The Optimum Boardroom Composition and the Limitations of the Agency Theory

The optimum boardroom composition and the limitations of the agency theory.

Subject:Agency theory (Evaluation)Boards of directors (Research)Corporate governance (Evaluation)Author:Rebeiz, Karim S.Pub Date:01/01/2008Publication:Name: Journal of Academy of Business and Economics Publisher: International Academy of Business and Economics Audience: Academic Format: Magazine/Journal Subject: Business; Business, general; Economics; Government Copyright: COPYRIGHT 2008 International Academy of Business and Economics ISSN: 1542-8710Issue:Date: Jan, 2008 Source Volume: 8 Source Issue: 1Topic:Event Code: 310 Science & researchGeographic:Geographic Scope: United States Geographic Code: 1USA United States

Accession Number:192587608Full Text:ABSTRACT

I examine the extent of the linkage between the percent independent directors in the boardroom (measured by the ratio of independent directors over total directors) and the market returns of firms belonging to the technology, engineering and communication industries. The results indicate that an independent boardroom configuration positively impacts on the financial performance of the firms, which is in compliance with the agency theory of the firm. The relationship "boardroom configuration--financial performance" is however not linear in nature, but rather curvilinear with a negative concavity. The implication is that there is a limitation to the agency theory of the firm as the optimum boardroom configuration does not consist of 100% independent directors; instead, it comprises a minority of inside directors to compensate for the information deficit inherent with a 100% independent boardroom configuration.

Keywords: Board of Directors; Corporate Governance; Agency Theory; Boardroom Composition; Outside Directors; Inside Directors; Financial Performance

1. INTRODUCTION

The separation of ownership and corporate control has resulted in agency cost because the passive owners are largely unaware of the subtle conflicts of interests regulating the principal-agent interactions, particularly that they no longer have the jurisdiction over the modus operandi of the firm. The agency cost is further magnified in the case of largely diffused and heterogeneous ownership because the control mechanism and the managerial incentives are weak. Without an adequate mechanism of checks and balances, management would operate in all impunity or minimum accountability (Agrawal and Knoeber, 1996; Bothwell, 1980). This situation has created a propitious setting for free-ride opportunisms as some shareholders may take advantage on the efforts of other fellow shareholders to do the monitoring of the firm on their behalf. In effect, the costs of corporate monitoring are borne by a few shareholders, while the benefits of an active monitoring are shared by all of them. According to Fama and Jensen (1983), and to Jensen and Meckling (1976), the agency problem would not arise if it were possible to write a "complete contract" to ensure that the managers are running the businesses with the best interest of the shareholders in mind. However, complete contracts are impractical for the obvious reason that it would be costly and unrealistic to anticipate all the contingencies involved in running the daily operations of the business.

An independent boardroom configuration would mitigate the agency cost of the firms due to the detachment of the independent directors from the management team. Conversely, an insider-dominated boardroom is marred with conflicts of interests. Indeed, inside directors are often put in the awkward (if not impossible) position of evaluating the CEO who is after all their boss. Their judgments are consciously or unconsciously impaired by personal needs or fears. For example, a board consisting predominantly of inside directors may vote to unduly increase the compensation of the management team, which would result in an unwarranted transfer of wealth from the shareholders to the managers. Nonetheless, the determination of the optimum boardroom composition (one that would translate into superior financial performance for the firm) is still being vigorously debated in the corporate governance literature (e.g., Hermalin and Weisbach, 2003; Hillman and Dalziel, 2003; Daily et al., 2003; Gompers et al., 2003; Fields and Keys, 2003). Past results on the topic are mixed and often contradictory. A consensus does not exist on the issue because the association between boardroom configuration and firm's financial performance is often blurred by idiosyncratic firm's attributes, a notable one being the micro and macro environment, and the competitive position of the firms within its industry (Demsetz and Lehn 1985).

