Chapter
2 – Literature Review
CG generally refers to
the overall control of activities in a corporation to ensure that it functions
to maintain its integrity, reputation, and responsibility to its various
constituencies (Steiner & Steiner, 2003). A narrower view of CG is the
effective delineation of the rights and responsibilities of each group of
stakeholders in the company (Ho & Wong, 2001).
The Organisation for
Economic Co-operation and Development (OECD) has issued the OECD Principles of
Corporate Governance to guide its member countries. The latest version (OECD,
2004) covers six broad areas:
- establishing an effective CG framework;
- setting out the rights of shareholders and
key ownership functions;
- equitably treating shareholders;
- outlining the role of stakeholders in CG;
- ensuring transparency, timely and accurate
disclosure; and
- delineating the responsibilities of the
Board.
Hong Kong listed
companies are predominantly family-controlled (as elaborated in Section 2.5.1)
with the majority shareholders usually holding executive positions in the
company. As they are involved in running the business, transparency and
disclosure are not as significant as for those companies with widely dispersed
shareholdings. In contrast with the traditional corporate absentee owner
characteristic dominating western companies, the shareholders of the
closely-held Hong Kong corporates can be expected to enjoy a greater proximity
to their companies’ day-to-day operations. Of the six broad OECD principles,
this study focuses on the role played by the Board, and in particular the
impact of independent directors on firm performance.
History shows that
individuals first started trading as sole traders or as members of
partnerships. The earliest form of incorporation under the Common Law was only
by Papal bull or royal charter; rights of association and corporate status
originally bestowed by the Church or the Crown. Bearing in mind the manner in
which royal charters were accorded companies such as the East India Company and
the Hudson’s Bay Company to enhance the British world trading dominance,
initially such a corporation might well be considered to have been (in effect)
an “arm of the state”, formed for the public good. From 1844 the UK commenced a
system of company incorporation by mere registration, arguably an event marking
the creation of the modern corporation (Laine, 1998). In that year the first
general UK Companies Act was passed providing for incorporation by registration
of Deeds of Settlement. Incorporation changed from an ad hoc privilege
granted to a select few on certain terms (supposedly) for the public benefit,
to a right granted with relatively few conditions to all capable of taking
advantage of it. Apparently, the obligation for company boards to act in the
public interest was a quid pro quo for incorporation, and responsible,
good governance might be perceived to have been an implied expectation.
However, the economic structure of corporations and their mode of operation
contain inherent managerial difficulties.
Ronald Coase
(1937) argued that firms are established to reduce transaction costs. Whereas
individuals can produce according to market price and sell their products or
services on their own behalf in the market, there are various costs involved in
“market” transactions – information costs, measuring costs, negotiation costs,
contract costs, enforcement costs, etc. – making market price difficult to
determine. Coase’s proposition was that when transaction costs are so high that
market price is not readily known, individuals would rather work under a
manager. Thus, according to Coase, firms evolve as a result of transaction
costs.
It was largely in the American
manufacturing sector that the potential of the company to assume enormous
proportions was realised. With American industrialisation, sizeable companies
began to be formed to handle major projects around the second half of the
nineteenth century (Learmount, 2002). The “Robber Barons” who emerged in the
late-nineteenth century as industrialists used their professional managers to
amass great wealth through, in particular, takeover activities and other
commercial ventures that were at times controversial in respect of both their
commercial propriety and social desirability. These professional managers in
the US started to establish strong control in large corporations, whilst
shareholders were becoming more numerous and dispersed. Berle and Means (1932)
who observed and wrote of such a development of managerialism from the turn of
the twentieth century to about 1920 and introduced the focus on the “separation
of ownership and control”, are regarded as the forefathers of modern-day focus
on CG (Learmount, 2002). The separation of ownership and control of which they
observed and wrote, and the implied responsibility it spawned were the portends
of the notion of “agency”, creating the many situations in which the interests
of managers and owners could be in conflict. In the corporate setting this
manifests in the circumstances in which managers act in their own interests to
the detriment of those of the shareholders, and some argue to the detriment of
the interests of the community at large.
Consistent with the “agency”
theme, Cheung (1969) in the 1960s explored the contractual relationships
between landlords and tenants in Taiwanese farms. When generalised, Cheung’s
theory of share tenancy can be interpreted, by way of analogy, as a theory
explaining the relationship between principals and their agents. Governance
problems foreseen by Adam Smith (1776) were likely to surface through the
business forms conducive to the industrialisation of production. Their
manifestations later observed by Berle and Means (1933) to characterise the
exploits of the robber barons, in the 1970s crystallised into the agency theory
formulation (Alchian & Demsetz, 1972; Jensen & Meckling, 1976) which is
now so firmly embedded in the CG literature. Agency theory explicitly considers
a company’s managers to be the “agents” of the shareholders, the “principals”,
and is underpinned by a main assumption that, without constraints and being
free to enter into a contract or contract elsewhere, parties to a contract will
act to maximise their own self-interests. More specifically, agency theory
suggests that the best option for owners is to design contracts that align the
interests of the managers with their own. When the optimal compensation
contract cannot be achieved or when managers are reluctant to bear greater
risks, owners must create or utilise existing mechanisms to monitor managerial
action (Fama, 1980).
