

Receivedin revised form 29 September2015

Accepted5 October 2015

Availableonline 22 October 2015

JEL classification:

G32

G34

Keywords:

Financialconstraints

Internalmonitoring

Corporatecash holdings

This study examines whether financial constraints and board governance play substitution roles in lowering

agency concernsin corporate cash holdings. Using four firm-specificcharacteristicsoffinancialconstraints and

28 forward-lookingboard governance standards, we find that board governance mitigates agency concernsin

cash holdingsmore significantly for financiallyless-constrained firms. Consistently, financiallyless-constrained

firms increasethe level of boardgovernance and adopt moreboard governance standards.A natural experiment

withthe 2007 financial crisisprovides robustnessto our findings. Our evidencesuggests that financialconstraints

interrelatewith the effectivenessof board governance on corporatecash holdings.

© 2015 ElsevierInc. All rights reserved.

1. Introduction

Corporatecash holdings have receivedgrowing attentionfrom both

business practitioners and a cademic researchers. In Febru ary 2013,

David Einhorn, an activist shareholder of Ap ple, Inc., filed a lawsuit

against Apple's management, cl aiming that Apple, despite bein g

one of the financially healthiest firm s in the US, sat on more than

$137 billion in cash rather than distribute it to shareholders and that

its poor governance structureinterfered with the effective monitoring

of managers. Managers generallyprefer internal cash over external fi-

nancing(Myers and Majluf(1984)), which couldlead to large stockpiles

of cash, whereas shareholders may be concerned a bout managers'

discretion in using that cash. Moreover,self-interested managers may

intend to spend excess cash flow for their private benefit(Jensen and

Meckling (1976)), and shareholdershave an incentive to improve the

quality of corporate governance to mitig ate agency problems. Thus,

shareholders may allow management to hold larger c ash reserves

when they are better protected by good go vernance mechanisms

(Harford, Mansi, and Maxwell (20 08)). A well-functioning board

enhances the financial and operation al transparency of a firm

(Bebchuk (2007);Core, Holthausen,and Larcker (1999)) and reduces

the likelihoodthat management wastes cashfor its private benefit.

In addition to board governancemechanisms, financial constraints

play an important role in determining a firm's cash holdings. Financially

constrained firms have limited accessto the external financingmarket,

and their managers are more dependent on internal funds and more in-

clined to reserve sufficient cash for precautionary motives. As for the pre-

cautionary motive, the shareholders of financially constrained firms tend

to be less concerned about managers holdingrelatively large cash re-

serves (Opler, Pinkowitz, Stulz, and Williamson (1999);Almeida,

Campello, and Weisbach (2004);Han and Qiu (2007);Harford et al.

(2008)). Moreover, Luo (2011) argues that managers with limited access

to the external financing market have an incentive not to waste valuable

internal cash, which is considered a disciplinary function of financial con-

straints. In contrast, shareholdersof financially less-constrained firms

tend to be more concerned with improvingthe internal monitoring of

managers because of the lack of the disciplinary function.

We examine the interactionbetween board governance and finan-

cial constraints in mitigatin g agency problems related to corpo rate

cash holdings. We propose that the effectiveness of board governance

on cash holdings is more significant for financially le ss-constrained

Reviewof Financial Economics 28 (2016)21–34

☆The authors thank the editor (Tarun K. Mukherjee) and an anonymous referee for their

many valuablecomments. The authorsalso thank Hursit S. Celil,Fan Chen, Kee H. Chung,

Anna-Leigh Stone, Lei Gao, and the seminar participantsat Peking University, the 2014

Eastern Finance Association conference, and the 2014 World Finance and Banking

symposium for their valuable comments and suggestions. This study began while Choonsik

Lee was at the University at Buffalo. Choonsik Lee thanks Institutional Shareholder Services

Inc. (ISS) for proving corporate governance data.All remaining errors are our own.

⁎Corresponding author. HSBC Business School, Peking University, University Town,

Shenzhen,China, 518055. Tel.:+86755 2603 3191.

E-mailaddresses: Choonsik.Lee@quinnipiac.edu(C. Lee), hpark@phbs.pku.edu.cn

(H. Park).

http://dx.doi.org/10.1016/j.rfe.2015.10.001

1058-3300/©2015 Elsevier Inc. All rightsreserved.

Contents listsavailable at ScienceDirect

Review of Financial Economics

journal homepage: www.elsevier.com/locate/rfe