The relationship between board structure and performance.pdf

The Relationship Between Board Structure and Financial Performance

BY

NEBERT OMBAJO MANDALA

D80/61102/2011

An Independent Study Paper Submitted in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy in Business Administration

(Finance)

School of Business University Of Nairobi

January, 2013

[email protected]/+254722421422

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DECLARATION

THIS INDEPENDENT STUDY PAPER IS MY ORIGINAL WORK, AND HAS NOT BEEN PRESENTED FOR THE AWARD OF A DEGREE IN ANY OTHER UNIVERSITY. SIGNED DATE ………………………. ………………… NEBERT OMBAJO MANDALA THIS INDEPENDENT STUDY PAPER HAS BEEN SUBMITTED FOR EXAMINATION WITH MY APPROVAL AS THE UNIVERSITY SUPERVISOR. SIGNED DATE ……………………….. ..………………. PROFESSOR ERASMUS KAIJAGE SCHOOL OF BUSINESS, UNIVERSITY OF NAIROBI.

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DEDICATION

To my precious wife Doreen and daughter Leila, for giving me a new purpose for living and a

renewed zeal to excel.

To my late Dad and Mum Mr. David Mandala and Mrs. Beliah Mandala, for laying the

foundation for my academic advancement and outstanding achievements.

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ACKNOWLEDGEMENTS First and foremost, I would like to express my deepest gratitude and appreciation to my

supervisor, Professor Kaijage without whom I would not have achieved this. His guidance,

encouragement and support were of great value. He gave me a push to go on at a time when I

almost despaired.

Special thanks also go to all my friends, particularly those in my PhD class. Their

contribution throughout my study period is highly appreciated.

Most importantly, I thank God the Almighty for giving me life, health and the ability to

undertake this journey.

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ABSTRACT

Kenya has characteristics of board structures and ownership concentration similar to those

found in most countries. Firms in transition economies are characterized by high degree of

ownership concentration. Empirical studies suggest that ownership concentration is related to

firms’ corporate governance, financing and investment policies. Ownership for most firms is

distributed among institutional investors and retail investors; with ownership concentrated

mainly to institutional investors. The ownership can also be categorized into state ownership

and public ownership. The type of ownership structure of a firm ultimately affects the board

structure categorized in this study as type 1 board, whose members directly own equity shares

in the firm; type 3 board, where the board members do not hold any equity shares in the firm

whose board they sit on; and type 2 which is a blend between the two extremes, whose some

members own equity shares and some do not hold any equity shares.

This study reviews empirical literature related to the relationship between board structure and

financial performance. The effectiveness of boards of directors, including board type, board

composition, board size, and aspects of board leadership including duality and board

busyness are addressed using a number of theories of corporate governance: agency theory,

resource dependency theory, entrenchment and convergence of interests theory.

The study was motivated by the fact that one could imagine a simple causal structure such

that board structure directly influences financial performance and thus the firm value. Type 1

boards would be motivated in ensuring that the entity’s financial performance is enhanced

while type 3 board members may not be motivated to ensure better financial performance.

Type 2 boards that is a combination of the two extremes may be considered the control

variable. The study focused on whether empirical literature exists to support these thoughts.

This study explored literature related to the issues above to determine any theories and

empirical studies carried out in the past. It has established gaps in knowledge, research and

methodological problems related to board structures and financial performance.

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TABLE OF CONTENTS

DECLARATION ................................................................................................................. iii DEDICATION ..................................................................................................................... iv ACKNOWLEDGEMENTS................................................................................................... v ABSTRACT ........................................................................................................................ vi 1.0 INTRODUCTION ...................................................................................................... 1

1.1 Statement of the Problem ..................................................................................... 3 1.2 Objectives of the Study ........................................................................................ 5 1.3 Corporate Governance ......................................................................................... 5 1.4 Ownership Structure ............................................................................................ 6 1.5 Financial Performance Measures ......................................................................... 7 1.6 Outline of the study ............................................................................................. 8

2.0 THEORETICAL REVIEW ...................................................................................... 10 2.1 Agency Theory .................................................................................................. 10 2.2 Competing Theories .......................................................................................... 14 2.2.1 Convergence-of-interests Theory ....................................................................... 14 2.2.2 Entrenchment Theory........................................................................................ 15

3.0 EMPIRICAL REVIEW ............................................................................................ 17 3.1 Introduction ....................................................................................................... 17 3.2 Corporate Governance and Financial Performance............................................. 17 3.3 Board Structure and Financial Performance ....................................................... 18 3.4 Board Composition and Firm Performance ........................................................ 24 3.5 Ownership Structure, Corporate governance and Financial Performance............ 26 3.6 Corporate Governance and Bankruptcy.............................................................. 31 3.7 Corporate Governance Variables and Performance ............................................ 32 3.8 Board Size and Firm Performance ..................................................................... 34 3.9 Board Composition and CEO performance ........................................................ 35 3.10 Research Gaps ................................................................................................... 36 3.11 Conceptual Framework ...................................................................................... 39

4.0 CONCLUSIONS AND RECOMMENDATIONS..................................................... 41 REFERENCES ................................................................................................................... 42

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1.0 INTRODUCTION

Kenya has characteristics of board structures and ownership concentration similar to those

found in most countries. Ownership for most firms is distributed among institutional

investors and retail investors; with ownership concentrated mainly to institutional investors.

The ownership can also be categorized into state ownership and public ownership. The type

of ownership structure of a firm ultimately affects the board structure categorized in this

study as type 1 board, whose members directly own equity shares in the firm; type 2 board,

where the board members do not hold any equity shares in the firm whose board they sit on;

and type 3 which is a blend between the two extremes, whose some members own equity

shares and some do not hold any equity shares.

Agency problems have in the recent past become an integral part of the modern-day

corporation, owing to the widening separation of ownership and control responsibilities,

growing business diversification and segmentation across industries, business lines, and

investor emphasis on near-term performance and return outcomes. Financial scandals further

lead to the question of whether firms are being run in the best interests of stakeholders. The

board of directors and the executive management have the control responsibilities for the firm

while the owners may not be able to offer adequate supervision or accountability, particularly

in companies with widely dispersed ownership. Agency conflicts (conflicts that arise from

the separation of ownership and control) may not be fully resolved effectively through

corporate governance systems hence managers may not act to maximise the returns to

shareholders unless appropriate governance structures are implemented in the large

corporations to safeguard the interests of shareholders (Jensen and Meckling 1976).

Agents or managers may not always act in the best interest of shareholders when the control

of a company is separate from its ownership. Herbert (1959) (quoted in Baysinger and

Hoskisson, 1990) proclaimed that managers might be “satisfiers” rather than “maximisers,”

that is, they tend to play it safe and seek an acceptable level of growth because they are more

concerned with perpetuating their own existence than with maximising the value of the firm

to its shareholders. But shareholders delegate decision-making authority to the agent (Board

of Directors) with the expectation that the agent will act in their best interest.

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One of the most important functions of the corporate governance system in this context is to

ensure the quality of the financial reporting process. Board members, acting as agents of

owners, are being held increasingly responsible for controlling the actions of management

and for evaluating and implementing effective systems of controls. Recent legislation in

Kenya and the guidelines on corporate governance issued by Capital Markets Authority for

listed firms require boards to have audit committees and a majority of outside directors and

consequently have independent directors. In some instances the ideal numbers of these

independent directors is mentioned in the various enabling legislations for the Industries. The

intent is to limit the ability of management to engage in earnings management and

opportunistic behaviour by increasing the ability of both the board and audit committee to

monitor management (Farinha, 2003).

Encouraging equity ownership among directors is often used to align the interest of directors

with those of the owners. Convergence-of-interests theory and the Entrenchment theory try to

explain how members of the board of directors, acting as agents for the stockholders, react to

owning stock in the firms they serve. A question that keeps on lingering in corporate

governance cycles is why in some cases independent directors are not effective monitors

(Pergola and Gilbert, 2009). The explanation may be found by examining the power and

incentive of board members to perform their fiduciary duties. In this study, the researcher

examines literature on firms with diverse ownership structures, and thus different board

structures whose directors act as agents of stockholders with emphasis on how the board

structure may impact on the monitoring effectiveness.

A great deal of attention has been given to understanding how board structure as a variable of

corporate governance affects financial performance. Corporate governance can influence a

firm’s financial performance whenever there is an agency conflict among the various

relationships in the firm. In the management-shareholder conflict, the agency problem

manifests itself in management’s self interest. In the controlling-minority shareholder

conflict, controlling shareholders use their power to benefit themselves at the expense of the

minority shareholders, in what is called expropriation or private benefits of control. The root

of both conflicts is the fact that the managers in the first case, and the controlling

shareholders in the second case, receive only a portion of the firm’s earnings, while they fully

appropriate the resources diverted. Thus, it is conceivable that, in light of this incentive

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structure, insiders will maximize their pecuniary and non-pecuniary utility even when the

firm as a whole will not.

Corporate-governance mechanisms assure investors in corporations that they will receive

adequate returns on their investments (Shleifer and Vishny, 1997). If these mechanisms did

not exist or did not function properly, outside investors would not lend to firms or buy their

equity securities. Businesses would be forced to rely entirely on their internally generated

cash flows and accumulated financial resources to finance ongoing operations as well as

profitable investment opportunities. Overall economic performance is likely to suffer because

many good investment opportunities would be missed and temporary financial problems at

individual firms would spread quickly to other firms, employees, and consumers.

Effective corporate governance also assists in the attainment of high level financial

performance and market valuation (Klapper & Love, 2004; Rajagopalan & Zhang, 2008). La

Porta, Lopez-de-Silanes, Shleifer, and Vishny (2000) argue that emerging economies have

traditionally been discounted in financial markets because of their weak governance.