Whereas agency theory
is the most commonly pursued governance paradigm in respect of western
corporations, the wider stakeholder focus might be considered to be
gaining ground. Virtues attributed to the legal dominance of the rights and
interests of shareholders are increasingly being questioned by the
counter-focus pursued in the corporate social responsibility literature.
Stakeholder theory thus comprises a set of ideas bridging what shareholder
theory treats as a divide between corporates’ legal and their social
responsibilities.
The roots of stakeholder
theory can also be traced to the promotional elements of social and
financial reform underpinning the 1844 UK Companies Act. Freeman (1984), for
instance, graphically modelled the concept of stakeholders to be impacting
factors on the firm and, in turn, on whom the firm impacts. Stakeholder theory
thereby proposes that the interests of stakeholders must not be ignored, that
shareholders might properly be considered merely members of a larger
stakeholder class, and that a firm must negotiate tradeoffs between its greater
goals and the goals of its stakeholders. North (1994) notes in his lecture
delivered while receiving the Nobel Prize that the CG structure of a business
enterprise relates to both formal and informal contractual agreements among
corporate stakeholders. These may include the payoff structure for the
suppliers of capital, the incentive structure of corporate decision-makers, and
the organisational structure for maintaining an effective balance in bargaining
power of the participants (Lashgari, 2004).
Contrasting with the underlying
tenets of agency theory, stewardship theory proposes that instead of being an
agent of the shareholders, a manager is the steward of a company’s assets
(Donaldson & Davis, 1991). Here the perception is that managers are
inherently trustworthy and not prone to misappropriate corporate resources
(Donaldson & Davis, 1991). In this view the “separation of ownership and
control” described by Berle and Means does not create a problem to be overcome.
It suggests that depth of knowledge, commitment, access to current operating
information and technical expertise, are important requirements enabling a company
to be run effectively. In this respect stewardship theory might be perceived to
directly challenge the underpinnings of agency theory that emphasise on the
importance of the monitoring role of an independent board and a powerful
Chairman (Learmount, 2002). Stewardship theory thus promotes the necessity for
truthful ex post accountability by the steward regarding the outcomes of
whatever has been undertaken by the steward with the property entrusted, in
contrast with agency theory’s ex ante controlling and monitoring focus.
Kay & Silberston’s
(1995) notion of trusteeship presents the idea of a board of directors
functioning as the trustee of company assets. Like the idea of stewardship,
trusteeship is argued by its supporters to better capture the roles and
responsibilities of the company board than the economic theories discussed
earlier. As such, consideration of the company board as a collective trustee
has some appeal for those who view companies to be exploiting the privileges of
the commercial setting established by the State and supported by the populace.
For the advocates of the trusteeship paradigm, the NED is perceived to be a
valuable creative force on the board of directors, presumably because of the
imagined degree of independence attributed to such a person. This contrasts
with the representative of the shareholder interest as put forward by the
agency theory, and the interloper described by stewardship theory (Learmount,
2002). Trusteeship therefore implies that NEDs are more “stakeholder” oriented
than the executive directors.
It has been suggested (by, for
example, Powell, 1996; Roberts, 2001) that organisational trust might
constitute an alternative to the direct monitoring and control mechanisms
characterising economic approaches to the governance of companies. Theories of
organisational trust have thus emerged mainly in the context of a growing
interest in inter-firm collaboration, strategic alliances, partnerships and
joint ventures, but they have also begun to be used to explore board processes
and inter-firm governance processes (Learmount, 2002). The notion of
organisational trust embraces ideas contrary to those driving, in particular,
agency theory. In it, the agency costs are considered necessary because of the
perceived potential of agents to act in their own interests as they lack the
virtue of trustworthiness.
Despite all the
theoretical developments in the organisational research field, it is the
economists’ ideas, in particular those underpinning agency theory, which have
become by far the most prevalent and have most influenced the shape of the
national CG regimes currently in vogue. Against a backdrop of corporate
failures, scandals and general malpractices, the supposed virtues of director
independence permeate governance regimes and the pervading perceptions of what
are habitually promoted to be the corporate elements necessary for an orderly
commercial environment.
Good CG is said to serve as a tool for
attracting certain types of investors as well as influencing what will be paid
for stocks (Korac-Kakabadse, Kakabadse & Kouzmin, 2001). Consistent with
the international trend, the conventional wisdom in Hong Kong is that good CG
leads to better corporate financial performance. According to Mobius (2002),
for example, good CG brings about better management and a more prudent
allocation of the company’s resources, the combination of which enhances
corporate performance. The theme is that earnings from enhanced performance
contribute to increases in the company’s share price, and thus the value of a
shareholder’s holdings. Similarly, Tsui, a leading Hong Kong academic, also
strongly believes in the positive impact of good CG on economic performance
(Australian CPA Network, 2005).
For the most part the
etymological definitions have been resorted to without much regard for either
the CG context in which the matter of independence is being embedded, or for
the distinction between independence as a descriptor of a relational state of
individuals, and independence as a “state of mind” that might be brought to
bear in respect of a particular evaluation or assessment of business variables.
