Corporate Governance by Daley Mok (1/7)

Independent Directors and Corporate Financial Performance – A Hong Kong Perspective (A DBA Dissertation Completed in August 2005)

Summary

One of the key corporate governance (CG) principles lies with the role, powers and responsibilities of the company board. Despite variations in the CG schema, each seems to support the view that director independence and board independence are pivotal to good CG. Such a view is underpinned by the agency theory which explicitly considers a company’s managers to be the “agents” of the shareholders, the “principals”. This theory presumes that the monitoring role of the board of directors is key to good CG. The common perception is that outside representation on corporate boards, through the appointment of independent non-executive directors, can increase managerial monitoring and so improve firm performance. However, empirical evidence on the effectiveness of independent directors remains inconclusive. There is no unequivocal evidence that board composition is associated with company performance in the manner and to the extent so frequently claimed, particularly in tightly regulated markets like the US and the UK.

There is a paucity of such research in the Hong Kong context. Yet, the Hong Kong Stock Exchange (HKEx) ranks high internationally by market capitalisation, and its idiosyncratic features – dominance of family-owned companies and having an increasing presence of entities with mainland Chinese interests – make it a market of particular interest. This study, therefore, explores the effect of board composition on firm performance for Hong Kong listed companies. The primary focus is whether there are associations between the relative percentage and number of independent directors in a company board, and the company’s financial performance.

In broad terms, the research process entails: first, collation of a complete list of all Hong Kong companies listed on the HKEx as of 31 December 2003, followed by the collection of secondary data in relation to outside board composition and company financial performance from Yahoo Finance, local newspapers, company annual reports, and information provided by the HKEx. Subsequently, linear regression tests are run using outside board composition as the independent variable and financial performance indicator as the dependent variable. The companies are then sub-divided according to their characteristics into Main Board – China Enterprises (CEs), Main Board – China-affiliated Companies (CAs); Main Board – Large Companies (with market capitalization over HK$10,000 million), Main Board – Medium Companies (with market capitalisation from HK$1,000 million to HK$10,000 million), Main Board – Small Companies (with market capitalization under HK$1,000 million), and Growth Enterprise Market (GEM) Companies for further analysis. With a confidence interval pre-set at 95%, common statistical tools including R² (coefficient of determination), p-value, r (correlation coefficient) and Fisher’s r-to-z transformation, where appropriate, are employed to identify whether any significant relationship exists. In order to add reliability, different definitions of outside board composition and financial performance indicator (including accounting ratios and market-based returns) will be employed. The sample consists of all the 861 companies listed on the Main Board and the 187 companies on the GEM.

This study has three key findings: the proportion or number of independent directors in the board of directors is positively associated with company financial performance; the relationship between board composition and company financial performance is stronger in growth-oriented companies than non-growth-oriented companies; and the relationship between board composition and company financial performance is stronger in companies majority-owned by mainland Chinese interests than companies majority-owned by non-mainland Chinese interests.

As noted above, the findings of the empirical analysis reveal a positive relationship between independent directors being on company boards and corporate financial performance in the Hong Kong context. In contrast with the conflicting evidence in previous literature, it is useful to point out at the outset that this is consistent with research in the context of New Zealand where the regulatory standards are similar and family-controlled companies dominate the market.

Nonetheless, the improved corporate financial performance was not evident in all types of companies. Significant positive relationships were seen in medium-sized companies, GEM companies, high Market Value of Equity to Book Value of Equity (MV/BV) companies (with MV/BV over 3), CEs and CAs. No statistically significant relationships were found in large companies, small companies and low MV/BV companies. It, therefore, seems that applying the same governance standard in respect of independent directors to all companies would not lead uniformly to the same desired result.

This is in line with calls that a one-size-fits-all approach is inappropriate, and that the applicability of governance regimes is idiosyncratic rather than universal. Against that background, it is reasonable to suspect that regulations mandating all companies to adopt particular regimes with respect to board characteristics and membership may lead to suboptimal board structures and unpredictable outcomes.

Importantly, the enhanced performance was seen to be more related to non-executive directors (NEDs) than independent non-executive directors (INEDs). Most of the associations found were related to NEDs. Only in the cases of medium-sized companies and CAs were associations found with INEDs. Consequently, it appears that it is the non-executive characteristic of directors that contributes most to the outcome – as long as the added directors are non-executive (INEDs is a subset of NEDs), better financial performance will result. Thus, the emphasis of adding INEDs per se in governance standards might not lead to any additional improved financial performance. Why, is indeterminate. It might, for example, be that truly independent directors are rare in the Hong Kong setting, therefore the impact of (what are described as) INEDs is not significantly different from that of NEDs on enhancing financial performance.