1.1 Statement of the Problem In the recent past attention and interest in corporate governance has grown exponentially

especially with the major boardroom tussles and corporate collapses such as Enron and

WorldCom in the US and locally Uchumi Supermarkets, East African Portland and CMC.

The underlying thesis is that a crisis of governance is basically a crisis of board of directors.

The board of directors have been largely criticised for the decline in shareholders’ wealth and

most of these corporate failures. They have been in the spotlight for the fraud cases that had

resulted in the failure of major corporations. The need for strong governance is evidenced by

the various reforms and standards developed not only at the country level, but also at an

international level (e.g., the Sarbanes-Oxley Act in the US, enhanced listing requirements,

and the Corporate Governance Code in Kenya). Typically, corporate governance research has

focused on developed economies. However, limited research exists on the extent to which the

corporate governance issues of developed economies are applicable to emerging economies.

Despite the importance of the board in particular and corporate governance in general, it is

not clear whether adequate research has been done to establish the relationship between the

board structure and financial performance. The study was therefore expected to broaden our

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understanding of the impact of corporate governance variables for instance board structure on

financial performance.

There exists an ongoing debate on the relationship between corporate governance

mechanisms and firm performance. Mixed and contradictory results have been made from

previous studies especially the ones that were conducted in the developed nations,

particularly USA, UK, Japan, Germany and France. More so, few studies have been

conducted on the emerging and developing business environment, Kenya included.

This study was motivated by a need to understand whether empirical literature exists on how

corporate governance and specifically the structure of the board impacts financial

performance. The modern corporate are established in different ways and thus different

ownership structures which have an impact on the type of board. This study therefore has

explored if literature suggests that despite the formation constraints, the board can be

structured to be of value to an organisation.

The corporate scene is composed of both the public and private sector. Public sector

institutions that form a substantial proportion of the corporate world are characterized by

Type 2 board. In the public sector the board is mainly appointed by government chiefs while

in the private sector the board members are elected from the ownership. This leads to non

share ownership by the board members in the public sector begging the question whether the

firms are bound to perform poorly, in line with the convergence of interest theory.

Performance measurement on the other hand is characterised by measurement difficulties.

Although a great deal of research has focused on performance, researchers lament that the

field has ‘‘yielded little by way of conclusive results’’, often drawing ‘‘seemingly conflicting

findings’’ regarding the determinants of performance. Performance measures are many and

varied with some schools of thought advocating for financial performance measures and

others for the non financial performance measures. The study reviewed literature on financial

performance measures with the objective of determining whether a strong case exists in

literature for there adoption.

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1.2 Objectives of the Study

The study reviewed literature on the relationship between board structure and financial

performance of firms. It was an attempt to determine whether literature exists explaining

these relationships. Specifically the study aimed at;

1. Reviewing the theoretical approach within which board structure impacts on financial

performance.

2. Providing a critical review of empirical studies undertaken on how corporate

governance and specifically the structure of the board impacts financial performance.

1.3 Corporate Governance Corporate governance has gained global upsurge both in academia and the corporate level

mainly due to increased demands for better accountability and governance on all sectors of

the economy. It is concerned with the processes and structures through which the firm takes

measures to protect the interests of the stakeholders. Good corporate governance is centred on

the principles of accountability, transparency, fairness and responsibility in the management

of the firm. The separation of ownership and control creates the need for corporate

governance, which includes mechanisms to ensure prudent decision making and value

maximization. Factors like liberalization and globalization have also accentuated the

importance of the concept globally. Globalization has a two fold impact on the economy: it

increases the accessibility of world market to the Kenyan corporate world; and intensifies the

competition in the home market (with multinational firms). This scenario increases the

importance of good governance as a factor for survival and competitive advantage (Dwivedi

and Jain, 2005).

One difference between countries corporate governance systems is the differences in the

ownership control and board structures of firms that exist across countries. Corporate

governance structures and systems differ significantly across industries and countries. Maher

and Anderson (1999) classify corporate governance systems, on the basis of degree of

ownership and control and on the basis of controlling shareholders, into the outsider systems

and the insider systems. Systems of corporate governance therefore can be distinguished

according to the degree of ownership and control and the identity of controlling shareholders.

While some systems are characterized by wide dispersed ownership (outsider systems),

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others tend to exhibit concentrated ownership of control (Inside systems). In the Outside

systems of corporate governance especially in USA and UK, there exist a basic conflict of

interest between strong managers and widely dispersed weak shareholders. On the other

hand, in Insider systems (notably Germany and Japan), the basic the basic conflict is between

controlling shareholders (or blockholders) and weak minority shareholders.

Shleifer and Vishny (1997) view corporate governance as a means to make sure that

managers’ activities concentrate on value maximization of the firm. There are several

mechanisms like management ownership, corporate control activities, shareholder activism

and trading activities which ensure the same. Governance parameters include board size,

board structure, CEO duality, frequency of board meetings, director’s shareholding,

institutional and foreign shareholding, while the fragmentation in shareholding is captured by

public shareholding.”

Research works indicate that there exists a correlation between corporate governance and

financial performance; however, it varies across countries based on the national system of

corporate governance. A study done by Gedajlovic and Shapiro (1998) found statistically

significant differences in the relationship between ownership concentration and firm

performance in the context of Canada, France, Germany, the UK, and the US. Thomsen and

Pedersen (2000) also found similar results in their study where they took into consideration

12 European countries.

1.4 Ownership Structure Ownership structure is an important aspect of corporate governance systems, as concentrated

ownership may improve the chances of effective monitoring. Klein et al. (2005) stated,

“Presence of dispersed ownership increases expectation of a positive relationship between

measures of corporate governance and firm performance, other things being equal.”

Studies on the relationship between the ownership structure and firm performance dates back

to as early as 1932 when Berle and Means (1932) hypothesized that an inverse correlation

should be observed between the diffuseness of shareholdings and firm performance.

Therefore, management-controlled firms should be less profitable than owner-controlled

firms. Chen et al. (2008) conducted their study on all companies listed on the New Zealand

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Stock Exchange for the period 2000-03. The results indicate that none of the two measures of

ownership structure was found to be statistically significant with regard to firm performance.

Thus, the study showed that there is no strong evidence in New Zealand to support the Berle

and Means’s hypotheses of which a reverse relationship exists between ownership

concentration and firm performance.

Dwivedi and Jain (2005) in their study show that the presence of block equity holders

positively affects corporate performance and can be explained by arguing on the lines of

“cost of capital” and ‘effective monitoring’. The argument on ‘cost of capital’ reflects that

when the ownership structure is concentrated, financial performance tends to decrease due to

an increase in the firm’s cost of capital. Block holders represented on the board of directors

may also prove to be effective monitors of the management owing to their power to influence

the board’s decision-making process (Shleifer and Vishny, 1997).

1.5 Financial Performance Measures Corporate performance is an important concept that relates to the way and manner in which

financial resources available to an organization are judiciously used to achieve the overall

corporate objective of an organization, it keeps the organization in business and creates a

greater prospect for future opportunities.

Extant research addressing corporate governance structures and financial performance has

relied on accounting- based financial indicators (e.g., Boyd, 1995; Buchholtz and Ribbins,

1994; Finkelstein and D’Aveni, 1994; Ocasio, 1994), market-based indicators as well as

combinations of both (e.g., Hoskisson et al., 1994). Financial accounting measures have been

relied on by many studies though frequently criticized. It has been argued, for example, that

such measures (1) are subject to manipulation; (2) may systematically undervalue assets; (3)

create distortions due to the nature of accounting policies and methods adopted by the firm;

and (4) lack standardization in financial reporting as some jurisdictions have not adopted

international financial reporting standards. Also, financial accounting returns are difficult to

interpret in the case of multi-industry participation by firms (Nayyar, 1992) or where the

ownership structures are varied.

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Given the various imprecision involved in measuring and interpreting financial accounting

indices, perhaps it is not surprising that observers have suggested that such measures ‘may be

seen as more fully under management control’ (Hambrick and Finkelstein, 1995). This is

interesting, even unfortunate, as Joskow, Rose, and Shepard (1993) have suggested that

accounting returns provide a more convenient benchmark for boards of directors to evaluate

CEOs and firm performance. Perhaps one would expect, then, that studies examining the

association between CEO compensation and firm performance have found larger

relationships with financial accounting returns than market-based returns (e.g., Hambrick and

Finkelstein, 1995; Jensen and Murphy, 1990a; Kerr and Bettis, 1987; Joskow et al., 1993).

Interestingly, the choice of accounting vs. market-based financial performance indicators is

repeatedly at issue in one of the more fundamental of board decisions—CEO compensation.

Market-based returns on the other hand have a number of advantages. They do reflect risk

adjusted performance; they are not adversely affected by multi-industry or multinational

contexts (Nayyar, 1992). The issue may be, however, that market-based performance

indicators are often subject to forces beyond management’s control (Deckop, 1987; Hambrick

and Finkelstein, 1995; Joskow et al., 1993).

As there appears to be no consensus regarding the efficacy of reliance on one set of indicators

(accounting-based) or another (market-based), many studies have resorted to using a mix of

the many financial performance measures.

1.6 Outline of the study The study is structured as follows; section II outlines the theoretical underpinnings of the

corporate governance nexus. The theoretical approach within which board structure impacts

on financial performance is described in detail. This theoretical approach is based mainly on

agency theory by Jensen and Meckling (1976) together with other two competing theories

about how board of director members, acting as agents for the stockholders, react to owning

stock in the firms they serve.