It is no surprise that there is, however, no precise definition other than
identifying specific circumstances precluding independence.
The general definition
of independent director depicts one who is free from relationships with the
company, companies related to the company, or the company’s officers, or any
other relationship that could be seen as interfering with a director’s
independent judgment (Tsui & Gul, 2002). For instance, the 2001 Ramsay
Report on auditor independence spells out that no independence is likely if
there exists any employment, financial or business relationships. Similarly,
under the Listing Rules of the HKEx, the independence of a director is likely
to be questioned if there are employment, financial or business relationships
under circumstances such as holding more than 1% of the total issued share
capital of the company, acting as a professional adviser, financially dependent
on the company, or was connected with a director, the chief executive, a
substantial shareholder or management shareholder of the company within 2 years
immediately prior to the date of appointment, etc.
Without a clear
definition of independent director, the notion of an independent board
is equally unclear, indeed arguably a non
sequitur. Perhaps by default, an “independent board” is generally taken to
be a company board having a “high proportion” of independent directors – a
rough quantitative rather than an essentially ethical characteristic; or to
mean a company board functioning independently from managerial interference – a
behavioural characteristic.
Understandably, in such
an indefinite state, Daily, Johnson and Dalton (1999) were able to identify
over two dozen operationalizations of board composition, warning that some of
the evident inconsistencies in board composition/outcomes research may be due
to the incongruent manner in which this key governance variable has been
formulated. Since they feature frequently in the CG literature, it is helpful
for this thesis to bear in mind the confusing state of play and the variations
in how the terms “non-executive director”, “independent director”, “independent
non-executive director” and “outside director” are used in descriptions of the
so-called “independent board”.
In principle, there are three
key roles played by the directors: a service role (underpinned by stewardship
theory) – entailing developing policies, enhancing company reputation, etc.; a
control role (drawing upon agency theory) – engaging in monitoring CEO and
management performance on behalf of shareholders; and a strategic role
(injecting stakeholder theory) – guiding the development of corporate mission
and providing strategic direction (Korac-Kakabadse, Kakabadse & Kouzmin,
2001). The function of the Board, according to Coulson-Thomas (1992), is often
described in terms of establishing objectives and strategy, and subsequently,
monitoring and reviewing their achievement. In particular, Leblanc and Gillies
(2003) consider the independent oversight of management and corporate
stewardship as a key task of the Board. Some even go further in suggesting the
oversight by the board of directors as the most critical of directors’ roles.
It may not be very meaningful to
rank the importance of the three roles outlined above, as their relative
significance probably varies with companies of different characteristics.
Instead, it is perhaps more constructive to assign different roles to different
classes of directors. From the various theories discussed earlier, it seems
logical that the service role is best performed by executive directors who
possess intimate knowledge of company operations. Control and strategic roles
are better performed by NEDs as they are likely to have more independent views
of managerial performance and company mission. In particular, the control role
is commonly perceived to be best performed by independent directors who have no
employment, business or other financial relationships with the company.
Member of a board of
directors in the US can generally be grouped under the following four
categories (Daily, Johnson & Dalton, 1999):
- Inside director
- Outside director
- Independent/interdependent director
- Affiliated director
The inside/outside director
dichotomy distinguishes between board members in the direct employ of the
company and those who are not, the prevailing mantra being that outside
directors possess greater independence, thus are less susceptible to be
influenced by others. By reviewing the existing empirical literature, Daily,
Johnson and Dalton (1999) identified four different ways used to classify
inside director. They also identified no fewer than nine ways of defining
outside director – employment being the primary discriminator.
A distinction is to be made
between the dependent/independent and the independent/interdependent
dichotomies. The latter does not rely on employment relationship, but on how
directors are appointed to the Board – the independent directors being those
appointed to the Board by a prior CEO, and the interdependent directors those
appointed during the tenure of the current CEO. There are differences in
definition depending on whether one includes only outside directors, inside
directors, or both. It is worth noting that in this particular context the
“independent director” carries a very different meaning from the general use of
the same term “independent director” as it is used in Hong Kong, and indeed in
many parts of the world outside the US, as well as in the US when it could mean
“outside director” in a general sense. The definitions adopted in Hong Kong and
for the current study are detailed below.
The fourth category,
affiliated director, refers to an outside board member who maintains a close
personal or professional relationship with the firm or its top officers.
Directors in this category are expected to exercise their professional
integrity for the benefit of the company, though arms-length relationships in
technical matters could be the seeds of indifference in respect of many of the
matters the subject of CG regimes, producing the potential for conflict with
their legal and social underpinnings.
Curiously, though
Daily, Johnson and Dalton (1999) identified over two-dozen operationalizations
of board composition, none constituted a single construct of board
independence. It is not surprising that research relying on these non-fitting
measures yielded inconsistent results (Daily, Johnson & Dalton, 1999). This
is to be borne in mind in the review of past literature in subsequent sections.
