Do Weak Internal Controls Affect Institutional Ownership Decisions?

Abstract

Weak internal controls should increase risk perception among various contracting parties, e.g., institutional investors. This study examines whether the penalty firms pay for weak internal controls is associated with ownership decisions made by institutional investors in Taiwan and whether such decisions differ from those made by qualified foreign institutional investors (denoted as QFIIs) and local institutional investors. Empirical results indicate that weak internal controls are negatively associated with changes to institutional investor ownership, particularly for QFIIs. Further evidence shows that this negative association is more pronounced for firms with high divergence of control and cash-flow rights. This suggests that, faced with weak internal controls, institutions passively vote with their feet rather than actively monitor their portfolio firms. We demonstrate several diagnostic tests and show that the results are robust in various specifications.