A review of empirical studies undertaken in the area of study is done in section III. A

summary of key empirical literature is provided, which includes a review and a critique with

the aim of identifying research gaps in the area. Empirical research is critically reviewed and

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its consequences analysed. The section reviews the arguments put forward and its subsequent

investigation on; how feasible the theory is in the face of the empirical evidence; how

successful are the theoretical constructs and how much further are we now in understanding

corporate governance and in particular the impact of board structures on financial

performance. This will culminate into a conceptual framework for the study.

Finally the conclusions and recommendations arising from the study are provided in section

IV. In particular, the study conclusions focus on the gaps in literature.

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2.0 THEORETICAL REVIEW Scholars and governance practioners both agree that the relationship between board structure

and financial performance is more “varied and complex” than can be covered by any single

governance theory (Nicholson & Kiel, 2007). Neither can the general pattern and links

between the two variables be explained fully by any single theory (Jackling and Johl, 2009).

The practice and theory of strategic management and business policy has however been

greatly influenced by agency theory.

2.1 Agency Theory Agency theory explores the contribution to performance directors’ play through their various

roles. This entails an examination of board structure and board leadership in terms of the

impact on performance.

The principal-agent theory is generally considered as the starting point for any debate on the

issue of corporate governance (Coleman and Biekpe, 2006). Indeed, the theoretical

underpinnings for most research studies in corporate governance come from the classic

thesis, “The Modern Corporation and Private Property” by Berle & Means (1932). The thesis

describes a fundamental agency problem in modern firms where there is separation of

ownership and control. It has long been recognized that modern firms suffer from separation

of ownership and control as they are run by professional managers (agents), who are

unaccountable to dispersed shareholders (principals).

This view fits into the principal-agent paradigm. To this end, the fundamental question is how

to ensure that managers follow the interests of shareholders in order to reduce cost associated

with principal-agent theory? The principals are hence confronted with two main problems:

First, they face an adverse selection problem: selecting the most capable managers. Second,

they are also confronted with a moral hazard problem: giving the managers the right

incentives to put forth the appropriate effort and make decisions aligned with shareholders

interests (e.g., take the right amount of risk and do not engage in empire building).

Agency theory connotes that owners are principals and the managers are agents. It argues that

in the modern corporation, in which there is diverse and widespread share ownership,

managerial actions may not likely be those required to maximise shareholder returns.

Therefore there always exists an agency loss which is the extent to which returns to the

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residual claimants, the owners, fall below what they would be if the principals, exercised

direct control of the corporation (Jensen and Meckling 1976). Agency theory further tries to

specify mechanisms which may reduce agency loss. These include incentive schemes for

managers which may comprise of plans whereby employees obtain shares, perhaps at a

reduced price, thus aligning their financial interests with those of shareholders (Jensen and

Meckling 1976). Other similar schemes are bonus or performance pay which tie executive

compensation and levels of benefits to shareholders returns and have part of executive

compensation deferred to the future to reward long-run value maximisation of the corporation

and deter short-run executive action which harms corporate value.

Jensen & Meckling (1976) further define agency relationship and identify agency costs.

Agency relationship is a contract under which “one or more persons (principal) engage

another person (agent) to perform some service on their behalf, which involves delegating

some decision-making authority to the agent”. Conflict of interests between managers or

controlling shareholders, and outside or minority shareholders refer to the tendency that the

former may extract “perquisites ” (or perks) out of a firm’s resources and less interested to

pursue new profitable ventures. Agency costs include monitoring expenditures by the

principal such as auditing, budgeting, control and compensation systems, bonding

expenditures by the agent and residual loss due to divergence of interests between the

principal and the agent. The share price that shareholders (principal) pay reflects such agency

costs. To increase firm value, one must therefore reduce agency costs. This is one way to

view the linkage between corporate governance and corporate performance. Fama (1980)

aptly comments that separation of ownership and control can be explained as a result of

“efficient form of economic organization”.

Similar to agency theory, the kindred theory of organisational economics is concerned to

forestall managerial “opportunistic behaviour” which includes shirking and indulging in

excessive perquisites at the expense of shareholder interests (Williamson 1985). A major

structural mechanism to curtail such managerial “opportunism” is the board of directors. A

corporate board is the primary and dominant internal corporate governance mechanism

(Brennan, 2006). Board monitors or supervises management, gives strategic guidelines to the

management and even may act to review and ratify management proposals (Jonsson, 2005).

A board will work to enhance the firm performance due to legally vested responsibilities or

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due to its fiduciary duty (Zahra and Pearce II, 1989). “…the board must spot the problems

early and must blow the whistle”.

Despite the fact that the board may play an important role in corporate governance by

monitoring the management, the “board culture is an important component of board failure”

(Jensen, 1993). The wave of corporate scandals at Enron, WorldCom and HIH raise the

question to what extent the board is able to monitor the management. Geneen (1984) in a

study found that among the board of directors of fortune 500 companies, 95% are not doing

what they are legally, morally, and ethically supposed to do. It is criticized that (1) the board

is a rubber stamp, (2) the board is dominated by CEO, and (3) the board is plagued with the

conflicts of interests; board responds to the wishes of controlling shareholders. Therefore, an

important question of monitoring the board may arise. That is, who will monitor the

monitors? Although it is argued that the shareholders will monitor the board by exercising

their ownership right by appointing and removing board members, shareholders may not be

aware of the inside activities of the firm.

Agency and organisational economics theories predict that when the CEO also holds the dual

role of chairman to the board, then there will be managerial opportunism and agency loss as

the interests of the owners will be sacrificed to a degree in favour of management. The

human nature underlying agency and organisational economics is that of the self-interested

actor rationally maximising their own personal economic gain. The man is individualistic and

is predicated upon the notion of an in-built conflict of interest between owner and manager.

Moreover, an individual will always calculate likely costs and benefits, and thus seeking to

attain rewards and avoid punishment, especially financial ones. This is a model of the type

called Theory X by organisational psychologists (McGregor 1960 as cited in Donaldson,

1991).

There are, however, other “models of man” which originate in organisational psychology and

organisational sociology. Organisational role-holders are conceived as being motivated by a

need to achieve, to gain intrinsic satisfaction through successfully performing inherently

challenging work, to exercise responsibility and authority, and thereby to gain recognition

from peers and bosses (McClelland 1961). Thus, there are non-financial motivators. While

agency theorists posit a clear separation of interests between managers and owners at the

objective level (Jensen and Meckling 1976), this may be debatable, and organisational

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sociologists would point out that what motivates individual calculative action by managers is

their personal perception (Silverman1970 as cited in Donaldson, 1991). To the degree that an

executive feels their future fortunes are bound to their current corporate employers through

an expectation of future employment or pension rights, then the individual executive may

perceive their interest as aligned with that of the corporation and its owners, even in the

absence of any shareholding by that executive.

These theoretical considerations give rise to stewardship theory which argues with a view of

managerial motivation alternative to agency theory (Donaldson 1991). The executive

manager, under this theory, although being an opportunistic shirker, essentially wants to do a

good job, to be a good steward of the corporate assets. Thus, stewardship theory holds that

there is no inherent, general problem of executive motivation. Given the absence of an inner

motivational problem among executives, there is the question of how far executives can

achieve the good corporate performance to which they aspire. Thus, stewardship theory holds

that performance variations arise from whether the structural situation in which the executive

is located facilitates effective action by the executive. The issue becomes whether or not the

organisation structure helps the executive to formulate and implement plans for high

corporate performance (Donaldson 1991). Structures will be facilitative of this goal to the

extent that they provide clear, consistent role expectations and authorise and empower senior

management.

Jensen & Meckling (1976) integrates elements from the theory of agency, the theory of

property rights and the theory of finance to develop a theory of the ownership structure of the

firm. They show the relationship of agency costs to the ‘separation and control’ issue, and

investigate the nature of the agency costs generated by the existence of debt and outside

equity. They conclude that agency costs are as real as any other costs due to separation of

ownership and control. The level of agency costs depends among other things on statutory

and common law and human ingenuity in devising contracts. Both the law and the

sophistication of contracts relevant to the modern corporation are the products of a historical

process in which there were strong incentives for individuals to minimize agency costs.

Related to agency theory is also the resource-dependency theory which posits that the board

of directors play an important role in the firm and can create value addition for the firm. This

is expounded in the resource-dependency theory (Pfeffer and Salancik 1978), which

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maintains that boards serve four fundamental roles: providing advice, building legitimacy,

strategic oversight, and stakeholder management. An organization’s survival prospects are

enhanced by these activities as they lead to the acquisition of key resources (Johnson et al.

1996). As the organization relies on the external environment, the board must assist in both

managing and forming bridges with relevant outside entities

2.2 Competing Theories Agency conflict can be resolved by encouraging stock ownership among directors so as to

align the interest of directors with those of the shareholders. There are two competing

theories about how board of directors, acting as agents for the stockholders, react to owning

stock in the firms they serve.

2.2.1 Convergence-of-interests Theory Convergence-of-interests theory, posits that when board members have no share ownership,

they are self-oriented but they have little power to overcome corporate controls designed to

align their actions for the benefit of the stockholders. The corporate governance mechanism

in this case includes the existence of independent board members who could influence the

managers on the board, which has been shown to result in less fraud and earnings

manipulation (Beasley et al., 2000; Klein, 2002a). As stock ownership rises, board members

automatically and gradually align their interest with the stockholders leading to better quality

decisions that increase the value of the firm (Jensen and Meckling, 1976; Beasley, 1996).

Theoretically, as even small increments of stock ownership occur, the interests of the

manager incrementally become more aligned with the interests of the stockholders. Increased

quality of decision making results in better alignment of actual cash flows with profits, that

is, increased earnings quality. As managers’ interests become more aligned with

stockholders’ interest, managers become increasingly more conscientious, are involved in

fewer fraud activities, and would feel less motivated to intentionally manipulate earnings to

make performance appear better than it actually is. Ultimately, when they own all the stock,

they act as sole proprietors; any action they take against the firm’s interest only hurts them.