In a related study,
Dalton, Daily, Johnson and Ellstrand (1999) state that whereas inside directors
are predominantly for providing expertise and counsel, independent directors
are principally for control-monitoring. The focus on board independence,
drawing on agency theory, addresses supposed inefficiencies that might arise
from the separation of ownership and control in companies (Dalton et al.,
1999). Goo and Carver (2003) also subscribed to the control role and agreed
that such a role of the board of directors is pivotal to good CG. Within the
context of agency theory, the composition of the corporate board is thus seen
as a key internal governance mechanism. In particular, outside directors are
seen as providing more independent shareholder-and-stakeholder-interested
monitoring. The reasoning being that since outside directors are not part of
the organisation’s management team, they may not be subject to the same
potential conflicts of interest that are likely to affect the judgments of
inside directors (Rhoades, Rechner & Sundaramurthy, 2000).
Consequently, the general proposition is
that independent directors are perceived better able to distance themselves
from the top management, exercise greater objectivity, and protect
shareholders’ interests (Wood
& Patrick, 2003).
In the Hong Kong context, the main classes of
directors include executive directors, NEDs and INEDs. NEDs are members of the
board who do not hold any office in the company and have no management
responsibility. Those who also have no interest in the company comprise the
INED category (Goo & Carver, 2003). These definitions will be adopted when
Hong Kong listed companies are sampled for analysis later in this study.
Similar to their counterparts in other developed markets, regulators in Hong
Kong also appear to subscribe to the importance of independent directors in CG,
as evidenced by their recent raising of the minimum number of INEDs of each
listed company from two to three.
Ranking CG mechanisms
and collective regimes of CG mechanisms has become a frequent exercise, no
doubt intended to influence perceptions of market control. Accordingly, Mobius
(2002) characterised good CG as “fair play”. From the perspective of
institutional investors, proper CG means how to protect and promote the
legitimate interests of minority shareholders (Mobius, 2002).
CLSA Emerging Markets,
an equity research house, ranks companies in ten Asian markets (Singapore, Hong
Kong, India, Taiwan, Korea, Malaysia, Thailand, China, the Philippines and
Indonesia) according to its CG scoring system. In a study using 5-year data to
the end of 2002, CLSA (2003) finds that companies in the top CG quartile
outperformed the market on average by 35%, while the bottom quartile
underperformed by 25%.
Jin (2003), representing the
Asian Development Bank in the Asian Business Dialogue on Corporate Governance
2003 (organised by the Asian Corporate Governance Association in Hong Kong),
proclaimed that CG absolutely increases a firm’s shareholder value. To support
his claim, Jin (2003) said that studies by McKinsey, CLSA, S&P 500 and the
World Bank all showed clear evidence that good CG is rewarded with a higher
market valuation for companies’ securities.
Though such claims are attractive
propositions, they are perhaps too strong. For even if an association is in
evidence, statistical association per se does not amount to causation.
Such questionable interpretations of the meaning of statistical association,
presented as cogent cases to support the implementation of particular CG
regimes, are doomed to be costly and problematic!
Against that background it is
understandable that corporate board structures, functions and compositions have
perhaps been the most frequently researched governance mechanisms in the CG
literature (Dalton et al., 1998). A positive relationship might reasonably
be expected between overall board independence and company performance, because
the perception of independence currently in vogue is linked to a greater
degree of objectivity and appraisal of the directors (Weir & Laing, 2001).
It is to be noted that a
majority of the studies have been undertaken of US data. Being much more
tightly regulated and having greater institutional investor involvement, the US
corporate environment differs substantially from the predominantly
family-controlled environment in Hong Kong. Caution should thus be exercised in
drawing likely HK-relevant inferences from the findings of the research into US
phenomena. Nevertheless, with that caveat in mind, the US studies are useful
for the methodologies they demonstrate and the potential insights they might
contain.
In that context, it is
to be noted that Baysinger and Butler (1985) found weak evidence that firms
with more outside directors in 1970 had higher industry-adjusted return on
equity (ROE) in 1980. They argue, however, that their findings support a
positive relation between outside board composition and firm performance. Of
course, the use of ROE data calculated with both the numerator and denominator
subject to the vagaries of US Generally Accepted Accounting Principles (exposed
to earnings management, thus making them highly unreliable) present red
flags for caution when reading too much into the results regarding likely
parallels for Hong Kong companies.
Baysinger and Butler’s
outcome contrasts with the findings of a subsequent study by Hermalin and
Weisbach (1991). Whilst no relationships were found between board composition
and performance, Hermalin and Weisbach nonetheless argue that insiders are
valuable insofar that they may provide firm-specific advice and knowledge to
CEOs. This opens a countervailing view to that strongly promoting the push for
the independence of directors and auditors.
Also, contrary to the general
expectation, Agrawal and Knoeber (1996) observed that increasing outsiders on
the board of directors negatively affected performance, a finding supported in
a longitudinal study of 932 firms by Bhagat and Black (1999). They conclude
that the proportion of outside directors on the board is negatively related to
firm performance as measured by Tobin’s q, return on assets (ROA) and
several other accounting measures. Their evidence suggests a possible negative
correlation between supermajority-independent boards and firm performance, but
that does not provide support that such a relationship exists.
In a meta-analysis of
the influence of outside directors, Rhoades, Rechner and Sundaramurthy (2000)
showed that the correlation between board composition measures (inside or
outside director) and financial performance measures (ROA, ROE, etc.) depends
on the definitions used in the study. They reiterated an earlier comment by
Daily, Johnson and Dalton (1999) that definition matters. And, of course it
does. That the point had to be made is illustrative of how so much of the CG
debate, and the function of independence, in particular, is more linguistic
than technical and operational.
