Corporate Governance and Leadership

Literature review

Corporate governance

There are many definitions of corporate governance in literature. “Corporate governance is concerned with the processes and structures through which members interested in the overall well being of the firm take measures to protect the interests of the stakeholders” (Ehikioya, 2009, p. 231). Corporate governance is the system through which corporations are directed and controlled (Cadbury, 1992). Corporate governance is responsible for the balanced relationships among company’s management, board of directors and its shareholders (Demidenko & McNutt, 2010). Corporate governance is a mechanism which ensures that all the decisions made by the top authorities are for the benefit of the company instead of their private interest (Zaidi & Aslam, 2006). Corporate governance is a key factor for risk management. It doesn’t completely eliminate the risk but minimize it to a certain limit (Aronson, 2005). It is a mechanism through which outside investors protect themselves against the expropriation by the insiders (La Porta, Lopez-de-Silanes, Shleifer, & Vishny, 2000). Insiders include managers (agents) and controlling stakeholders. Basically corporate governance means rules and procedures which are designed to reduce conflicts of interests between mangers and shareholders of the company i.e. agency problem.

There are two parties in a firm. Principals, who are the owner of resources of firm and mangers (agents), who have responsibilities to utilize resources for the benefits of firm. Economists consider a firm as a nexus of contracts entered between the capital providers (principals, shareholders, creditors) and the managers (agents, directors, employees) (Cheffins, 2005; Abbasi, 2009). Corporate governance is centered on the principles of accountability, transparency, fairness and responsibility in the management of the firm (Ehikioya, 2009). Management of the firm is responsible for hiring the audit committee. The function of internal audit is to present the true picture of financial statements to the shareholders. It assures the transparency within the accounts of the firm. It also plays advisory role by giving advices to management regarding acquisitions, mergers and system development and implementation (Brody & Lowe, 2000).

Board composition

Corporate governance deals with firm’s ownership structure, composition, size and independence of board of directors of the firm (Ehikioya, 2009). Board composition means the board size and the demographics of director (male/female, local/foreign, outsider/insider) and the degree of affiliation directors have with the corporation Zahra and Pearce, 1989; Maassen, 1999 as cited in (Korac-Kakabadse, Kakabadse, & Kouzmin, 2001) . Board of directors play very important role in organization as they are mainly responsible for monitoring managerial performance and achieving enough return for shareholders (Ballesta & Meca, 2005). Board of directors is the highest governing body in the corporation who are believed to make decisions which ultimately protecting the shareholder’s interests (Zaman, 2001). Board structure of the firm is critical to oversee the firm activities. Board of directors are given in trust with the responsibility of protecting the share holders’ interest by leading and driving the firm in right direction (Abdullah, 2004).

Board independence

Board independence may also have an impact on firm value and performance (Bhagat & Black , 2001). Inside directors provide firm and project specific knowledge that assists the board in understanding the detailed aspects of the firm’s business. In contrast, outside (or independent) directors contribute expertise and objectivity that ostensibly mitigates managerial entrenchment and expropriation of firm resources (Bhagat & Black, 2001). Independent outside directors strengthens the firm’s board (Petra, 2005)

Independent outside directors is hired by the firm with aim to utilize their qualifications, managerial skills and experience. In this way they help in decision making and improve the firm performance (Fields & Keys, 2003). Independent directors in a board also add economic value in firm performance (Hermalin & Weisbach, 2003) (Tian & Lau, 2001) (Larmou & Vafeas, 2009). A firm with smaller board size with high ratio of outside directors shows better alignment goals between owners and managers. It ultimately leads to good governance and better firm performance (Jaskiewicz & Klein, 2007).

On the other hand side, the firm having board with zero independent board members facing less agency issues as there is good alignment of principal’s and agent’s interests. Study show that independent board members have advisory role rather than monitory role. They are not able to perform their monitory role properly because of information asymmetry (Fernandes, 2005). Firms having high percentage of inside directors show low level of transparency in their financial disclosure. Financial market shows positive response to the appointment of independent director in firm’s board (Felo, 2009). Ratio of outside independent directors in board of firms does not show any impact on firm’s financial performance (Coles, Lemmon, & Wang, 2008).

Outside directors in board can only play a good advisory role but in the real sense they cannot add potential economic value to firms. There are information asymmetries between outside independent directors and the other directors. Due to that reason outside independent directors are not able to perform their managerial activities properly. Board size also shows negative impact on firm performance in Bangladesh (Rashid, Zoysa, Lodh, & Rudkin, 2010). It is a perception in market that highly independent boards improve governance within a firm but evidences show that firms with highly independent board structure do not necessarily improve the governance and the performance of the firm (Laux, 2005). Literature shows that there are very ambiguous results regarding the relationship of board independence and board size with firm’s performance.

Leadership structure: CEO duality

Leadership is also an important factor in determining the corporate governance. There are different types of corporate leadership structures throughout the world. There are two major corporate leadership structures. First, offices of CEO and chairperson of the board is held by the same person. In such a case, CEO is also chairperson of the board. Extant literature uses the term CEO duality, when CEO is also chairperson of the board. Second, both position (CEO and Chairperson) are separated to reduce the conflict of interests. This structure where chairperson is the leader and CEO has no power to influence the board called CEO non duality.

Performance of the firm increases when there is combines leadership structure (CEO duality) as CEO has great authority to make more critical decisions (Harris & C. E. Helfat, 1998) (Schooley, Rennerm, & Allenm, 2010). CEO duality is better for firm as it reduced the hidden cost of non duality leadership structure (CEO and chairman of board on separate posts). Non duality leadership reduces the CEO authority and the addition of outside person in a board as a director of board creates tension between CEO and board of directors (Allen & Berkley, 2003).