I revisit the issue "boardroom configuration--financial performance" by confining the scope of the investigation to the technology, engineering and communication sectors. The utilization of such firms is justified from the standpoint that the level of information needed by the board in such industries is usually more complex and more elaborate than in other organizational contexts. Moreover, the engineering and high tech sectors have predominantly fallen outside the radar scrutiny of the corporate governance literature. Accordingly, this investigation would provide a fresh perspective and would shed new lights on an important subject. The findings of this investigation point out that the boardroom's independent composition varies in a curvilinear manner (and with a negative concavity) with the market returns of the firms. This study confirms the agency theory of the firm by showing that independent directors are predominantly more effective monitors of corporate stewardship than inside directors. The results also highlight the limitations of the agency theory of the firm because there is a residual value-added component of incorporating a minimum number of inside directors (executives) into the boardroom.

2. LITERATURE REVIEW

Three different schools of thoughts have emerged from the stream of research linking the boardroom configuration to the performance of the firm as reflected in the following propositions:

Proposition 1: The outside-dominated board improves on the performance of the firm in conformance with the agency theory of the firm. The outside directors could add value to the firm through a controlling/monitoring role, and a servicing role. Rosenstein and Wyatt (1990) show that the increase of the critical mass of outside directors to an already outsider dominated board results in modest higher returns. Lee et al. (1992) also indicate that shareholder's wealth increases during a management buy out in the case of outside-dominated boardrooms. In addition, Barnhart et al. (1994) pinpoint that when outside directors begin to dominate the board, performance is positively affected by this increase in independence. As it specifically relates to the controlling and monitoring role of the board, Kesner and Johnson (1990) report that boards being sued for failure to maintain their fiduciary responsibilities to the shareholders have a greater proportion of inside directors. Similarly, Crutchley et al. (2007) suggest that firms are more vulnerable to fraud if there are fewer outsiders on the audit committee and if the outside directors appear overcommitted by other board assignments. Moreover, Weisbach (1998) reports a greater likelihood of CEO's turnover in outsider-dominated boards than in insider-dominated boards and this occurrence is correlated with firm performance. As it specifically pertains to the servicing role, the outside directors offer a fresh perspective and advice to the CEO because of their unique expertise and experience in different firms and industries. In addition, they fulfill a valuable resource dependence role; i.e., they are in a unique position to secure outside resources and information from the external world due to their associations with other firms and their networking relationships (Dalton et al., 1998).

Proposition 2: The inside-dominated board improves on the performance of the firm in conformance to the stewardship theory of the firm. As background information, the stewardship theory is the antithesis of the agency theory; it assumes that managers are loyal stewards for the corporation with no conflict of interest (Donaldson and Preston, 1995; Fox and Hamilton, 1994; Donaldson and Davis, 1991; Mizruchi, 1983). Accordingly, the corporate control should be bestowed to the managers because of their intimate knowledge of the business, its competitive environment and its macro environment (Davis et al., 1997). For instance, Kesner (1987) states that inside dominated boardrooms yield to better firm performances than outside dominated boardrooms (the study is confined to Fortune 500 firms). Vance (1978) reports a positive and significant relationship between the proportion of inside directors and returns to investors. Baysinger and Hoskinson (1990) suggest that insider directors have more and easier access to corporate information than outsiders, and that this situation would lead to more effective evaluation of top managers.

Proposition 3: An increase in outside representation on a company's board of directors does not automatically translate into superior financial performance for the firm. Klein (1998) and Mehran (1995) indicate a non-significant association between accounting performance measures and the portion of outside directors comprising the boardroom. Likewise, Hermalin and Weisbach (1991) find no significant relationship between the proportion of outside directors and Tobin's Q performance measure. Bhagat and Black (2002; 1999) also show no relationship between board composition and long-term stock market and accounting performance. In addition, a meta-analysis review of 54 empirical studies reports no systemic link between governance structure and financial performance (Dalton et al. 1998).

3. RESEARCH METHODOLOGY

The null hypothesis in this study is that the independent boardroom composition does not impact on the financial performance of the firm. In this context, the concept of independence is not merely confined to the outside directorship position, but to functional activities that span beyond the directorship position. The NYSE definition of an independent director has been adopted herein, namely that a board member should have no material personal or business affiliations with the firm that span beyond the customary directorship functions. The independent director could have been an ex-executive to the firm provided that five years have passed since the individual has been employed by or has been otherwise affiliated with the company.