Bhagat and Black (2002)
noted the operational aspect of the independence push, finding that
low-profitability firms increase the independence of their boards of directors,
even though, despite claims to the contrary, there is no evidence that this
strategy works. Firms with more independent boards in general do not perform
better than other firms. Independence appears to have been pursued more as a
matter of faith than in response to hard positive evidence.
In respect of large US
companies, Wood and Patrick (2003) studied the largest 250 by annual total
revenue, focusing solely on the percentage of insider and outsider directors
compared against ROA and ROE. The results did not show either linear or
non-linear relationships between the variables and that, in accord with the
results, increasing outside representation on a company’s board of directors
would have a significant effect on returns. It has to be noted, though, the
study was biased on large American companies with high standards of information
disclosure and accounting standards. Obviously, the results could be different
in other countries or in respect of smaller companies where good CG arguably
might make a bigger impact. Hong Kong listed companies noticeably fall into
such category.
One important inference can be drawn from
the US empirical evidence. Wood and Patrick (2003) suggest that the
independence function of the board of directors of large US companies is
already served by the countless number of regulatory bodies protecting
shareholders’ interests by monitoring the activities of publicly held
corporations. Such a view echoed a similar comment in an earlier study
(Hossain, Prevost & Rao, 2001). Significant for this thesis is whether in
the lesser regulatory environment of Hong Kong, the presence of independent
directors may have a greater relevance and impact.
In addition to studies
on the biggest market in the world, studies on other markets are also
noteworthy for the insights they provide:
Laing and Weir (1999)
randomly selected and tested 115 UK quoted companies which appeared in The
Times 1000 for the years 1992 and 1995. Little evidence was found to
suggest either that the board characteristics recommended in the 1992
Cadbury Report led to improved performance or that moving towards them
improved performance.
Likewise, Lawrence and
Stapledon (1999) failed to find consistent evidence that a direct relationship
exists between the proportion of independent outside directors and firm
performance in a sample of listed Australian firms.
Furthering their
earlier research, Weir and Laing (2000) produced mixed evidence that outside
director representation is associated with better performance. Outside director
representation is negatively related to accounting performance, but not to
market returns. This study demonstrates, again, that the choice of performance
measure has important implications for understanding the impact of governance
structures.
Hossain, Prevost and Rao (2001)
explored the effectiveness of monitoring by the board of directors, and
especially independent outside directors, in New Zealand. Their study concluded
that the 1993 legislation designed to increase and enhance monitoring by directors
does not seem to strengthen or weaken the positive relationship between outside
board representation and firm performance. Importantly, firm performance as
proxied by Tobin’s q is found to be positively impacted by the
proportion of outside members on the board. This finding will be further
discussed in Section 2.5.2.
Elloumi and Gueyié
(2001) chose to examine the relationship from the angle of financially
distressed firms. In a sample of Canadian companies, the results showed that
boards of financially distressed firms have significantly fewer outside
members.
With a slight change in
focus, using a sample of 110 New Zealand firms, Mak and Roush (2000) found that
the proportion of outside directors is positively related to the growth
opportunities in a firm.
In a subsequent study,
Matolcsy, Stokes and Wright (2004), using Australian firms as the sample,
conclude that independent directors seem to add value only where their firms
have substantial amounts invested in growth options.
These studies demonstrate that
the search for association between director independence and corporate
performance has been extensive. But, unfortunately for those looking for
support for the injection of prescriptions for board compositions, the primary
associations sought and evidence of any unequivocal impact of director
independence have, at best, been elusive. Overall, there is no conclusive
evidence that independent directors and company performance are associated in
either the US or elsewhere.
According to Webster’s
Third New International Dictionary, independent means “not subject to control
by others”; “not affiliated with or integrated into a larger controlling unit”;
or “not requiring or relying on something else”. Independence means “the
quality or state of being independent”.
Being independent
encompasses both relationship and behaviour. However, regulations and rules can
only govern obvious relationship, but not behaviour which is indeed the crux of
the matter. Perhaps partly due to such, regulators have stopped short of giving
independent or independence any definite meaning.
Nonetheless, it is
clear that the overall impetus driving the push for independence as the
essential personal behavioural characteristic necessary for board members comes
from the ideas nurtured in the agency literature (see Section 2.2.1). There,
the underlying notion that managers who are agents will act opportunistically
to the detriment of the shareholders’ interests, justifies the burden of agency
costs to align the interests of the agents to those of their shareholder
principals. Yet that becomes a hollow objective, once the wider stakeholder
interests are considered. It seems that then, independence that entails an
absence of alignment of interests is what is being pursued. Whereas
independence is possibly the most overworked notion in the recent governance
literature, its advocates are somewhat schizophrenic. The linkages sought between
interests of agents, the board members and the interests of the shareholders
really require dependency, whereas the social interest of the community at
large requires independency.