At this extreme, no governance mechanisms would be needed. If the convergence-of-interests

theory is true, the best strategy for firms is to encourage (or require) stock ownership by

managers and board members. Compensation packages that include stock options or awards

of free shares and restrictions that delay the ability to sell these shares are designed to

15

gradually build ownership. Fewer governance controls would be needed as stock ownership

increases (Pergola & Joseph, 2011)

2.2.2 Entrenchment Theory Morck et al. (1988) in contrast to convergence-of-interest theory argue that there is a negative

relationship between board equity ownership and corporate performance. They developed the

“entrenchment theory”, which opines that higher levels of ownership lower the corporate

performance. The logic followed is that managers with high equity ownership levels focus

more on maximizing market share and technological leadership rather than maximizing

profits.

Directors’ shareholding also has a negative impact on firm value (Dwivedi and Jain, 2005). A

study conducted by Perrini, Rossi and Rovetta (2008) probed into two aspects of the

ownership structure: first, the percentages owned by the top five shareholders (ownership

concentration) and the second, managerial shareholding pattern to check its effect on firm

performance. Managerial ownership was taken as the shares owned by the members of the

corporate board, the CEO and the top management. The findings revealed that the ownership

concentration (of the five largest shareholders) showed a positive effect on Tobin’s Q, while

managerial ownership has a negative effect on the valuation in concentrated (ownership)

companies. Anderson and Reeb (2003), in their study in the US, came up with an interesting

conclusion that the family firms perform better than the non-family firms.

The entrenchment theory has similar conclusions about managers and directors at extremely

low and extremely high levels of equity ownership. At low ownership levels their interests

are not aligned with the stockholders, but they possess so little stock that they have no power

to subvert governance mechanisms. At high stock ownership levels, the managers or directors

are the stockholders and inappropriate actions would only hurt themselves. It is the middle

range of the graph that differs. When managers or board directors obtain relatively large

stock ownership (but not extreme ownership levels that would align their interests with those

of the stockholders) they may possess sufficient power to overcome governance mechanisms

(Fama and Jensen, 1983).

This would allow managers to act in their own self interests with little fear of removal or

sanctions; they would have become ‘‘entrenched’’. Previous studies have indicated that

16

entrenchment can occur at relatively low levels of absolute stock ownership (Morck et al.,

1988). If the entrenchment range exists, it should be reflected in poor earnings quality. Poor

earnings quality means that managers intentionally manipulate earnings, shirk and make poor

accrual decisions, or conduct fraud activities that would also adversely affect earnings. All

such activities result in actual cash flows being different from what profits project that cash

flows should be. If the entrenchment theory is true, one strategy for firms might be to build

stock ownership in managers and board members, but increase governance mechanisms

within the entrenchment range. Thus, it becomes important to know where the thresholds into

and out of the entrenchment range exist and whether governance mechanisms are able to

overcome entrenchment.

17

3.0 EMPIRICAL REVIEW

3.1 Introduction Corporate Governance is arguably one of the most significant subjects in modern finance

theory. This is reflected not only in the formal recognition that it has received in recent years

but also in the attention that it has continued to receive from researchers for over four decades

now. Although the majority of theories of corporate governance are in agreement about

explaining the agency problem and resolutions, the empirical research has been handicapped

by the unobservability of some key variables.

This section provides a review of empirical studies undertaken in the area of study. A

summary of key empirical literature is provided, which includes a review and a critique with

the aim of identifying research gaps in the area. The section reviews the arguments put

forward and its subsequent investigation on; how feasible the theory is in the face of the

empirical evidence; how successful are the theoretical constructs and how much further are

we now in understanding corporate governance and in particular the impact of board

structures on financial performance.

3.2 Corporate Governance and Financial Performance In an important and often-cited paper, Gompers, Ishii, and Metrick (GIM, 2003) study the

impact of corporate governance on firm performance during the 1990s. They studied US

firms that went through mergers and acquisitions to examine the effect of governance

provisions on forced CEO turnover following value-reducing acquisitions. GIM, 2003

modelled a governance index which was used to analyse the impact of various board structure

variables on performance. They concluded that stock returns of firms with strong shareholder

rights outperform, on a risk-adjusted basis, returns of firms with weak shareholder rights by

8.5 percent per year during this decade.

On the policy domain, corporate governance proponents have prominently cited this result as

evidence that good governance (as measured by GIM) has a positive impact on corporate

performance. Their results showed that managers of firms with staggered boards are less

likely to be replaced by the takeover market than are managers of firms with annually-elected

boards. Combined with the evidence that CEOs of firms with staggered boards are more

likely to pursue value-reducing acquisitions, this finding is consistent with the notion that

managers can use staggered board structure to pursue their self interests and to facilitate

18

managerial entrenchment. However, the aggregate indices of governance provisions are not

significantly related to force CEO turnover suggesting that they do not measure entrenchment

effectively. Although GIM, 2003 reviews board structure their study is limited by the fact that

an important aspect of board structure classified as the three board types in this study are

ignored.

In Kenya a study by Kihara, (2006) on the relationship between ownership structure,

governance structure and performance of firms listed at the NSE concluded that privately

owned enterprises had better governance structures which further improved their performance

compared to state corporations. His study however was limited to one aspect of corporate

governance that is the governance structure and looked at ownership structures from the point

of view of whether a firm is state or private owned.

Other research studies done on corporate governance and firm performance in Kenya include

a study by Jebet (2001) in which she set to determine the existing corporate governance

structures in publicly quoted companies in Kenya. Her findings were that most listed firms

had both executive and non executive directors as the supreme control body assisted by

various committees. Others include: Mululu (2005), who studied the relationship between

board activity and firm performance and concluded that those firms with active boards

performed better than those with inactive boards. Mululu (2005), study found out that the

frequency of board meetings is related to the number of corporate governance variables, such

as the board size, the number of executive directors, number of total shares held by the largest

shareholders, the number of shares held by unaffiliated block holders, the number of

percentage of shares held by officers and directors and the number of other directorship held

by outside directors. From the study there was evidence that the number of board meetings

decrease with the board size.

3.3 Board Structure and Financial Performance Does the structure of a board of directors influence firm performance, or does firm

performance influence the structure of the board? There has been indications that both forces

may be at work simultaneously, implying that financial performance and board of director

structure are endogenously determined. Prior research on the relation between board structure

and financial performance has yielded mixed results (Dalton, Daily, Ellstrand & Johnson

(1998).

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The impact of board structure on financial performance is not very clear. This may be due to

the fact that board of director structure and financial performance are endogenously

determined and that due to fixed board terms and periodic financial reporting, the relation

may be intertemporal. Dalton, Daily, Ellstrand & Johnson (1998) find no overall support for

the hypothesis that board composition significantly influences financial performance.

Although prior research addressing issues of board governance has often relied on board

structure as a variable, the measurement of board composition structure has not been uniform.

Prior studies have agreed that the key issue is the extent to which there exists independence

between the members of a firm's board and its CEO. Several approaches have been used to

capture this perspective. One considers the ratio of inside directors to total directors (e.g.,

Baysinger, Kosnik, & Turk, 1991; Goodstein & Boeker, 1991), mainly because of the

recognition that few officers of a firm will be independent of its CEO. Other approaches

focus on the ratio of outside directors to total directors.

Due to the fact that various researchers have defined outside board members differently, the

second ratio is not necessarily the complement of the first. Some authors have defined an

outside director as one who is not in the direct employment of the firm on whose board he or

she sits (e.g., Kesner & Johnson, 1990; Kesner, Victor, & Lamont, 1986; Singh & Harianto,

1989). However, others have relied on the independent-interdependent distinction made by

Wade, O'Reilly, and Chandratat (1990) and Boeker (1992). Independent directors are outside

directors who were appointed to a board prior to a current CEO's appointment.

Interdependent directors are either inside board members or outside directors appointed by

the current CEO. Another approach (e.g., Boeker & Coodstein, 1993; Cochran, Wood, &

Jones, 1985; Johnson et al.,1993; Pearce & Zahra, 1991) largely captures the distinction

provided by the Securities and Exchange Commission's (SEC's) regulation 14A, item 6b,

which sets forth the conditions under which directors' affiliation with a firm must be

disclosed in proxy materials

Wallace et.al, 2004 developed a theory of intertemporal endogeneity of board composition

and financial performance using data from US mutual funds. The results indicate only

minimal evidence of intertemporal endogeneity. The evidence that board composition

influences financial performance is not very strong and depends on the definitions of

financial performance and board composition as well as the type of statistical model

20

employed. They do find somewhat stronger evidence that prior financial performance impacts

board composition, but the relation still depends on how board composition is defined. The

methodology used in the study is causality tests in panel regressions with three years of data

for 130 closed-end mutual funds. The study is limited to the mutual fund industry and thus

the findings may not have general applicability.

Wallace et.al, 2004 propose a theory that the relation between board composition and

financial performance is both endogenous and intertemporal. Inter-temporal endogeneity

predicts that financial performance in one period will impact board composition in a later

period which in turn influences financial performance in subsequent periods. Financial

performance is defined in the study using three different ways, objective-adjusted return on

assets, an average of 12 month-end premium/discount ratios, and Jensen’s (1968) alpha. On

the other had board of director composition is also defined in three ways: by percentage of

outside directors, by percentage of independent directors plus fund family directors, and by

percentage of independent directors. The results are sensitive to the definition of board

composition. The significant causal impact of financial performance on board composition is

strongest for all measures of financial performance when we measure board composition as

percentage of all outside directors, that is when we include affiliated, fund family, and

independent directors. The results become insignificant for all three measures of performance

when we measure board composition as only independent directors.

