Independent Directors and Corporate Financial Performance – A Hong Kong
Perspective (A DBA Dissertation Completed in August 2005)
Chapter 1 – Introduction
1.1 Background
In recent years there
have been a number of high-profile corporate failures worldwide. The most
publicised include WorldCom and Enron in the US; Barings and Marconi in the UK;
HIH Insurance and One.Tel in Australia; Peregrine and CA Pacific in Hong Kong.
Though attributable to myriad causes, these corporate fallouts appear to have
evoked a convergence of focus on one main issue – poor corporate governance
(CG). As a result, there has been a growing awareness of the importance of CG.
The argument seems to be that had these companies been subjected to more
effective (and impliedly a more regimented system of) CG, they would not
have collapsed, and the consequential huge losses to the shareholders, other
stakeholders and the society at large, would have been avoided.
In response to the
recent failures, CG laws, regulations, and listing rules have been promulgated
and codes of best practice proliferated around the globe. In the UK, for
example, there have been a series of ad hoc commissions looking
specifically into CG. The prominent Cadbury Report in 1992 was followed by the
Greenbury Report in 1995, the Hampel Report in 1998, the Turnbull Report in
1999, and the Higgs Report in 2003. The latest development was a revised
Combined Code for UK listed companies which came into effect for reporting
years beginning on or after 1 November 2003 (Freshfields Bruckhaus Deringer, 2003)
with heightened CG standards. In the US the Sarbanes-Oxley Act, enacted in July
2002, has imposed numerous new regulations on the manner in which listed
companies manage their affairs. The Australian Stock Exchange (ASX) has
introduced governance guidelines and many features of Sarbanes-Oxley have been
enacted in the Australian Companies legislation. The Hong Kong Stock Exchange
(HKEx), likewise, followed the international trend and added various governance
requirements in its Listing Rules, including raising the minimum number of
independent directors on the Board of each listed company.
1.2 The
Corporate Governance Arena
Good CG has been argued
by Mobius (2002), a renowned Hong Kong institutional investor, to be capable of
protecting the interests of the shareholders, as well as enhancing corporate
financial performance. Different organisations and interest groups have
proposed different objectives and principles of CG. One of the key 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
independence of the board and of its members are pivotal to good CG. This view
is based on the agency theory which has come to dominate discussions of CG
among practitioners, policymakers as well as academics. Agency theory explicitly considers a company’s managers to be the
“agents” of the shareholders, the “principals”. It presumes that managers are
opportunistic and have to be monitored to prevent them from acting in their own
interests to the detriment of the shareholders. The pre-eminent focus of CG research and policy, therefore, is the
elaboration of hierarchical mechanisms that can help capital providers to
control the behaviour of company managers.
Underpinned by the
tenets of agency theory, one of the key components of CG is the monitoring role
of the board of directors. Independent directors are regarded as the most
appropriate to exercise this monitoring role as they are independent by
definition. The common perception is outside representation on corporate boards
can increase managerial monitoring and so improve firm performance (Agrawal
& Knoeber, 1996). Indeed, in a recent consultancy report commissioned by
the Hong Kong Special Administrative Region government on institutional
investors’ attitudes towards CG standards in Hong Kong, each of the eleven
institutional investors and two merchant bankers interviewed believed that CG
would lead to better firm performance in the long run, and they would pay a
premium for firms with better CG (Tsui & Gul, 2003).
Empirical evidence of
the monitoring effectiveness of independent directors, however, remains
inconclusive. There is no uncontestable evidence that board composition is
associated with company performance. On the contrary, after performing
meta-reviews of the effect on firm performance of 54 empirical studies of board
composition and 31 empirical studies of board leadership structure, Dalton,
Daily, Ellstrand & Johnson (1998) were confident in concluding that the
population relationship across the studies of 228 samples was close to zero.
Despite having no solid empirical backing, the global regulatory trend is to
prescribe the addition of independent directors to company boards.