The Business Roundtable
guidelines suggest that a substantial majority of directors of a publicly owned
corporation should be outside, non-management, directors (Goo & Carver,
2003). The NYSE Listing Standards, however, only require three independent
directors on each board, though there are proposals to increase that to a
majority. The implications are that the more independent directors on the
board, the more independent the board becomes, hence the higher the level of
CG. To qualify as independent, the 2003 proposed amendment to the Listing
Standards requires that a director must be determined to have no material
relationship with the listed company (Shearman & Sterling, 2003). The test
is deliberately broad as the NYSE considers it impossible to provide rules for
all potential conflicts of interest (Shearman & Sterling, 2003).
The 1992 Cadbury
Committee recommended that there should be at least three NEDs on the boards of
quoted companies (Laing & Weir, 1999). The 2003 Higgs Report describes NEDs
as “custodians of the governance process” (Goo & Carver, 2003). The
Combined Code of the LSE requires the board to have a balance of executives and
non-executives (including independent non-executives), and that a majority of
non-executives should be independent (Goo & Carver, 2003).
The Code of the Australian
Investment Manager’s Association requires that the board of directors of a
listed company must consist of a majority of INEDs (Goo & Carver, 2003).
The Bosch Report on Corporate Practices and Conduct required a majority of a board
to be non-executives and at least one-third of the board members to be
independent. The majority of non-executive directors should preferably be
independent. According to the Bosch Report, an independent director (Lipton,
2002) is one who:
- has not been an executive in the past few
years;
- is not a professional adviser;
- is not a supplier or customer; and
- has no other significant contractual
relationship with the company.
The Investment and Financial Services
Association, an umbrella organisation for most major Australian institutional
investors, also recommends that there should be a majority of independent
directors on the board (Lipton, 2002). These codes and recommendations aside,
it is worth noting that the current legal requirement is simply for companies
to disclose whether a director is executive or non-executive (Psaros &
Seamer, 2002).
The Japanese government
is leading an overhaul of Japan’s Commercial Code. It aims, for instance, to
require the country’s traditional all-insider boards to add at least one
non-executive to each body (Davis, 2002), However, the government failed to
include such a provision in the recent amendments that came into force on 1
April 2003 (Freshfields Bruckhaus Deringer, 2003). Thus, whereas there is a noticeable
trend among a handful of multinationals to add non-executive outsiders to the
boards, nearly all are individuals representing companies doing business with
the firm, and sometimes from a firm that is a major shareholder. As such, in
terms of the characteristics of independence, Japanese companies have virtually
no independent directors (Davis, 2002). Against a background of Japanese
industrial success, this begs the question as to whether much is achieved by
endless listings and pursuit of independence as a business virtue.
Perhaps intentionally,
the Hong Kong Companies Ordinance does not make distinctions between an
executive director, a NED or of an INED. The categorical distinctions are,
however, made in the Listing Rules in which the independence or otherwise of an
INED is specifically defined together with guidelines on the duties of an INED.
Also under the Listing Rules, since 1995, every listed company must have at
least two INEDs (Ho & Wong, 2001). Following the global trend to increase
independent directors on the board, the requirement was raised to at least
three independent directors as from 1 October 2004 (Chow, 2004a).
Being a small city,
Hong Kong has a relatively small business circle and the listed companies are
family-dominated. The independence of independent directors is highly
questionable as they are appointed by the majority shareholders or their
representatives on the board. It is thus doubtful if those deemed to be
independent directors are truly independent in the Hong Kong context. The
“board structure” approach emphasises the independence relationship, but
ignores the behavioural aspects and the ethical characteristics of those
holding directorships. Adopting such an approach in Hong Kong seems to be fundamentally
“flawed” if independent directors are not de facto independent.
Corporations in which
the general public hold shares and, in consequence CG, are relatively new
concepts in the PRC. The China Securities Regulatory Commission (CSRC) was set
up in 1992 to monitor and regulate the then newly established stock markets in
Shanghai and Shenzhen.
Although Articles 46
and 112 of the Company Law have ten rules that restrict the powers and
functions of the board of directors, they do not clearly specify the ambit of
the duties and responsibilities of board directors (Ho & Xu, 2002). Over
70% of directors are appointed by the state and legal entity shareholders (Ho
& Xu, 2002). Since major shareholder representatives and senior executives
dominate the board, there are relatively few independent directors. Similar to
their Hong Kong counterparts, it is also commonly perceived that independent
directors in China have limited independence (Ho & Xu, 2002).
Nevertheless, perhaps
as a genuflection to western convention, at the end of 2000, approximately 5%
of listed firms had introduced independent directors, though their capabilities
and independence remained questionable (Ho & Xu, 2002). In August 2001, the
CSRC released the Guidelines to Implementing the Independent Directors System
in Listed Companies requiring at least one-third of directors be independent.
These independent directors should also possess certain legal and market
knowledge and have at least five years’ relevant experience.
Clearly, there is a
diverse range of definitions and requirements in relation to director
independence in different countries. Though there is no consensus in using a
standard description of independent director, there have been ongoing efforts
in enhancing board independence. Unfortunately, the efforts suffer from unclear
notions of “independent director” and “independent board”, and have not
resulted in legally enforceable legislation. The various codes, listing rules,
guidelines, ad hoc committee reports, etc., imposing higher standards of
board independence than the laws, are not mandatory. In the case of
non-compliance, penalties imposed are usually not severe enough to have any
significant deterrent effect. Furthermore, there are problems in enforcement.