The sample consists of 158 publicly-listed firms that are drawn from the Compustat database. The chosen firms have been publicly trading in the U.S. organized exchanges for more than 12 years. In other words, they have passed a minimum maturity level in the life cycle in terms of growth and earnings performance. The data on the corporate governance and firms' attributes have been obtained from the annual filing in the EDGAR/SEC filings databases and the Corporate Register. The dependent variable used in this study is the market return of the firm, which is equal to the total increase in shareholder wealth (i.e., share price appreciation and income from dividends--measured on a yearly basis). The average market return represents the geometric mean over a five-year period spanning from January 2002 to January 2007. It is noteworthy that past investigations have utilized accounting returns (e.g., return on equity) as a proxy to financial performance (Bhagat and Black 2002, 1999; Klein 1998; Mehran 1995; Hermalin and Weisbach 1991). Nonetheless, the recent trend in the academic literature has been in the direction of short and long-term shareholders' wealth (Bauer et al. 2004; Drobetz et al. 2003; Gompers et al. 2003).

The explanatory variable is the percent of independent directors in the boardroom. The control variables include beta (the firm's systematic risk), the insiders' holdings (the percentage of shares owned by insiders and top 5% owners), the board's size (the sum of the insiders, the outsiders and the gray directors), the market capitalization of the firms (the share price multiplied by the number of outstanding shares), and the boardroom leadership configuration (whether the boardroom adopt a dual or dissociated CEO/Chairmanship boardroom leadership structure). The aforementioned independent variables are the arithmetic averages for the years January 1997-January 2002. The lag time difference between independent and dependent variables is justified by the fact that the directional impact of specific firms' attributes on a variety of organizational outcomes is not an instantaneous phenomenon.

4. RESULTS AND DISCUSSION

The sample descriptive statistics are shown in Tables 1. The average market returns (over a five year period) of the firms in the sample is 11.59% per year. The average percent of independent directors in the boardroom is 76%. In terms of leadership structure, 33% of the firms actually dissociate the roles of CEO and Chairmanship to the board. These statistics conform to the general corporate governance trend in the U.S. market.

The correlation matrix, shown in Table 2, suggests that the board's size and the percent of independent directors are positively related to the market capitalization of the firm. In other words, large size firms have more inclinations to adopt large boardroom sizes that also consist of a higher fraction of independent directors. Conversely, the board's leadership is negatively related to the market capitalization, thus suggesting that the probability of having the combined boardroom leadership structure increases with the size of the firm.

I begin the OLS regression on the market returns with a simple specification that contains the control variables, namely beta, insider's holdings, board's size, market capitalization and leadership configuration (i.e., establishing the control model). I then add the linear, quadratic and cubic terms of the explanatory variable (represented by independent directors) to assess linear and non-linear effects of the augmented models over the control model. At each step of the process, the significance in the difference of R square between the augmented model and the preceding one is assessed for its significance at the 95% level (two-tailed).

The different regression models used in this study are illustrated in the equations below:

Control Model:

[MR.sub.i(t+5)] = [[alpha].sub.c][BE.sub.i(t)] + [[beta].sub.c][IH.sub.i(t)] + [[chi].sub.c][BS.sub.i(t)] + [[delta].sub.c][MC.sub.i(t)] + [[gamma].sub.c][BL.sub.i(t)] + [[epsilon].sub.c] (1)

Augmented Model I:

[MR.sub.i(t+5)] = [[alpha].sub.1][BE.sub.i(t) + [[beta].sub.1][IH.sub.i(t)] + [[chi].sub.1][BS.sub.i(t)] + [[delta].sub.1][MC.sub.i(t)] + [[gamma].sub.1][BL.sub.i(t)] + [[eta].sub.1][ID.sub.i(t)] + [[epsilon].sub.1] (2)

[Model 1 is the control model augmented by the variable independent directors]

Augmented Model 2:

[MR.sub.i(t+5)] = [[alpha].sub.2][BE.sub.i(t)] + [[beta].sub.2][IH.sub.i(t)] + [[chi].sub.2][BS.sub.i(t)] + [[delta].sub.2][MC.sub.i(t)] + [[gamma].sub.2][BL.sub.i(t)] + [[eta].sub.2][ID.sub.i(t)] + [[lambda].sub.2][ID.sup.2.sub.i(t)] + [[epsilon].sub.2] (3)