Wallace et.al, 2004 study however focuses on closed-end mutual funds only the research

ought to have been directed at other industries to know if the results can be generalized to

other types of companies. In addition, intertemporal endogeneity may apply to other issues as

well. For example, Dalton, Daily, Johnson, & Ellstrand (1999) find a positive relation

between board size and performance in meta-analysis of 131 samples. Yet others, such as

Yermack (1996) find that smaller boards produce better results. Further there is need to

redirect the research focus on boards and performance.

The relationship between board structure and financial performance has been the most-

studied aspect among all board investigations (Bhagat & Black, 1999). Most studies have

focused on two areas of board structure which are CEO-chairman duality and insider/outsider

directors (Zahra & Pearce, 1989). Under CEO-chairman duality, the CEO of a company plays

the dual role of chairman of the board of directors. Several researchers argue that CEO-

21

chairman duality is detrimental to companies as the same person will be marking his "own

examination papers". Separation of duties will lead to avoidance of CEO entrenchment;

increase of board monitoring effectiveness; availability of board chairman to advise the CEO;

and establishment of independence between board of directors and corporate management

(Baysinger & Hoskisson, 1990; Fama & Jensen, 1983; Rechner & Dalton, 1991). Opposing

views believe that since the CEO and chairman is the same person, the company will; achieve

strong, unambiguous leadership; achieve internal efficiencies through unity of command;

eliminate potential for conflict between CEO and board chair; and avoid confusion of having

two public spokespersons addressing firm stakeholders (Davis, Schoorman & Donaldson,

1997; Donaldson & Davis, 1991).

A closer look at the empirical evidence reveals that the relationship between CEO-chairman

duality and company performance is mixed and inconclusive. See Table 1 for a list of some

of these studies.

Table 1: Relationship between CEO-Chairman Duality and Company Performance

Study (Year) Dimension Performance Indicators Sample Major Findings

1.Berg & Smith (1978)

CEO-chairman duality

Change in value of common stock Dividend growth Stock price growth ROI

Fortune 200 firms

Independent CEO-chairman was positively related with ROI No relationship with other indicators

2.Chaganti et al. (1985)


Firm bankruptcy 21pairs (successful/failing) of retail firms

No relationship with financial performance

3. Rechner & Dalton (1991)


ROE ROI Profit margin

250 Fortune 500 firms

Independant CEO-chairman was positively related with financial performance

4. Donaldson & Davis (1991)


ROE 337 U.S. firms from S&P

Dual CEO-chairman was positively related with financial performance

5. Daily & Dalton (1992)


ROA ROE P/E ratio

Inc. 100 firms No relationship with financial performance

6.Daily & Dalton (1993)


ROA ROE P/E ratio

186 small firms No relationship with financial performance

22



ROA 183 Inc. firms and small corporations

Independent CEO-chairman was positively related with financial performance



Firm bankruptcy 214 firms Independant CEO-chairman was positively related with bankruptcy

9.Boyd (1995)


ROI 192 U.S. firms

Dual CEO-chairman was positively related with financial performance in high complexity environments

10.Ong (1999)


Sales Net profit before tax ROI ROS

377 Singapore firms


Source: Chin and Tai (2002)

The second most-studied dimension of board structure is the proposition of outside-inside

directors. Some researchers argue that outsiders are likely to show more objectivity in their

deliberations and are willing to consider diverse groups in making their decisions (Jones &

Goldberg, 1982; Spencer, 1983). Other theorists in contrast noted that outside directors do not

have the requisite time and expertise to do their job well. Some claim that since outside

directors are chosen and retained by the CEO, they function and rely heavily on information

provided by the CEO (Geneen, 1984; Vance, 1983).

A list of key studies which relates outside-insider directors to company performance is shown

in Table 2. Again, the conclusions are equivocal.

23

Table 2: Relationship between Inside-Outside Directors and Company Performances

Study (Year) Dimension Performance

Indicators Sample Major Findings

1.Vance (1995)

Insiders vs Outsiders

Net income Sales Owners' equity

200 major manufacturing firms (1925-1950)

Insiders' representation was positively associated with financial performance

2.Vance (1995)

Insiders vs duality

Net income Sales Owners' equity

103 major industrial firms (1925-1963)

Insiders were conducive to effective financial performance

3.Schmidt (1975)

Insiders vs duality

Long-term debt Dividends Current ratio

80 chemical companies (1962-1963)


4.Cochran et al. (1985)

Insiders' representation

Operating income Sales ROE ROA Excess value ratio

406 Fortune 500 in 1982

Insiders' ratio was positively associated with financial performance

5.Baysinger & Butler (1985)

Outsiders ROE 266 major corporations in 1970 and 1980

Companies achieved higher performance did so without having a majority of outsiders

6.Caganti et al. (1985) Outsiders Firm bankruptcy

21 pairs (successful/failing) of retail firms


7.Kesner (1987)

Proportion of insiders on board

Profit margin ROE ROA EPS Stock price

250 of 1983 Fortune 500 companies in 27 industries


8.Zahra & Stanton (1988)

Outsiders' ratio

ROE Profit margin on sales EPS DPS

100 Fortune 500 1980-1983

Outsiders' ratio was not associated with financial performance

9.Agrawal & Knoeber (1996)

Outsiders Performance index

400 large Forbes 800, 1987

Negative relationship between number of outside directors and financial performance

Source: Chin and Tai (2002)

Various reasons have been put forth for the mixed relationship between board structure and

board performance. Firstly, there is no consensus as to which structure leads to what level of

performance (Johnson, Daily & Ellstrand, 1996; Zahra & Pearce, 1989). Dalton and Daily

24

(1999) noted that in spite of several decades of research designed to link the relationship

between board structure and company performance, results have been described as "vexing",

"contradictory", "mixed" and "inconsistent".

Dalton and Daily (1999) used a meta-analysis of more than 40 years of data from 159 studies

to conclude that there is no evidence of a substantive relationship between board structure

and financial performance, regardless of the type of performance measures, size of firm or the

manner board composition is defined. Dalton and Daily also queried why there should be a

relationship between board structure and firm performance in the first place. For example,

they noted that while board independence is a legitimate concern, it should not be the only

concern. Adding further, a board could be completely independent and at the same time, does

badly in its expertise/counsel and service roles. Alternatively, in a board with a majority of

inside directors, the directors may fail in its control and monitoring roles.

Johnson, Daily and Ellstrand (1996) also shared the above sentiments. They argued that the

relationship between board structure and financial performance might not exist at all. Or, if

there is a relationship, their magnitude may not be of practical significance. Kesner and

Johnson (1990) suggested that under normal circumstances, the board is probably not an

important, direct determinant of firm performance. The reason is that boards are not involved

in daily decision-making.

3.4 Board Composition and Firm Performance Researchers such as Lorsch and MacIver (1989); Mizruchi (1983); Zahra and Pearce (1989)

generally agree that effective boards consist of greater proportions of outside directors.

Ezzamel and Watson (1993) find that outside directors are positively associated with

profitability among a sample of U.K. firms. In a similar study of 266 U.S. corporations,

Baysinger and Butler (1985) report that firms with more outside board members realize

higher return on equity. Several other researchers have also reported a positive relationship

between outside director representation and firm performance (Pearce and Zahra, 1992;

Rosenstein and Wyatt, 1990; Schellenger et al., 1989).

Rosenstein and Wyatt (1990) used CRSP financial data and announcements of outside board

appointments from the Wall Street Journal and found out that announcements of appointment

of an outside director are associated with increase in shareholder wealth. The positive

relationship between board composition and shareholder wealth has been corroborated by

25

Brickley et al. (1994) who find a statistically significant, positive relation between the stock-

market reaction to the adoption of poison pills and the fraction of outside directors, a finding

consistent with the hypothesis that outside directors represent shareholder interests. Arosa et

al. (2010) find that the presence of independents on the board of a non-listed family firm has

a positive effect on performance when the firm is run by the first generation. However, no

effect on performance is seen when the firm is run by the second and subsequent generations.

Two theoretical perspectives underpin the penchant for outside directors. The resource

dependence school of thought spearheaded by writers such as Burt (1983 views outside

directors as a critical link to the external environment of the firm. Such board members,

according to the theory, may provide access to valued resources and information especially in

times of adversity (Daily and Dalton, 1994a, 1994b; Sutton and Callahan, 1987).

Another theory which justifies the proclivity for outsider-dominated boards is agency theory

(Eisenhardt, 1989, and Jensen and Meckling, 1976). Agency theory argues that due to the

separation of ownership and control in modern organizations which creates information

asymmetry between corporate owners and managers, the latter are likely to exploit the

amount and quality of the information they have to their advantage by engaging in self-

serving ventures that are injurious to the interest of the former. One of the primary duties of

the board of directors is to serve as the monitoring agent for shareholders to check the

behaviour of corporate managers (Fleischer et al., 1988; and Waldo, 1985). Therefore, having

an insider-dominated board of directors is likely to exacerbate the situation as the board’s role

as a monitoring agent of shareholders will be curtailed, paving way for managers to harm

shareholders’ wealth. Consequently, agency theory argues that effective boards will consist

of outside directors.

Notwithstanding the growing interest in outsider-dominated boards, there are studies that do

not offer logical basis for such boards. Studies by Chaganti et al. (1985); Daily and Dalton

(1992), (1993); and Zahra and Stanton (1988) have found no relationship between board

composition and firm performance. Fosberg (1989) is not able to confirm the hypothesis that

the presence of outside directors enhances firm performance by its effective discipline of

corporate managers. Fosberg argues that the insignificant relationship between the presence

of outside directors and firm performance could be explained by the possibility of

management of the firms manipulating to get incapable or unwilling to-properly-discipline-

26

management directors on the board or other controlling mechanisms such as markets for

corporate control effectively motivate and discipline management, thus, rendering stale the

monitoring role of outside directors.

