Impact of Independent Directors on Corporate Financial Performance –
A Hong Kong Perspective
Introduction
Corporate governance (CG) principles center on the role, powers and responsibilities of the company board. Despite differences among CG advocates, they all seem to agree that director independence and board independence are central to good CG. Such a view is supported by the agency theory which deems a company’s managers to be the “agents” of the shareholders. This theory postulates that the monitoring role of the board of directors is pivotal to good CG. With the appointment of independent directors, outside representation on corporate boards is commonly perceived to strengthen managerial monitoring, and thus lead to better company performance. However, empirical evidence on the effectiveness of independent directors remains questionable. There is no indisputable evidence that board composition is linked with firm performance so often claimed, especially in tightly regulated markets such as the US and the UK.
Literature Review
Coase (1937) advocated that firms are formed for lowering transaction costs. While individuals can produce in line with market price and sell their products or services on their own in the market, there are various costs involved in “market” transactions – information costs, negotiation costs, contract costs, administrative costs, gauging costs, etc. – rendering market price hard to ascertain. Coase argued that since transaction costs are so high that market price is not readily determined, individuals would prefer working under a manager. Firms therefore evolve.
Following American industrialization, large companies started mushrooming in the latter half of the nineteenth century (Learmount, 2002). Professional managers emerged to amass control in big corporations, while shareholders were becoming more diverse and dispersed. With the term “separation of ownership and control” introduced by Berle and Means (1932), it is often argued that, in the corporate environment, managers act in their own interests to the detriment of shareholders, other stakeholders as well as the community at large. Hence the rise of the agency theory to suggest that owners must find ways to monitor managerial action (Fama, 1980). The agency theory proposes that independent directors are better placed to oversee the board of directors as well as management (Allam, 2018). From a resources-dependent viewpoint, independent directors can also heighten the board’s ability to perform supportive and monitoring roles (Allam, 2018).
Good CG is proclaimed to be able to attract certain types of investors as well as positively influence stock value (Korac-Kakabadse et al., 2001), leading to better corporate financial performance. According to Mobius (2002), good CG enhances management and a sounder allocation of the company’s resources.
In principle, directors play three key roles: a service role (promulgated by the stewardship theory); a control role (advocated by the agency theory); and a strategic role (underpinned by the stakeholder theory). 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.
The general definition of independent director portrays 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). There is, however, no precise delineation other than identifying specific circumstances precluding independence. Without a clear definition of independent director, the concept of an independent board is equally unclear. It is worth noting the confusing application of the terms “non-executive director” (NEDs), “independent director”, “independent non-executive director” (INEDs) and “outside director” in constructing the so-called “independent board”.
Despite numerous research on how firm performance is impacted by board independence over the past few decades, there have been conflicting results (Wenhao et al., 2022). Daily et al. (1999) identified over two-dozen operationalizations of board composition, yet none constituted a single definition of board independence. It is therefore not surprising that research relying on these non-fitting measures yielded inconsistent results (Daily et al., 1999).
To further complicate the issue, Allam (2018) noted that it has always been difficult to have truly independent directors. This may likely be a worldwide phenomenon not just in the less advanced countries. As proclaimed by Warren Buffett, arguably the world’s most astute investor in the past few decades, this is also the case in the US (Thomson, 2020). This has to be borne in mind when analyzing past and the following more recent literature.
For the more advanced economies, in a study of 100 companies listed on the New York Stock Exchange from 2008 to 2013, Mehrotra (2016) found that outside directors had no significant relationship with firm performance. For firms included in the FTSE All-Share Index, Allam (2018) found that board independence had no significant impact on return on assets (ROA), though a positive and significant impact on Tobin’s Q was identified.
In Europe, Merendino and Melville (2019) found that independent directors have a non-linear effect on firm performance for companies listed on the Italian Stock Exchange over 13 years from 2003 and 2015. In a study of over 200 Russian companies during 2007 to 2011, Berezinets et al. (2017) found no relationship between board independence and firm performance.