[Model 2 is model 1 augmented by the variable independent directors to the square]

Augmented Model 3:

[MR.sub.i(t+5)] = [[alpha].sub.3][BE.sub.i(t)] + [[beta].sub.3][IH.sub.i(t)] + [[chi].sub.3][BS.sub.i(t)] + [[delta].sub.3][MC.sub.i(t)] + [[gamma].sub.3][BL.sub.i(t)] + [[eta].sub.3][ID.sub.i(t)] + [[lambda].sub.3][ID.sup.2.sub.i(t)] + [[mu].sub.3][ID.sup.3.sub.i(t)] + [[epsilon].sub.3] (4)

[Model 3 is model 2 augmented by the variable independent directors to the cube]

where

i = Firm 1 through 158

MR = Market return

BE = Beta (a measure of systematic risk)

IH = Insiders' holdings

BS = Board's size

MC = Market capitalization

BL = Board's leadership, a dummy variable in which a value of zero is assigned to the dual (joint) leadership structure and a value of one is allocated to the non-duality configuration

IND = Ratio of independent directors over board's size

The overall hierarchical OLS assessment on the market returns is shown in Table 3. The OLS findings indicate that the addition of "independent directors" variable to the control model results in significant improvement of R square for the quadratic and cubic models. In other words, a large percent of market returns variations could be explained collectively by the independent directors when it is accounted in a non-linear fashion. It is therefore evident that the percent of independent directors' variable does influence the market returns of the firm, and this variation is in the form of a polynomial equation. In fact, the model 3 (that contains the linear and non-linear terms of the independent directors' variable) has a coefficient of determination of 0.619, which is a significant value for this kind of an investigation. To test the robustness of the aforementioned findings, the same hierarchical regression (with the same control and augmented models) is repeated with the Tobin's Q, which is defined as the ratio of the market value of a firm's assets (i.e., the market value of outstanding stock and debt over the replacement cost of the firm's assets). The Tobin's Q used herein is the arithmetic mean over the period January 2002- January 2007. The overall OLS hierarchical results on the Tobin's Q, shown in Table 4, are in many respects similar to those obtained previously with the market returns. This analysis validates the previous regression (with market returns) that the financial performance of the firm is enhanced with higher boardroom independence, and that this relationship is curvilinear and not linear.

The unstandardized and standardized OLS coefficients (beta weights) corresponding to the control and the added models for the market returns and the Tobin's Q are shown in Tables 5 and 6, respectively. The results indicate that the coefficient of the independent directors corresponding to the linear model (model 1) is significantly different than zero. Thus, the null hypothesis should be rejected at the 5% level. The same findings also apply to the coefficients of the independent directors for the quadratic and cubic terms of models 2 and 3, respectively. Likewise, the sign of the coefficient for the independent directors for the model 1 (linear model) is positive, which indicates a positive directional impact of the independent directors on the market returns of the firm. The sign corresponding to the coefficient of the quadratic term (model 2) is negative, which indicates that the non-linear relationship between the boardroom's independent composition and the financial performance of the firm has a negative concavity. In other words, the optimum boardroom configuration does not comprise 100% outside/independent directors; rather the optimum boardroom consists of majority of outside directors (close to 80%) and a minority of inside directors (close to 20%).

5. CONCLUSIONS

This investigation does recognize the financial superiority of an outsider-dominated boardroom in conformance with the agency theory of the firm. It also acknowledges the importance of including a minority of executives in the boardroom to compensate for the information deficit that is associated with a 100% outsider-dominated boardroom, thus highlighting the limitations of the agency theory of the firm. The inside directors provide valuable information on the products, processes, and culture of the firm, as well as its external surrounding. As a matter of fact, a previous study conducted by Bhagat and Black (1999) gives evidence to the limitation of the agency theory; they report that firms with supermajority-independent boards are less profitable than other firms. Undoubtedly, the presence of inside directors with intimate knowledge of the firm helps in expeditiously and effectively securing key information from the right sources. Moreover, Adams and Ferreira (2007) indicate that the presence of inside directors could produce a friendly board that is propitious to receiving the right information and, accordingly, providing the right advice to the CEO. Although inside directors do have an essential function within the confines of the boardroom, their span of influence should, however, be strictly limited to an advisory role; they should certainly not assume a monitoring and controlling role. Specifically, they should not serve in the key committees (e.g., audit, compensation, nominating), nor be involved in the selection of outside consultants because of obvious conflicts of interests inherent to their dual roles as directorates and executives to the firm.