Stewardship theory which argues that managers are inherently trustworthy and are not

susceptible to misappropriate corporate resources (Donaldson, 1990; Donaldson and Davis,

1991, 1994; and Pieper et al., 2008) also explains the significance of insider directors. Indeed,

Donaldson and Davis (1994: 159) suggest that ‘managers are good stewards of the

corporation and diligently work to attain high levels of corporate profit and shareholder

returns.’ According to stewardship theory the main role of the board of directors is to advise

and support management rather than to discipline and monitor, a view which is diametrically

opposed to the agency theory. The theory asserts that relationship between board

independence and firm performance potentially exists due to the counsel and advice that

outside directors’ offer, rather than their monitoring and control activities (Anderson & Reeb,

2004).

In congruence with stewardship theory, some studies have found that inside directors are

associated with higher firm performance. In a study of Fortune 500 corporations, Kesner

(1987) find a positive and significant relationship between the proportion of inside directors

and returns to investors. Vance (1978) has also reported a positive association between inside

directors and firm performance.

3.5 Ownership Structure, Corporate governance and Financial Performance Firms in transition economies are characterized by high degree of ownership concentration.

Empirical studies suggest that ownership concentration is related to firms’ corporate

governance, financing and investment policies. In a sample of firms from 27 mostly

developing and transition economies, Durnev and Kim (2005) found a positive association

between ownership concentration and corporate governance. Guriev et al (2003) found a

similar effect for Russia. Filatotchev et al. (2001) show on a sample of Russian firms that

ownership concentration is negatively related to investment. Filatotchev et al. (2007)

demonstrate for a sample of Hungarian and Polish firms a hump-shaped relationship between

ownership concentration and the management’s expectations of relying on public equity

finance.

27

A number of studies such as Demsetz (1983), Demsetz and Lehn (1985), Shleifer and Vishny

(1986) Morck et al. (1988), La Porta et al. (1998, 1999), Holderness and Seehan (1988)

among others, suggest that Berle and Mean´s (1932) model of widely dispersed corporate

ownership is not common, even in developed countries. In fact, large shareholders such as

family are common in public traded firms around the world (La Porta et al. 1999; Burkart et

al., 2003). Anderson and Reeb (2003) show that one-third of S&P 500 firms are family

controlled. In Western Europe, the majority of public held firms remain family-controlled (La

Porta et al., 1999; Faccio and Lang, 2002; Maury, 2006). Such controlling families often hold

large equity stakes and frequently have executive representation (Holderness et al., 1999;

Burkart et al., 2003).

Shleifer and Vishny, 1997 suggest that ownership concentration creates a trade-off between

incentive alignment and entrenchment effects. In this context, the question of whether a

family ownership hinders or facilitates firm performance becomes an empirical issue that is

related to institutional and politico-regulatory factors (Anderson and Reeb, 2003).

According to financial theories, individual investors tend to maintain diversified portfolios,

such that they have only a small stake in any one firm and few incentives to monitor the

firm’s managers, a situation that causes principal-agent conflicts (Berle & Means, 1932;

Fama, 1980; Jensen & Meckling, 1976). By contrast, institutional investors, such as pension

funds, mutual funds, and corporations usually have a greater stake in individual firms, thus

increasing their incentives to monitor the managers of such firms (Connelly et al., 2010;

Tihanyi, Johnson, Hoskisson, & Hitt, 2003). Therefore, when principal-agency conflicts are a

significant problem, institutional ownership can improve monitoring of firm managers, thus

mitigating IPO under pricing. However, in emerging economies, market institutions such as

pension funds and mutual funds are inactive in equity markets (La Porta et al., 1999). For

instance, mutual funds that invested in equity account for only 3.2 per cent of the total stock

market in Taiwan, as compared to 24.5 per cent in the United States (Khorana, Servaes, &

Tufano, 2005).

In Taiwan and other emerging economies, most institutional ownership consists of cross-

holdings among affiliated firms within business groups. Ownership by other corporations

accounts for approximately 30 per cent of the total equities of firms in Taiwan (individuals

28

hold about 50 per cent of total equities). Cross-holdings within business groups make it

difficult for minority shareholders to determine where control resides, let alone to monitor it

(Young et al., 2008). Complicated cross-holdings also make it difficult for minority

shareholders to identify unethical transactions among these firms (La Porta et al., 1999).

Olga et.al (2008) analyzes interrelations between ownership structures, corporate governance

and investment in three transition countries: Russia, Ukraine and Kyrgyzstan. In contrast to

most empirical papers on corporate governance, they study companies with very little

exposure to public financial markets. The empirical analysis is based on two years of data

obtained through large-scale surveys of firms. Ukrainian companies appear to have the best

corporate governance practices, while Russian companies – the worst. They find that the

relationship between ownership concentration and corporate governance is non-linear. In

Russia, the relationship between the share of the largest non-state shareholder and corporate

governance is either positive or insignificant when the blockholder’s stake is below certain

threshold; however, a further increase in the blockholder’ share is associated with worsening

corporate governance. They find a similar effect in Ukraine, but only for managerial

ownership. In both countries, corporate governance improves as the combined share of small

shareholders grows. No robust effects of the ownership structure are found for Kyrgyz firms.

The results indicate that there is no link between the quality of corporate governance and

either the need for outside finance or actual investments financed with outside funds in any of

the three countries.

A number of approaches have been employed within the literature to shed light on the

existence of agency costs within corporations and the attributes that aid in mitigating such

undesirable costs. Firstly, there is a stream of research evaluating the association between

different agency-mitigating mechanisms and interpreting from this the agency cost

consequences and the attributes that impact prominently on agency costs. Early studies in this

regard include Jensen et al. (1992) which identified an interrelationship between levels of

inside ownership, leverage and dividend payout, with inside ownership negatively impacting

on debt and dividend levels. This suggests that inside ownership and financing policy

(leverage and dividend payout) are substitute mechanisms in potentially reducing agency

costs.

29

Similar conclusions are drawn by Moh’d, Perry and Rimbey (1995) who find that inside

ownership and leverage negatively impact on dividend payout ratios, and that higher

institutional investment significantly increases payout ratios, suggesting that firm dividend

policy is determined in a manner consistent with minimizing agency-related costs. Agrawal

and Knoeber (1996) provide some evidence of interrelationships between alternative agency

mechanisms, including leverage use, insider ownership, institutional ownership, the existence

of block holders and takeover market activity, and Crutchley et al. (1999) provide evidence of

simultaneity between various agency-control mechanisms and support for institutional

ownership substituting for other attributes mitigating agency costs.

The second approach taken in the empirical literature has been the evaluation of the

association between agency control mechanisms and firm performance outcomes, with

positive performance effects of agency attributes intimated through their contribution to

lowering agency costs. Although this strain has spurned extensive research, substantial

inconsistency is observed across studies evaluating the impact of individual agency-

controlling mechanisms on firm performance.

Potential governance related attributes that have been evaluated in this context include the

size of the board of directors (Jensen, 1993 and Yermack 1996), the composition of the board

of directors (Hermalin and Weisbach, 1991 and Agrawal Yermack 1996), CEO and board

chairperson duality (Daily, Ellstrand and Johnson, 1998; and Dedman and Lin, 2002), board

committee formation and independence (Klein, 1998 and Brown and Caylor, 2006), and

managerial remuneration and compensation structure (Yermack, 1995 and Shleifer and

Vishny, 1997).

There has also been significant investigation into the role of shareholding influences on firm

performance, with Morck et al. (1988), McConnell and Servaes (1990), Hermalin and

Weisbach (1991), providing evidence of a statistically significant non-linear relationship

between managerial ownership and firm performance, and McConnell and Servaes (1990)

identifying positive relationships between performance and levels of institutional and large

external ownership respectively. Contrasting with these results however, Demetz and

Villalonga (2001) in relation to managerial ownership, and Morck et al. (1988) evaluating

institutional ownership identified no statistically significant performance impacts.

30

Given the inconsistent findings based on the examination of individual attributes, increasing

focus has been placed on considering the overall governance or agency structure of firms,

using measures such as shareholder rights or takeover vulnerability indices. This approach

relates to the expectation that firms offering lower protection for shareholder claims, those

with poorer governance practices or firms that are increasingly immune to takeover threat are

more likely to experience agency and managerial entrenchment problems leading to

incurrence of agency costs and lower relative performance. The evidence in this regard is

much more conclusive, with La Porta, Lopezde-silanes, Shleifer and Vishny (1998) and

(2000), Black (2001), Gompers, Ishii and Metrick (2003) and Klapper and Love (2004), all

finding a positive association between measures representative of superior corporate

governance quality, stronger shareholder rights or increased takeover vulnerability and firm

performance.

The final relevant subset of literature, involves those studies that have directly attempted to

measure (or proxy for) the level of agency costs inherent in firms, and then evaluated the

factors that significantly impact on the variation in firm agency costs within cross-sectional

or longitudinal sample constructs. Ang et al. (2000) applied this method to a sample of non-

listed US small businesses based on measuring agency costs, using operating expense and

asset turnover ratios, relative to a zero-agency cost base firm represented by a 100% owner-

manager firm. Agency costs were found to be negatively related to the manager’s ownership

interest and the extent of external bank monitoring and positively related to the number of

shareholders and the existence of an outside (non owner) manager.