Despite the difficulties and “flaws”, Hong Kong has been following the
international trend of increasing CG specifications, including the number of
independent directors required on each board. It is thus reasonable to presume
that the virtue attributed to independent directors in western countries has
infiltrated Hong Kong. Bearing in mind the significance of the Hong Kong
financial market, the characteristics of Hong Kong and PRC companies are
matters of particular importance which will be explored in the following
section.
Hong Kong listed companies
operate in a developed market. The World Federation of Exchanges calculated
that, in terms of market capitalisation, the top four stock exchanges at the
end of 2003 were respectively New York, Tokyo, NASDAQ and London. The HKEx,
with a market capitalisation of USD 715 billion, ranked ninth on the list.
In addition to the Main
Board, a second board, the GEM, was launched in November 1999 to provide growth
enterprises with fund raising opportunities. Numerous growth
enterprises, particularly those emerging ones, even with good business ideas
and growth potential, do not fulfil the profitability or track record
requirements of the Main Board, and are therefore unable to obtain a listing on
it. The GEM was designed to fill this gap.
Two groups of PRC-related companies, the H-share and the red
chip, commenced listing in Hong Kong in the 1990s. The HKEx H-share
companies are those incorporated in the PRC and approved by the CSRC for a
listing in Hong Kong. H stands for Hong Kong. Red chip companies, on the
other hand, are those with at least 30% of issued shares held directly by
mainland China entities, or indirectly through companies controlled by them, of
which the mainland China entities are the single largest shareholders in
aggregate terms. Alternatively, a company would be considered a red chip
company if less than 30%, but more than 20%, of its shares are held directly or
indirectly by mainland China entities and there is a strong influence of
mainland China-linked individuals on the company’s board of directors. Mainland
China entities in this context include state-owned enterprises and entities
controlled by provincial and municipal authorities. For practical purposes the
important difference between a red chip company and an H-share company is that
a red chip company is not mainland-registered.
Of particular significance is the
predominantly family-owned nature of listed companies in Hong Kong. According to a survey of the ownership
structure of 553 listed companies in 1995 and 1996, 53% had only one
shareholder or one family group of shareholders owning more than half of the
entire issued capital (Hong Kong Society of Accountants, 1997). The ratio was
increased to 77% if the threshold was lowered to more than 35% of issued
capital, and further to 88% if the threshold was more than 25% of issued
capital.
Indeed, Chow, the chief
executive of the HKEx, has noted that “[w]ith one or two exceptions, all of the
our [Hong Kong] listed companies are closely controlled – the directors are the
same as, or represent the interests of, the major shareholders.” (2004b, p.
27).
Being “closely held”
distinguishes the typical Hong Kong listed company from its western
counterparts, especially US companies. Accordingly, the appropriateness of the
US independence focus (particularly the independence of directors) with the
accompanying focus on the alleged agency problems and CG regimes drawing heavily
on the independence theme, is contestable in respect of Hong Kong companies.
In the US, governance
mechanisms primarily target the risks perceived to emerge from the agency
problem, particularly in respect of incentive-compensation contracts such as
stock-option plans related to executive remuneration, and direct management
equity ownership. The natural monitoring by large shareholders, external
capital markets, outside members of the board of directors, and external forces
such as hostile takeovers and proxy contests are perceived to be offsetting
forces (Kang & Shivdasani, 1999).
While numerous studies
using data of the US, UK, Canada and Australia generally return a weak or
insignificant relationship between firm performance and board independence,
Hossain, Prevost and Rao (2001) found that New Zealand firms exhibit a
significant relationship. They come up with the following explanations:
- The external governance mechanisms in New
Zealand are comparatively weaker;
- The takeovers as a discipline mechanism
are not particularly strong in New Zealand;
- The stock market in New Zealand is not
nearly as efficient and therefore may not serve an effective disciplining
role;
- The very high ownership concentration in
New Zealand may interfere with effective governance of the firm.
As a result, outside board membership in New Zealand may play a pivotal role in
effective governance of the firm. The four factors identified are likely to
apply in Hong Kong, too. However, whether that would render the Hong Kong
marketplace more aligned with New Zealand than the US and the other parts of
the world remains an open empirical question.
Since the introduction of the “balanced scorecard” in the early 1990s
(Kaplan & Norton, 1992), much has changed in performance measurement.
Expanding the balanced scorecard concept, the term “corporate performance
management” has gained prominence in recent years. There is a growing trend
towards enhancing performance improvement by managing the underlying drivers of
performance – those improvements in the processes or the underlying resources
that give these processes capability (Bourne, Franco & Wilkes, 2003).
The past emphasis on pure financial performance is decreasing and there
appears to be a recognition that over-reliance on achieving short-term
financial results could adversely affect the capabilities and competencies
allowing companies to compete effectively in the longer-term (Bourne, Franco
& Wilkes, 2003). Nonetheless, the performances of these underlying drivers
are not readily observable by outsiders. Even if they could be identified, they
would not have been refined in any consistent manner among companies and are
thus difficult to compare.