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Karim S. Rebeiz, American University of Beirut, Beirut, Lebanon

Dr. Karim S. Rebeiz earned his Ph.D. from the University of Texas at Austin and his MBA from Harvard Business School. He has many years of responsible professional experience in Finance at Ford Motor Company. He is currently an Associate Professor in the Suliman Olayan School of Business at the American University of Beirut.TABLE 1. DESCRIPTIVE STATISTICS

StandardVariables Average Deviation Skewness Kurtosis

Market Returns 11.59% 2.15% -1.122 1.191Beta 0.74 0.441 0.714 1.419Insiders' Holdings 17.40% 20.58% 2.058 5.695Board's Size 9.02 2.58 0.563 0.470Market Capitalization 9034.72 2497.13 4.934 7.902 (Mils.)Separate CEO / Chairman * 32.91% -- -- --Independent Directors 76.45% 13.07% 1.933 -1.191

* Dummy variable

TABLE 2. PEARSON CORRELATION MATRIX FOR INDEPENDENT VARIABLES

Independent Variables 1 2 3

1. Beta 1.0002. Insiders' Holdings 0.019 1.0003. Board's Size -0.073 -0.053 1.0004. Market Capitalization -0.114 -0.190 0.2905. Boards' Leadership -0.066 0.271 -0.0446. Independent Directors -0.177 -0.129 0.067

Independent Variables 4 5 6

1. Beta2. Insiders' Holdings3. Board's Size4. Market Capitalization 1.0005. Boards' Leadership -0.150 1.0006. Independent Directors 0.206 -0.021 1.000

TABLE 3. OVERALL HIERARCHICAL OLS ASSESSMENT ON MARKET RETURNS

Statistics Control Model Model 1 Model 2 Model 3

R 0.149 0.417 0.683 0.787R Square 0.022 0.174 0.466 0.619F Statistics 0.691 28.400 110.720 170.458R Square Change 0.152 0.293 0.153F Change 27.709 82.320 59.738Significance of 0.631 0.000 * 0.000 * F Change

* Significant at the 0.05 level (2-tailed)

TABLE 4. OVERALL HIERARCHICAL OLS ASSESSMENT ON TOBIN'S Q

Statistics Control Model Model 1 Model 2 Model 3

R 0.151 0.388 0.626 0.746R Square 0.023 0.151 0.393 0.533F Statistics 0.713 23.376 82.871 138.408R Square Change 0.128 0.241 0.165F Change 22.663 59.495 55.537Significance of 0.000 0.000 * 0.000 ** F Change

* Significant at the 0.05 level (2-tailed)

TABLE 5. REGRESSION COEFFICIENTS FOR MARKET RETURNS

Models Unstandardized Standardized Coefficients Coefficients

Control ModelBeta -0.503 -0.103Insiders' Holdings 0.000 -0.004Board's Size 0.070 0.084Market Capitalization 0.000 -0.19Board's Leadership -0.321 -0.070Constant 11.460

Model 1Beta -0.200 -0.041Insiders' Holdings 0.004 0.036Board's Size 0.070 0.084Market Capitalization 0.000 -0.089Board's Leadership -0.362 -0.079Independent Directors 0.062 0.405Constant 6.498

Model 2Beta -0.264 -0.054Insiders' Holdings -0.006 -0.059Board's Size 0.136 0.163Market Capitalization 0.000 -0.066Board's Leadership -0.044 -0.010Independent Directors 0.589 3.853[(Independent Directors).sup.2] -0.389 -3.516Constant -10.796

Model 3Beta -0.029 -0.006Insiders' Holdings -0.003 -0.025Board's Size 0.031 0.038Market Capitalization 0.000 -0.024Board's Leadership -0.021 -0.005Independent Directors -0.743 -4.859[(Independent Directors).sup.2] 1.879 16.963[(Independent Directors).sup.3] -1.197 -11.946Constant 13.207