For African developing countries, in a study of companies listed on the Ghana Stock Exchange, Darko et al. (2016) found that non-executive directors adversely affected firm performance in terms of both return on equity (ROE) and ROA. Ongore et al. (2015) found that independent board members had no significant impact on firm performance for companies listed on the Nairobi Securities Exchange. Likewise, Assenga et al. (2018) found no significant relationship for Tanzanian companies listed on The Dar es Salaam Stock Exchange.
In respect of Asian developing countries, Dey and Chauhan (2009) found that, among 420 companies listed on the Bombay Stock Exchange, board independence had no significant impact on firm performance. It is worth noting that a subsequent study found significant effect of independent directors on ROA of large-cap and mid-cap Indian companies (Mehrotra & Mohanty, 2018). In Bangladesh, Rashid et al. (2010) found that outside directors did not add value to firm performance. However, for 217 Vietnam-listed companies from 2010 to 2014, Nguyen et al. (2017) found negative impact of independent directors on firm performance. For Malaysian companies, a positive and significant relationship was identified between CG Index and firm performance (Bhatt & Bhatt, 2017).
In China, Ren et al. (2020) found that the resignation of officials as independent directors had a significant adverse impact on firm performance as measured by Tobin’s Q. By studying 860 firm-year observations of companies listed on the Shanghai Stock Exchange during 2010 to 2019, Wenhao et al. (2022) found that board independence could improve firm performance.
In Hong Kong (HK), Mok (2005) found that the proportion or number of independent directors on the board was positively associated with firm performance; the relationship between board composition and company financial performance was stronger in growth-oriented companies than non-growth-oriented companies; and the relationship between board composition and company financial performance was stronger in companies majority-owned by mainland Chinese interests than those majority-owned by non-mainland Chinese interests. It is noteworthy that the enhanced performance was seen to be more related to NEDs than INEDs. Most of the associations identified were related to NEDs.
The HK Market
Significance
Companies listed in HK operate in a well-established market. The World Federation of Exchanges (2021) calculated that, in terms of market capitalization, as at February 2021, the Hong Kong Exchanges and Clearing Limited (HKEX), with a market capitalization of US$6,763 billion, ranked third in the world.
There have been claims that China’s heavy-handed 2020 National Security Law in HK and HK’s prolonged adherence to a zero-COVID policy have seriously hurt HK’s renowned image of a free economy. According to the latest Global Financial Centres Index (GFCI) released by think tanks Z/Yen Partners and the China Development Institute, HK did drop one place behind New York, London and Singapore (Millson, 2022). Even so, the GFCI still ranked HK fourth globally as a financial center.
Characteristics
Though densely populated, being a small city, HK has a relatively small business circle and many of its listed companies are family-dominated. Chow, a former chief executive of HKEX, noted that the vast majority of HK-listed companies are closely controlled, having directors the same as, or representing the interests of the majority shareholders (2004b). The independence of independent directors, like many other places, is highly questionable as they are appointed by the majority shareholders or their representatives on the board.
Under HKEX, in addition to the Main Board, a second board, the GEM, was launched in November 1999 to provide growth enterprises with fundraising opportunities. Two groups of PRC-related companies, the H-share and the Red Chip, commenced listing in HK in the 1990s. The H-share companies are those incorporated in the PRC and approved by the China Securities Regulatory Commission for a listing in HK. H stands for HK. Red Chip companies, on the other hand, are those with at least 30% of issued shares held directly by mainland Chinese entities, or indirectly through companies controlled by them, of which the mainland Chinese 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 Chinese entities and there is a strong influence of mainland China-linked individuals on the company’s board of directors. Mainland Chinese entities in this context include state-owned enterprises and entities controlled by provincial or municipal authorities. For practical purposes, the main difference between a Red Chip company and an H-share company is that a Red Chip company is not mainland-registered. In the remainder of this paper, we will standardize to use CEs (Chinese enterprises) to represent H-share companies, and CAs (China-affiliated companies) for Red Chip companies.
Under the HKEX Listing Rules, since 1995, every listed company must have at least two INEDs (Ho & Wong, 2001). The requirement was raised to at least three INEDs as from 1 October 2004 (Chow, 2004a). By 31 December 2012, to better align with the global trend, a percentage requirement was further imposed: an issuer must have INEDs making up one-third of the board (HKEX, n.d.).
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