1.3 Corporate
Governance Reform with Independent Directors
Regulators appear to hold the
view that all companies would benefit from more directors being independent
(Matolcsy, Stokes & Wright, 2004). The revised Combined Code of the London
Stock Exchange (LSE) implemented most of the recommendations made by the Higgs
Report, emphasising the importance of non-executive directors (NEDs) and their
independence. For instance, the Code now provides that at least half of the
company board, excluding the chairman, should comprise independent non-executive
directors (INEDs) and that the chairman must meet the test of independence on
appointment (Freshfields Bruckhaus Deringer, 2003).
The UK is not alone in
highlighting the importance of independent directors. The world’s largest stock
market, the New York Stock Exchange (NYSE), is amending Listing Standards to
require its listed companies to have a majority of independent directors
(Shearman & Sterling, 2003). In mainland China, independent directors at listed companies are
required to constitute a minimum of one-third of a company’s board as from June
2003 (The Hong Kong Accountant, 2003). Similarly in Hong Kong, all listed companies were required to have at
least two independent directors from 1995 (Ho & Wong, 2001). The threshold
has been raised to at least three independent directors since October 2004
(Chow, 2004a).
A perception that
independent directors are an essential element in an orderly commercial market
environment is firmly entrenched, notwithstanding an absence of the
underpinning of unequivocal empirical support.
1.4 The
Nature of the Firm
According to
classical economic theory, or the shareholder theory, the primary objective of
the firm is to maximise shareholders’ wealth (Friedman, 1970). Such a view has
become problematic in recent decades as all emphasis being placed on one
stakeholder group – the shareholders – comes under increasing questioning. Many
observers now argue that the interests of all the other stakeholders are
unjustly subordinated to the shareholders’ interests. Hence the stakeholder
theory enjoys increasing support. In broad terms, stakeholder theory proposes
that the interests of all stakeholders, not merely the shareholders, must be
protected, that a firm must make tradeoffs between its goals and the goals of its
stakeholders (Freeman, 1984). However, because of the operation of the
“invisible hand” (Smith, 1776), and provided that managers act “without
deception or fraud” (Friedman, 1962), it has been argued that the interests of
stakeholders will not be ignored as long as the primary objective of the firm
is being pursued (Coelho, McClure & Spry, 2003).
Raising the requirement
of independent directors and the bar of other CG standards inevitably
increase compliance costs. Understandably a common financially driven rationale
is that ultimately the benefits enjoyed from the increased CG mechanisms have
to be justified by exceeding the additional costs incurred. Thus corporate
financial performance under the new CG regimes is a critical metric.
1.5 Research
Question
Despite a wide perception that
good CG enhances corporate financial performance, empirical evidence so far has
been mixed. There have been claims that the ongoing CG reforms are to the
detriment of shareholders since they are not based on serious academic research
(Thain, 1994; Norburn, Boyd, Fox & Muth, 2000). A one-size-fits-all
approach may not be appropriate for all companies (Young, 2003); indeed, one-size
may not fit any (Clarke & Dean, 2005). Moreover, past research has
largely been concentrated on big corporations listed on highly regulated
markets such as the US and the UK. Not much, though, has been done in the Hong
Kong context. Most of the CG discussion has been undertaken without regard to
the differences between the Anglo-American structure of corporations and those
elsewhere such as in continental Europe. Questionably, lessons from the
UK and US experiences have been lauded as universally applicable. This study
pursues the contestability of the presumed relevance of the UK and US experiences
to the locus of this thesis – companies in the Hong Kong market.
The Hong Kong market is
peculiar in its own ways. While it is strongly influenced by western
individualistic culture, it retains the traditional Chinese collectivist
characteristics. The business circle is small and closely-knit. Maintaining guan-xi
(a Chinese term for relationship) is generally viewed as important as,
if not more than, arms-length transactions. As such, the potential agency
problems that dominate discussion in the Anglo-American CG literature (and
consequently resonate in the CG regimes in place) may not be a substantial
issue (Chow, 2004a). Rather, the degree of dependence of “independent
directors” may be more of a concern (Chow, 2004a), particularly to minority
shareholders and to the wider stakeholder class. Therefore, the tight CG
regulatory models of the US or the UK may not fit or may not be entirely
appropriate in the Hong Kong environment. Indeed, stewardship theory, which
proposes managers are trustworthy and good stewards of the corporation,
received stronger empirical support than the agency theory in a study of
Chinese shareholding companies listed in mainland China (Tian & Lau, 2001).