Models t Values Significance

Control ModelBeta -1.276 0.206Insiders' Holdings -0.045 0.964Board's Size 1.002 0.318Market Capitalization -0.223 0.824Board's Leadership -0.837 0.404Constant 15.336 0.000

Model 1Beta -0.540 0.590Insiders' Holdings 0.462 0.645Board's Size 1.081 0.281Market Capitalization -1.107 0.270Board's Leadership -1.022 0.309Independent Directors 5.264 0.000 *Constant 5.568 0.000

Model 2Beta -0.885 0.378Insiders' Holdings -0.928 0.355Board's Size 2.585 0.011Market Capitalization -1.015 0.312Board's Leadership -0.153 0.879Independent Directors 10.006 0.000 *[(Independent Directors).sup.2] -9.073 0.000 *Constant -5.079 0.000

Model 3Beta -0.114 0.910Insiders' Holdings -0.451 0.652Board's Size 0.674 0.501Market Capitalization -0.440 0.660Board's Leadership -0.085 0.932Independent Directors -4.141 0.000 *[(Independent Directors).sup.2] 6.353 0.000 *[(Independent Directors).sup.3] -7.729 0.000 *Constant 3.678 0.000 *

* Significant at the 0.05 level (2-tailed)

TABLE 6. REGRESSION COEFFICIENTS FOR TOBIN'S Q

Unstandardized Standardized Models Coefficients Coefficients

Control Model Beta -0.082 -0.115 Insiders' Holdings 0.000 -0.017 Board's Size 0.009 0.072 Market Capitalization 0.000 -0.032 Board' s Leadership -0.046 -0.069 Constant 1.300

Model 1 Beta -0.042 -0.058 Insiders' Holdings 0.000 0.020 Board's Size 0.009 0.071 Market Capitalization 0.000 -0.096 Board' s Leadership -0.051 -0.077 Independent Directors 0.008 0.371 Constant 0.636

Model 2 Beta -0.050 -0.070 Insiders' Holdings -0.001 -0.067 Board's Size 0.017 0.143 Market Capitalization 0.000 -0.075 Board' s Leadership -0.009 -0.014 Independent Directors 0.078 3.502[(Independent Directors).sup.2] -0.052 -3.192 Constant -1.654

Model 3 Beta -0.014 -0.020 Insiders' Holdings -0.000 -0.030 Board's Size 0.002 0.013 Market Capitalization 0.000 -0.032 Board's Leadership -0.006 -0.009 Independent Directors -0.124 -5.560[(Independent Directors).sup.2] 0.293 18.109[(Independent Directors).sup.3] -0.182 -12.426 Constant 1.988

Models t Values Significance

Control Model Beta -1.423 0.157 Insiders' Holdings -0.197 0.844 Board's Size 0.856 0.393 Market Capitalization -0.372 0.711 Board' s Leadership -0.822 0.412 Constant 11.955 0.000

Model 1 Beta -0.760 0.448 Insiders' Holdings 0.252 0.801 Board's Size 0.910 0.364 Market Capitalization -1.178 0.241 Board' s Leadership -0.982 0.328 Independent Directors 4.761 0.000 * Constant 3.686 0.000

Model 2 Beta -1.078 0.283 Insiders' Holdings -0.977 0.330 Board's Size 2.130 0.035 Market Capitalization -1.082 0.312 Board' s Leadership -0.209 0.879 Independent Directors 8.516 0.000 *[(Independent Directors).sup.2] -7.714 0.000 * Constant -4.995 0.000

Model 3 Beta -0.360 0.719 Insiders' Holdings -0.520 0.604 Board's Size 0.217 0.829 Market Capitalization -0.533 0.595 Board's Leadership -0.152 0.880 Independent Directors -4.392 0.000 *[(Independent Directors).sup.2] 6.287 0.000 *[(Independent Directors).sup.3] -7.452 0.000 * Constant 3.519 0.001

* Significant at the 0.05 level (2-tailed)Gale Copyright:Copyright 2008 Gale, Cengage Learning. All rights reserved.