On the contrary, financial measures for listed companies are compiled on
a consistent basis and publicly available. Financial performance measures are
therefore employed in this study.
Noting the importance of the choice of performance measure (Weir &
Laing, 2000), and in order to be more comprehensive, both accounting ratios and
market data are to be used in this study to measure corporate financial
performance. Accounting ratios chosen include ROE and ROA, while price-earnings
ratio (P/E) and market value per book value of equity (MV/EQ) are used to proxy
market performance. ROA is used in addition to ROE to minimise the impact of
debt financing on profitability. These two accounting measures are commonly
used and understood within the commercial environment, and can be calculated
with data extracted from annual reports. In respect of market-based returns,
P/E is a widely used indicator employed by market participants reflecting
market perception of firm value as well as growth potential, while MV/EQ is an
alternative measure commonly adopted by academics. Market-based returns have
the advantage in revealing risk-adjusted performance, though inevitably subject
to forces beyond the control of management. It is worth noting that previous
studies predominantly used ROE, ROA and MV/EQ as performance measures, while
some used Tobin’s q. Tobin’s q, being the ratio of the market
value of a firm’s assets to the replacement cost of the firm’s assets, is
little known outside the academic domain. It is also difficult to compile. For
instance, estimates of the replacement costs of a firm’s assets are not always
readily available. Tobin’s q is therefore not selected as a performance
measure in the current study. Instead, P/E is chosen as a second market
indicator.
The degree of influence independent directors exert on a firm may vary in
accordance with their proportion and their number in the company board. Despite
conventional wisdom and the conflicting empirical evidence, research findings
in the western developed countries seem to be skewed towards there being no
identifiable relationship between board independence and firm performance. This
is curious bearing in mind that the demand for independence to be a prevailing
characteristic of board members invites the inference that its presence
enhances shareholders’ interests. The same push for the independence of Hong
Kong companies’ boards, invites the same inference in respect of Hong Kong
listed companies. To test whether such relationship exists in the Hong Kong
context, and if so, whether such relationship varies with the two commonly used
definitions of independent directors, the first hypothesis can be sub-divided
into:
Null
Hypothesis 1a (H01a): There
is no relationship between the percentage of independent directors in the board
of directors and corporate financial performance.
Null Hypothesis 1b (H01b): There
is no relationship between the number of independent directors in the board of
directors and corporate financial performance.
The alternate hypotheses are thus:
Alternate Hypothesis 1a (HA1a): There
is relationship between the percentage of independent directors in the board of
directors and corporate financial performance.
Alternate Hypothesis 1b (HA1b): There is relationship between the number of
independent directors in the board of directors and corporate financial
performance.
Since there is no predicted
direction in the relationship, the Research Hypotheses 1a and 1b
(HR1a and HR1b) are the same as the
respective Alternate Hypotheses.
Past empirical evidence relating
to non-Hong Kong companies is more consistent in suggesting that the effect of
independent directors on firm performance is stronger in growth-oriented
companies. However, such researches are relatively few in number and can hardly
be interpreted as “conclusive”. To establish whether such a relationship exists
in the Hong Kong context, the second hypothesis is thus:
Null Hypothesis 2 (H02): The relationship between board
composition and corporate financial performance in growth-oriented companies is
the same as that in non-growth-oriented companies.
Alternate Hypothesis 2 (HA2): The relationship between board composition
and corporate financial performance in growth-oriented companies is not the
same as that in non-growth-oriented companies.
Given past empirical support in
other contexts, the predicted difference in relationship for Hong Kong listed
companies is as follows:
Research Hypothesis 2 (HR2): The relationship between board composition
and corporate financial performance is stronger in growth-oriented companies
than non-growth-oriented companies.
Companies listed on the GEM are,
by definition, growth-oriented. Companies with high MV/EQ can also be taken as
high-growth companies as perceived by the market. Through undertaking a sensitivity
analysis, these high MV/EQ companies will be identified and analysed alongside
the GEM companies.
The PRC is a
transitional economy, moving gradually from socialism to the adoption of some
of the characteristics of capitalism. Many of the PRC’s numerous state-owned
enterprises are in the process of privatisation. Since the state, provincial
and municipal authorities retain the majority of shares in these companies and
thus have the final say, board independence, if any, is often perceived as a
matter more of form than of substance. Even though H-share and
red chip companies, being listed in Hong Kong, are subject to the same
regulatory framework as the other Hong Kong listed companies, the influence
their independent directors have on the companies is questionable. To test if
independent directors make less contribution to firm performance in H-share and
red chip companies than the other companies, the third hypothesis is formulated
as:
Null Hypothesis 3 (H03): The relationship between board
composition and corporate financial performance in companies majority-owned by
non-mainland Chinese is the same as that in companies majority-owned by
mainland Chinese.
Alternate Hypothesis 3 (HA3): The
relationship between board composition and corporate financial performance in
companies majority-owned by non-mainland Chinese is not the same as that in
companies majority-owned by mainland Chinese.
Research Hypothesis 3 (HR3): The
relationship between board composition and corporate financial performance is
stronger in companies majority-owned by non-mainland Chinese than companies
majority-owned by mainland Chinese.