Interestingly, relative measures have emerged more definitive than absolute measures. More obvious associations were found with % of NEDs rather than No. of NEDs. Though both are proxies for the influence of independent directors, this finding implies that the relative proportion of independent directors on company boards has a stronger bearing on financial performance than the absolute number of them. That, perhaps, is understandable in voting settings. This may be the reason why the global trend is more on increasing the proportion of independent directors than the absolute number of them. This is the case for leading stock exchanges including the New York Stock Exchange, the London Stock Exchange, as well as the Australian Stock Exchange and the two exchanges in mainland China. The HKEx, on the other hand, regulates on the exact number of independent directors.

The relationship between NEDs and MV/BV was significantly stronger in GEM companies than Main Board companies. This supports empirical evidence in New Zealand and Australia that the relationship was positive only in companies oriented towards growth. More specifically, the significant differences lay between GEM companies and medium-sized Main Board companies, and between GEM companies and small Main Board companies. Distinctively, increasing NEDs makes significantly more contribution towards enhancing market-based returns in GEM companies than in small or medium-sized Main Board companies. Therefore, from the market return perspective, it is important to ensure that the boards of GEM companies have a relatively high proportion of independent directors.

Similarly, the relationship between NEDs and accounting returns was significantly stronger in GEM companies than small Main Board companies. However, in terms of accounting returns, the outcome was different when medium-sized companies were compared with GEM companies. Increasing INEDs in medium-sized Main Board companies was found to lead to significantly higher accounting returns than the same increase in GEM companies. One possible explanation could be that the medium-sized Main Board companies have relatively truly independent directors whose impact is reflected in superior operating results. The boards of the larger companies might have too much clout for their INEDs to be truly independent, whereas the smaller companies might only have nominees as INEDs to fulfil the HKEx’s requirements.

This study has also revealed significantly stronger association between NEDs and MV/BV for CEs than companies majority-owned by non-mainland Chinese interests. The significant difference lay mainly between CEs and small Main Board companies.

The strongest relationship was found in CAs. A significantly stronger relationship existed between independent directors (including both NEDs and INEDs) and financial performance indicators (including both accounting returns and market-based returns) when CAs were compared with companies majority-owned by non-mainland Chinese interests.

It is therefore apparent that the data support a view that independent directors contributed more towards improving company performance in companies majority-owned by mainland Chinese interests than otherwise. While the contribution in CEs was evident in market perception only, the contribution in CAs comprehensively covered both accounting and market-based returns. The significant difference between companies majority-owned by mainland Chinese and companies majority-owned by non-mainland Chinese could be that independent directors are viewed by the market as relatively more valuable in companies of “lower” governance status, hence their influence on company performance is consequently more profound. In relation to CAs, as they are non-PRC registered companies, they might be more inclined to accepting the management practices prevalent in Hong Kong and in the developed western countries. Therefore the influence of independent directors is not limited to market perception but extended to improving actual operating results as well.

Arguably, a one-size-fits-all approach to this aspect of governance only imposes unnecessary costs on firms with the low agency problems characteristically inherent in family-controlled companies. There was, for example, no evidence that large Main Board companies benefited financially from having more independent directors. Similarly, there was no such evidence for small Main Board companies. Indeed, there were some hints in the statistical tests to suggest that independent directors and corporate financial performance were negatively associated for small Main Board companies, though the evidence failed the homogeneity of variance assumption test, and therefore could not be taken to support such a claim.

This point aside, while having the same governance standard for all companies might be seen as fair and equitable on the surface, it might also be argued as unfair and inequitable if the companies regulated do not benefit to the same extent. Even if the additional transaction costs of adding independent directors may be well absorbed by large companies because of their larger scale of operations, the costs may be inappropriately high for small companies. In any event, costs not recovered by the financial value attributed to the ensuing benefits cannot be justified as money well spent.

It is noteworthy that the better financial performance found was in general market-based returns. Only in medium-sized Main Board companies and CAs were higher accounting returns found. Market-based returns are predominantly a function of market perception of a company’s valuation, while accounting returns reveal periodic operating results. Apparently the improvement in financial performance was more because of favourable market sentiment towards companies with additional independent directors than actual improvement in operating results. Nevertheless, higher valuation of a company’s stocks remains a reflection of better company performance.

These findings make the HKEx’s focuses on adding INEDs to company boards contestable. It was shown that the strength of relationship lies on NEDs, but as a board component inclusive of their INED members, rather than on INEDs as a separate cohort. Indeed, of the many relationships found, it was only in medium-sized Main Board companies and CAs that significant relationships were evident in relation to INEDs. With respect to enhancing company financial performance, it appears that the thrust should rather be on increasing NEDs than INEDs.

It is noteworthy that contrary to the prevalent global trend on increasing the proportion of independent directors instead of their absolute number, that the HKEx adopts the absolute number approach; indeed, from 1 October 2004, increasing the minimum INEDs each company board has from two to three. This runs counter to the empirical evidence in this study that % of NEDs has stronger relationship with financial performance than No. of NEDs. Accordingly, specifying a minimum percentage threshold of NEDs might be a more prudent policy in terms of achieving better company performance.