Fleming, Heaney and McCosker (2005) identified similar results in an analysis of non-listed

Australian firms. Singh and Davidson III (2003) found that larger managerial ownership and

smaller-sized boards both enhance asset utilization ratios for larger listed US companies.

Doukas et al. (2000) examined agency cost determinants for listed US firms and concluded

that greater analyst following generally reduces agency costs, but its effect is more prominent

for single-segment as opposed to diversified firms. They also provided evidence of non-linear

relationships between inside ownership and leverage and the level of agency costs, whereas

agency costs are found to be positively associated with the level of institutional ownership. In

a similar study of listed UK firms, Doukas et al. (2005) find that greater analyst following

only reduces agency costs for small firms.

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3.6 Corporate Governance and Bankruptcy Daily and Dalton (1994) examined the relationships among governance structures and

corporate bankruptcy. They employed a logistic regression analysis on bankrupt major

corporations and a matched group of survivor firms and the results indicated robust power for

financial indicators, constituent common stock holdings, board of director quality, and

corporate governance structures as predictors of bankruptcy. The reported results suggest a

relationship between governance structures and bankruptcy. Specifically, the model indicates

differences between the bankrupt and matched groups in proportions of affiliated directors,

chief executives, board chairperson structure, and their interaction. The research specifically

focused on the potential relationship between bankruptcy and two much-debated aspects of

corporations: board composition, or the ratio of outside members to total members, and chief

executive officer (CEO)-board chairperson structure.

Daily and Dalton, (1994) results however should be interpreted with caution and not extended

beyond the focused context provided in their study. The data set comprises bankrupt firms

and a matched control group. The study is not extended to determine at what point

governance structures no longer have some predictive ability concerning future bankruptcy.

The firms on which the study relied on were large corporations, and the results may not be

generalizable to their smaller counterparts. It has been argued, for example, that larger firms

have greater assets, greater credibility in the financial markets, and longer-term contracts and

can delay the onset of formal bankruptcy filing well beyond the point at which smaller firms

can do so. Moulton and Thomas (1993) for example, explained that "firm size dominates all

other factors in predicting success in completing the reorganization process".

Poorly governed firms are expected to be less profitably, have more bankruptcy risks, lower

valuations and pay out less to their shareholders, while well-governed firms are expected to

have higher profits, less bankruptcy risks, higher valuations and pay out more dividends to

their shareholders. Claessens (2003) also argues that better corporate frameworks benefit

firms through greater access to financing, lower cost of capital, better performance and more

favourable treatment of all stakeholders. The position has been stated that, weak corporate

governance does not only lead to poor firm performance and risky financing patterns, but are

also conducive to macroeconomic crises like the 1997 East Asia crisis. Other researchers

contend that good corporate governance is important for increasing investor confidence and

market liquidity (Donaldson, 2003).

32

Previous studies on the elements of governance structures and bankruptcy are scanty; only

two studies have attempted to empirically test these two variables. Chaganti, Mahajan, and

Sharma (1985) found no relationship between board composition and bankruptcy in a study

of 21 retailing companies. In what for us is a provocative report, Hambrick and D'Aveni

(1992) found that dominant CEOs were more likely than weaker CEOs to be associated with

firm bankruptcy. Although their measurement of dominance was based on the ratio between

CEO's compensation and that of the remaining members of a firm's top management team,

their results suggest that an examination of governance structures-some of which are

considered to enhance CEO power-may be productive.

In Kenya, Kamere (1987) noted that agency problems may bring about an optimal ratio of

debt and equity financing when agency costs related to debt and equity financing are

considered. Costs associated with protective covenants are substantial and rise with the

amount of debt financing. Shareholders incur monitoring costs to ensure manager’s actions

are based on maximizing the value of the firm. Jensen and Meckling (1976) noted that with

increasing costs associated with higher levels of debt and equity, an optimal combination of

debt and equity may exist that minimizes total agency costs.

3.7 Corporate Governance Variables and Performance Previous empirical studies have provided the nexus between corporate governance and firm

performance (see Yermack 1996, Claessens et al., 1999; Klapper and Love, 2002; Gompers

et al., 2003; Black et al., 2003 and Sanda et al (2003) with inconclusive results. Others,

Bebchuk & Cohen (2004), Bebchuk, Cohen & Ferrell (2004) have shown that well governed

firms have higher firm performance. The main characteristic of corporate governance

identified in these studies include board size, board composition, and whether the CEO is also

the board chairman.

In Africa, Kajola (2004) seeks to examine the relationship between four corporate

governance mechanisms and two firm performance measures. The corporate governance

mechanisms studied include; board size, board composition, duality and audit committee

while the performance measures employed are return on equity, ROE, and profit margin, PM,

of a sample of twenty Nigerian listed firms between 2000 and 2006. Using panel

methodology and OLS as a method of estimation, the results provide evidence of a positive

33

significant relationship between ROE and board size as well as duality. The implication of

this is that the board size should be limited to a sizeable limit and that the chief executive and

the board chair should be different persons. The results further reveal a positive significant

relationship between PM and duality. The study, however, could not provide a significant

relationship between the two performance measures and board composition and audit

committee.

Shleifer and Vishny, (1997) as quoted in Kajola (2004) contends that effective corporate

governance reduces "control rights" shareholders and creditors confer on managers,

increasing the probability that managers invest in positive net present value projects. Thus,

the relationships of the board and management, according to Al-Faki (2006), should be

characterized by transparency to shareholders, and fairness to other stakeholders. This will in

effect mitigate the agency cost as predicted by Jensen and Meckling (1976).

Kajola (2004) study is a contribution to the ongoing debate on the examination of the

relationship that exists between corporate governance mechanisms and firm performance.

Mixed and contradictory results have been made from previous studies especially those ones

that were conducted in the developed nations, particularly USA, UK, Japan, Germany and

France. More so, few studies (see Adenikinju and Ayorinde, 2001 and Sanda, Mikailu and

Garba, 2005) have been conducted on the Nigerian business environment.

Jackling and Johl, (2009) investigates the relationship between internal governance structures

and financial performance of Indian companies. Corporate governance variables are used to

determine the effectiveness of boards of directors. The variables including board

composition, board size, and aspects of board leadership including duality and board

busyness are addressed in the Indian context using two theories of corporate governance:

agency theory and resource dependency theory. They rely on a sample of top Indian

companies taking into account the endogeneity of the relationships among corporate

governance, corporate performance, and corporate capital structure. The study provides some

support for aspects of agency theory as a greater proportion of outside directors on boards

were associated with improved firm performance.

The notion of separating leadership roles in a manner consistent with agency theory is not

supported. For instance, the notion that powerful CEOs (duality role, CEO being the

34

promoter, and CEO being the only board manager) have a detrimental effect on performance

is not supported. There was some support for resource dependency theory. The findings

suggest that larger board size has a positive impact on performance thus supporting the view

that greater exposure to the external environment improves access to various resources and

thus positively impacts on performance. The study however failed to support the resource

dependency theory in terms of the association between frequency of board meetings and

performance. Similarly the results showed that outside directors with multiple appointments

appeared to have a negative effect on performance, suggesting that “busyness” did not add

value in terms of networks and enhancement of resource accessibility.

Empirical evidence supports the position that outside directors have been more effective in

monitoring managers and protecting the interests of shareholders. Larger numbers of outside

directors have been associated with a negative relation between CEO turnover and

performance Weisbach (1988), a lower probability that the board pays greenmail in a control

contest Kosnik (1990) and a lower probability that the board adopts a poison pill (Mallette

and Fowler, 1992).

Byrd and Hickman (1992) argue that the greater the proportion of outside directors, the better

the stock market’s reaction to their firm’s tender offers for other firms. Weisbach (1988)

finds that the sensitivity of CEO turnover to firm performance increases with the number of

outside directors on the board. He suggests that outside directors who own a substantial

number of shares and who hold more corporate directorships (presumably measuring the

value they place on their reputations) are better at negotiating a favorable deal for

shareholders who face a takeover bid. Lastly, Hallock (1997) finds that firms whose boards

are interlocked (contain a CEO on whose board the firm’s CEO serves) tend to pay their

CEOs more. He argues that interlocked directors are less independent and, consequently, give

the CEO a larger fraction of the rents than necessary.

3.8 Board Size and Firm Performance It is generally agreed that a board’s efficiency in monitoring increases as more directors are

added. This has been the position of Klein (2002) and Andres and Vallelado (2008) who

argue that a large board size should be preferred to a small size because of the possibility of

specialization for more effective monitoring and advising functions. However, the benefit of

35

specialization which Klein (2002) and Andres and Vallelado (2008) tout may be swallowed

by the incremental cost of poorer communication and decision-making associated with larger

groups.

This view has been articulated by researchers such as Fama and Jensen (1983); Lipton and

Lorsch (1992); and Yermack (1996) who favour small boards. Jensen (1993), for instance,

has questioned the effectiveness of boards with more than about seven to eight members,

arguing that such boards are not likely to be effective. He argues that large boards result in

less effective coordination, communication and decision making, and are more likely to be

controlled by the Chief Executive Officers of such firms.

His hypothesis has since received empirical corroboration from findings by Yermack (1996)

and Eisenberg et al. (1998). Eisenberg et al. (1998), in particular, find a significant negative

correlation between board size and profitability in a sample of small and midsize Finnish

firms. Cheng (2008) also lends credence to Jensen’s hypothesis. His study provides empirical

evidence that firms with larger boards have lower variability of corporate performance. The

results indicate that board size is negatively associated with the variability of monthly stock

returns, annual accounting return on assets, Tobin’s Q, accounting accruals, extraordinary

items, analyst forecast inaccuracy, and R&D spending, the level of R&D expenditures, and

the frequency of acquisition and restructuring activities.