It is noteworthy that a number of Hong Kong listed companies are outgrowths of
these mainland entities and are, therefore, likely to display similar
characteristics.
Though the business
circle in Hong Kong is small, the size of its securities market is not. The
World Federation of Exchanges calculated that, as at the end of 2003, the HKEx
ranked ninth in the world by market capitalisation. With the establishment of
the Growth Enterprise Market (GEM) in 1999, together with the Main Board, more
and more companies with mainland Chinese interests are seeking to list in Hong
Kong. In addition, unlike the other major financial centres in the world,
companies in Hong Kong are predominantly family-owned (Hong Kong Society of
Accountants, 1997). Therefore, in terms of market capitalisation, growth
potential and firm characteristics, the HKEx and its listed companies are
atypical, and thus worthy of further in-depth analysis. There has been some
evidence that the contribution of independent directors in growth-oriented
companies is more profound than in stable companies (Mak & Roush 2000; Matolcsy,
Stokes & Wright, 2004). However, the relationship in companies with
different shareholding structure and whether further regulations and
investments in having independent directors are justified, remain contestable.
Accordingly, this study
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.
The findings of this study, when
compared and contrasted with those in the US and other countries, hopefully can
provide insight into whether the global reforms of board independence
permeating current CG regimes are relevant to the HK market.
1.6 Delimitations
and Assumptions
The focus of this paper
is the influence of independent directors on corporate performance. That
constitutes only a subset of the overall CG arena. The following delimitations
and assumptions are inherent:
Measurements relying on
the number or proportion of board members may not capture the dynamics of
directors’ multiple roles; monitoring is only one of the roles of a company
board, and though independence may improve directors’ monitoring performance,
it may be counterproductive with respect to managerial tasks. Thus, increasing
the formal independence of a company board should not be viewed as a panacea
for poor corporate performance (Young, 2003).
Furthermore, CG is
possibly impacted by numerous explicit and implicit factors. It is unlikely
that there is “one perfect model” with which all organisations can successfully
comply (Psaros & Seamer, 2002). Though structure is to be expected a
necessary condition for board effectiveness, it is most unlikely a sufficient condition
(Leblanc & Gillies, 2003). Social relationships, friendships and other
forms of conflicts that are not readily detectible may well compromise
independence.
1.7 Structure
of the Dissertation
The remaining chapters of this
dissertation are organised as follows:
Chapter 2 comprises a
comprehensive review of relevant literature. This review exposes the principal
CG theoretical frameworks underpinning the CG regimes, including agency theory,
stakeholder theory, stewardship theory, trusteeship and organisational trust;
these different frameworks are compared and contrasted; different definitions
of independent director used in various countries are discussed; and past
research findings are analysed as to their relevance to the Hong Kong
marketplace. Research hypotheses are then formulated. The meaning of board
independence and director independence are explored – the characteristics of
the Hong Kong marketplace investigated in greater depth; and the definitions in
force in Hong Kong for NED and INED, and adopted for testing the hypotheses,
are explained.
Chapter 3 details the research
methodology. The sample includes all Hong Kong listed companies on both the
Main Board and the GEM. Data collected from a prominent financial database (Yahoo
Finance), newspapers, annual reports and the HKEx are used to perform
regression analyses between board composition and firm performance. Since
previous studies showed that the correlation between board composition measures
and financial performance measures depends on the definitions used, and in
order to do a more comprehensive study, four operationalisations are used in
turn to proxy board composition. They are, respectively, number of NEDs,
number of INEDs, percentage of NEDs and percentage of INEDs.
Likewise, firm performance is proxied by four separate operationalisations –
the accounting ratios return on equity (ROE) and return on assets
(ROA), as well as market-based indicators price-earnings ratio (P/E)
and market value of equity over book value of equity (MV/BV). Arguably,
different relationship may exist for companies with different firm
characteristics. To explore whether that is the case, the companies are
sub-classified by firm size, growth-orientation, and shareholder background for
further comparison.
Chapter 4 undertakes analyses of
the results to identify significant statistical relationships.
Conclusions drawn from the study,
and the consequential policy implications are then detailed in Chapter 5.
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