Firms may show better economic outcomes if their CEOs have more dominating decision making authorities. Credit rating firms with more powerful CEO show higher spread (Yixin Liu a & Jiraporn, 2010). CEO duality has positive association with corporate diversification into unrelated industries. Firms which do unrelated diversification after related diversification try to minimize the industry risk for shareholder’s value. Study indicates rhat in this way CEO may increase the shareholder’s utility function (Kong-Hee Kima, Al-Shammari, Kim, & Lee, 2009).

CEO decision horizon is closely related with firm performance. Usually manager’s decision horizon is shorter then shareholder’s investment horizon. Due to which CEO’s pay less attentions on the cash flows occurring after their retirement time. Shorter decision horizon negatively associated with agency cost. Longer CEO’s decision horizon has positive impact on firm performance as it shows high firm’s market valuation (Antia, Pantzalis, & Park, 2010).

Board independence and CEO duality do not affect both jointly and individually on firm performance. There is no relationship between board independence and firm performance (Abdullah, 2004) (Dalton & Dalton, 2010). In Iran leadership structure of a firm do not have any impact on firm’s economic performance (Mashayekhi & Bazazb, 2008).In the study of Hong Kong; board independence has very little effect on firm’s performance. There is negative relationship between CEO duality and firm performance (Chen, Cheung, Stouraitis, & Wong, 2005), (Coles, Lemmon, & Wang, 2008).

In family controlled businesses, study shows non duality is good for firm’s value while in non family businesses CEO duality is good (Lam & Lee, 2008). Petra & Dorata (2008) argued that there is no evidence which show that board tenure, CEO’s decision horizon, board members experience and independent outside directors in a board improved the governance system and firm performance. Study of Greek firms revealed that the chairperson’s age negatively associated with firm’s performance. It means the presence of older and experienced chairperson in a board does not guarantee the efficient performance of firm (Koufopoulos, Zoumbos, Argyropoulou, & Motwani, 2008).

For small firms, CEO duality gives negative abnormal returns; on contrary it gives positive abnormal returns for large firms. Reasons for these results are, small firms get more benefits from clarity and decisiveness of decision making under CEO duality, whereas larger firm get more benefits through the check and balances which are performed by two different persons in the CEO and COB status (Palmon & Wald, 2002).

When firm’s CEO work as a non executive director of board of another firm in such situation there is great possibility that he can pursue his own interest rather than shareholder’s interest (Sullivan, 2009). There is an adverse effect of CEO duality on performance of firms. In order to get optimal performance, firms need to separate the positions of CEO and board’s chairman. Separation of posts increases the decision making ability of the firm (Ehikioya, 2009).

Agency theory vs stewardship theory

There are two divergent views regarding the cost of CEO duality in existing literature. On one hand, agency theory argues that by uniting these two key positions of the CEO and board chairperson adversely affect the balance of powers at the corporate leadership level, which may cast negative impact on the firm performance due to unfair expropriation of firm’s resources Fama and Jensen (as cited in Kim, Shammari, Kim, & Lee, 2009). Agency theory also argues that agents have more information then principals which lead to information asymmetry. Information asymmetry hinders the ability of principal to monitor the agent whether he makes decisions for the benefit of firm or not. Managers (agents) try to serve their own interest instead of firm’s benefits (Adams, 1994).

In agency theory major perception is that there is difference of interest between board and CEO. But in contrast CEOs and boards do not always have different interests. Both Agency and Organizational theory can co-exist. CEO duality is good for the shareholder’s value as it creates clear way of authority and responsibility (Finkelstein & Aveni, 1994).

Jaskiewicz & Klein (2007) argue that in family owned businesses with small board and low ratio of outside independent directors’ present good alignment of interest between manger and principal. Secondly firm with high ratio of outside independent directors on large board give conflict of interest between manager and agent. Contrary to agency theory there is stewardship theory argue that managers are trustworthy and are just custodian of the resources of the company; Donaldson (as cited in Lam & Lee, 2008).

Keeping in view the above research studies we have found the contradictory results about the corporate leadership structure, board compositions and firm performance. Several papers investigate the issues but present conflicting results. For example, studies offer evidence that too few inside directors may decrease firm performance, and no correlation exists between board composition and firm performance. Conversely, other research indicates that firms experience increases in market price when inside directors are replaced with outside directors, and shareholder lawsuits increase when firms have non-independent boards. While large shareholders prefer a split leadership structure, a combined leadership structure likely decreases information costs. Some studies also show that board size has no significant relationship with firm performance and board composition. On the other hand some researchers argue that relatively large the board size has encouraged CEO duality which in turn may reduce firm performance significantly. Researchers have also argued in the extant literature that Duality has no association with firm performance. In nutshell board composition (i.e. board independence) and CEO duality has remained an unsolved issue. In the existing literature firm performance with respect to board structure and leadership is only measured through short term accounting measures. Abdullah (2004) urge that these short term measures do not explain the real scenario. To get the better and vivid picture of impact on firm performance one needs to take account of few long term ratios such as sales ratio, dividend payout and net income ratios.

Methodology

Independent variable:

Board composition>board independence, board size

Leadership structure. Ceo duality

Dependent variable:

Firm’s performance:

ROE,EPS,Profit margin ratio, ROA, (Abdullah, 2004) dividend payout ratio

T test, correlation used by Abdullah, (Tian & Lau, 2001)(palmon)roa, tobinsq (Rashid)correlation descriptive(sdarticle2010)

regression (Tian & Lau, 2001)gls regression (palmon)regression (sdarticle 2010)(Rashid)regression(sdarticle2010)

Share price ratios (price earning ratio)

Control varriables

Borad size(sdarticle2010)

Abdullah, S. (2004). board composition, CEO duality and performance among Malaysian listed companies. Corporate Governance, 4, No.4, 47-61.