3.9 Board Composition and CEO performance Hermalin and Weisbach (1998) ask how boards can be chosen through a process partially

controlled by the CEO, yet, in many instances, still be effective monitors of him. Weisbach

(1988) reports that boards with at least 60 percent independent directors are more likely than

other boards to fire a poorly performing CEO. This type of firing is likely to add value

because boards are generally slow to fire CEOs. The stock price reaction to such firings is

hard to interpret because the firing announcement conveys information to the market both

about the event and about how the firm performed under the fired CEO, but there is evidence

that investors believe that these firings increase firm value. He quotes evidence (Daily and

Dalton, 1995) that firm performance improves modestly on average after a CEO is replaced.

Weisbach’s study suggests that independent directors behave differently to inside directors

with respect to retaining or firing a CEO, but it is not clear whether independent directors

make better or worse decisions, on average.

36

Hermalin and Weisbach (1998) assume that the board and the CEO negotiate over both the

CEO’s wage and the identity of new directors. These negotiations could be either explicit or

implicit, that is the CEO could nominate new board members subject to a tacit understanding

about the set from which they may be chosen. Were the CEO to violate this understanding,

the board would refuse to approve his nominees. The CEO’s bargaining power in these

negotiations comes from his perceived ability relative to a replacement.

Bonazzi and Islam (2006) set out to develop a model to resolve an on-going issue in financial

economics: how can CEOs be effectively monitored by the board of directors? They

undertake a survey of the literature on corporate governance and the relationship between

board composition and financial performance, which leads to the development of the

proposed model. This is based on a framework which takes into account the probability of

success representing a CEO’s ability, and the active monitoring function (which is

represented by the numbers of control visits) carried-out by the directors. The model

developed is aimed at identifying an optimal level of monitoring, which will maximise share

value, to guide internal and independent directors.

The model proposed however has a limitation where the focus is solely on the monitoring of

boards. The institutional literature (Mace, 1971; Vance, 1978) emphasizes that boards also

play important roles in providing information and advice to management, and serving as a

training ground for future CEOs. A richer model of boards should take into account these

roles as well.

More research is also required in devising objective measures to assess the ability of potential

directors to discern and address tough company situations, to know when painful decisions

are called for, to nurture their own independent opinions, and to decipher the conceptual

errors of corporate officers. In fact, more work is required in the area of pre-board selection

tests, and an accreditation system that guarantees at least some fundamental levels of skill,

knowledge and experience.

3.10 Research Gaps

Past literature on board research has centred around board structure and company

performance. Over the years, empirical studies do not reveal a conclusive relationship

37

between these two variables (Dalton & Daily 1999). As a result, exploration for new areas of

research on boards is much needed (Forbes & Milliken, 1999; Johnson, Daily & Ellstrand,

1996; Pettigrew, 1992).

Corporate governance strategies adopted by firms will be in accordance with a number of

variables including the ownership structures and the environment in which they operate. The

review of literature suggests that the board structure is also an important aspect in corporate

governance and impacts on performance. Although prior research addressing issues of board

governance has often relied on board structure as a variable, the measurement of board

composition structure has not been uniform.

Board structure variables studied include board size, CEO duality, board busyness and board

composition among others. However no evidence has been found that board types as defined

in this study has been widely used as a variable hence a research gap on the same. A gap

exists as to how board members with a financial stake in the firm are likely to impact on

financial performance. The question remains as to the casual relationship between these

variables. There is need to depart from traditional board structure variables and attempt

construction of a new, comprehensive theoretical model, which would cover all of the

emerging issues in board structure and close the gap.

The empirical literature review revealed that most studies on board structure and performance

relied on accounting measures of performance. These data is obtained from financial

accounting reports. Financial accounting reports suffer from the following flaws: are subject

to manipulation; may systematically undervalue assets; create distortions due to the nature of

depreciation policies adopted, inventory Valuation and treatment of certain revenue and

expenditure items; differ in methods adopted for consolidation of accounts; and lack

standardization in the handling of international accounting conventions (see, for example,

Chakravarthy, 1986). Studies using market based performance measures and a blend of

market and accounting measures should therefore be undertaken to bridge this gap.

Board research has traditionally centred on the relationship between board structure and firm

performance. Empirical studies have however shown that the relationship is equivocal. Over

the years, empirical studies do not reveal a conclusive relationship between these two

variables (Dalton & Daily 1999). As a result, exploration for new areas of research on boards

38

is much needed (Forbes & Milliken, 1999; Johnson, Daily & Ellstrand, 1996; Pettigrew,

1992). The board process could be the missing link. In general, board process refers mainly to

the decision-making activities of the board (Zahra & Pearce, 1989). Anderson and Anthony

(1988) noted that board process pertains to the healthy and sometimes rigorous discussion on

corporate issues and problems so that decisions can be reached and supported. Dulewicz,

MacMillan and Herbert (1995) denoted board process as the organizing and running of board

which need to be performed so that the objectives of the board can be achieved.

Further research should introduce an integrative conceptual model between board structure

and board performance, with board process as an intervening variable. Until lately, the

literature on board processes is lacking. The reason for insufficient empirical work on board

processes is possibly due to the difficulty of gaining access to boards. On the other hand, we

believe that such a limitation should not be an excuse for not developing a working model for

conceptual analysis.

The studies reviewed presented mixed findings regarding the relationship between board

structure variables and financial performance. While a number of them found a positive

relationship between the variables and performance, others found the opposite. This could be

linked to the variety of methodologies and definitions of variables used and the study

contextual factors that were not captured by the models employed. Most of these studies were

carried out in different countries and different managerial regimes.

Most of the studies reviewed also seem to examine the direct relationship between the

individual variables or specific set of variables and performance. As such they have

overlooked testing the variable interactions, their relations and causal linkage of all of them

and consequently the joint impacts on firm performance. As such critical organizational

context and implementation issues are ignored.

Finally, on a more practical note, understanding the different dimensions of board could lead

to better utility of boards to maximize their contributions. To the shareholders at large, they

might be eager to know how the dynamics of board processes impact on board and hence

company performance.

39

3.11 Conceptual Framework This study considers that due to the separation of ownership and control, the agent may be

driven by self-interest. The board structure in the form of share ownership by board members

will be able to provide important monitoring functions in an attempt to resolve the agency

conflict between management and shareholders. This could form the independent variable of

the study.

Therefore, this study is conducted within the ‘agency theory’ perspective. It can be argued

that share ownership by board members will bring independent advice which stewardship

theory ignores (Nicholson and Kiel, 2007). Similarly, consistent with ‘agency theory’, this

study argues that not owning shares will reduce the firm performance. This diminishes the

monitoring role of the board of directors due to lack of self interest, and this in turn may have

a negative effect.

There are a number of control variables that can be considered as evidenced by the literature.

Top managers’ ownership is calculated as the percentage of shares owned by top. Family

ownership is calculated as the percentage of shares owned by individual family members.

Institutional ownership is the percentage of shares owned by all institutional investors, or

Independent Variables:

• Board Structure (Board members ownership)

Moderating Variable: - Agency Theory

(Agency costs and Loss

Dependent Variable: • Financial

Performance (Market and Accounting measures)

Intervening Variables: • Board Size • Firm Age • CEO duality • Firm Size • Top management ownership • Family ownership • Institutional ownership • Independent outside directors

40

investors that are not individuals. Ownership by government agencies is excluded, because it

cannot be said that government agencies are used by controlling shareholders to engage in

cross-holding or pyramiding and to enhance their control rights. CEO duality is in most

studies a binary variable. When the CEO also serves as the chair of the board, 1 is coded;

otherwise 0 is coded. Independent outside directors is the number of independent directors

divided by the number of all directors. Others include; Board size, as prior studies have

revealed that it has effects on the efficiency of board meetings and thus the monitoring role of

the board (Andres et al., 2005; Eisenberg, Sundgren, & Wells, 1998). Board size is the

number of directors on the board. Size is the natural log of the total assets of the firm. Firm

age is the number of years from the establishment of the firm to the study date.

41

4.0 CONCLUSIONS AND RECOMMENDATIONS The effects of board structure on corporate performance are not well understood, but most

research begins with the premise that any effects of board structure must result from changes

in the efficacy, or monitoring capabilities, of boards. These changes are expected to affect

profits directly, and stock performance indirectly. However this poses a greater problem of

performance measurement. There appears to be no consensus in literature regarding the

efficacy of reliance on one set of indicators (accounting-based) or another (market-based).

Empirical studies reviewed show that corporate governance and in particular board structure

could increase firm’s performance and value by reducing agency costs. The improvement in

firm performance is attained particularly when there is strategic fit and alignment between

organizational strategy, management styles and various contextual factors.

Studies on corporate governance should in future move beyond the narrow band of theories

that has informed research to date. In academic studies of finance, a handful of economic

theories, such as agency theory and the efficient markets hypothesis, have dominated. These

explanatory frameworks assume fully rational actors making decisions based on careful

calculations about a firm’s current standing and future prospects. But in the stock market as

in other markets, behavior is shaped in important ways by psychological and sociological

factors that these theories neglect. Insights from psychology and economic sociology promise

to enrich our understanding of corporate governance.

Performance measures are many and varied with some schools of thought advocating for

financial performance measures and others for the non financial performance measures.

Frequently, when a body of findings is equivocal, methodological problems are at issue (e.g.,

Ferguson & Ketchen, 1999; Lewin & Minton, 1986; Short, Ketchen, & Palmer, 2002). One

possible contributor to this lack of performance findings in the literature derives from the

diverse and complex operationalization of the performance construct (Arin˜o, 2003; March &

Sutton, 1997; Venkatraman & Ramanujam, 1986). This should thus be explored further and a

uniform way for measuring corporate financial performance determined.

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