Business Ethics
Literature Review – Board Structure and Company Performance


In the recent years, the corporate scandals are becoming widespread negative events affecting investors and public in many of the countries around the world. The corporate scandals of WorldCom and Enron are just two of the often cited corporate scandals affecting the public and stakeholders negatively. Unfortunately, not only the frequency of occurrence of corporate scandals has not reduced, but the magnitude of the harms bring forward by these corporate scandals are becoming more serious in the recent years (Vasilescu & Russello, 2006). Consistent with such trends, there are greater concerns by the public as well as the regulatory bodies on better and more effective corporate governance to be implemented in public listed companies in the recent years. As such, it can be witnessed that in the past few years, corporate governance is a hot topic discussed by practitioners as well as academicians.

One aspects of effective corporate governance is about having more independent non-executive directors in the board structure (Aggarwal et. al., 2010). The degree or proportion of independent directors is often discussed in the context of corporate governance, risk management as well as prevention of scandals and management manipulation because the independent directors are supposed to be the third party to safeguard shareholders interests and company assets. This is not surprising because, a review of the literature found that a large amount of the discussions are concentrated on the agency costs or issues arise from the separation of management and ownerships in the many publicly listed companies around the world (Schiehll et. al., 2009). Accordingly, the issues arise when the manager (i.e., agent) is appointed to manage the assets of the business owners (i.e., the principal). The manager may not act in the best interests of the business owners, as they may have their personal agenda to push forward in the corporate scene (Hong-xia et. al., 2008). For example, it may be possible for the manager to engage in more risky venture to profit from the stock options granted to them, or to invest heavily on their personal pet projects (which might not be wealth maximizing projects for shareholders), or to the extent of heavily involving in fraud or misappropriation of company assets for selfish personal benefits (Brigham et. al., 2004). Thus, discussions have been centered on how to mitigate such risks due to agency costs or relationships between managers and business owners. Under such context, independent directors are appointed to monitor the agency relationships between business owners and shareholders.

Roles, Duties and Responsibilities of Independent Directors

Before the discussion go deeper into analyzing the existing empirical results on the impacts of independent directors to corporate governance or firm performances, it is important to have a brief understanding on the roles, duties and responsibilities of independent board of directors. Most of the time, directors can be categorized into non-executive or executive directors. Often, non-executive directors are employed to serve in a board of a corporation to monitor and supervise the management of the corporation. In the past, and in most of the countries around the world, the duties of the non-executive directors are as follow: (a) to attend important board meetings, (b) to provide advices on matters related to management of the company, (c) to assist in management of the company with their insights, experiences, network and knowledge, and (d) to safeguard the company assets and shareholders’ interests (Clarke, 2007). Overall, they are expected to be able to assist the managing directors in effective management of the company, for better organizational performance. They are expected to contribute to the development, growth, and leaderships of the company they are serving.

From these executive directors, they can be separated further into independent and non-independent directors. In such cases, independent non-executive directors are often appointed as the third party to mitigate the agency costs or relationship between business owners and shareholders. As they are independent, they are expected to be better to make fair and independent decisions in matters related to management of the company, in line with the shareholders interests. In listed companies, independent directors are crucial because many of the shareholders has relatively little knowledge or ways to get in touch with the business operations, or they will have the interests and time to do so (Petra, 2005). Thus, the independent non-executive directors have the responsibilities to oversee and monitor the management and executives in the corporations, and they are supposed to act objectively, independently, on the best-effort basis to protect the shareholders rights and interests. In such a context, the independent directors often have various roles to play in corporate governance or risk management of a company. Overall, when they able to carry out their job properly, better corporate governance would be expected, as management are monitored effectively, and improper management manipulation or exploitation of the company resources or assets for personal interests will be mitigated.

It is also worth to mention that there are arguments that the public and shareholders have too much to expect from independent directors. It is argued that there is only so much that can be performed by independent directors, and it is hard to ensure that corporate governance will be the case even when the independent directors acted responsibly in fulfilling their respective fiduciaries duties. Accordingly, as the independent directors do not spent they time fully in the management of the corporation, they are supposed to have lesser knowledge and control or understandings on the true situation of the company, if compared to the existing management or executives in the corporations (Liu et. al., 2008). It is also mentioned that in cases that management truly want to cheat or act unethically in an organization, the independent directors may have limited ways or resources to know the truth. To purely expect that the existence of independent directors will surely prevent corporate scandals of any sort is purely illusionary. Thus, to a certain degree, it is important to understand that independent directors may have several limitations in truly safeguarding the shareholders assets and interests (Sale et. al., 2006). More could be required to enhance the corporate governance of corporation in the complex business landscape.

Independent Directors for Better Risk Management

In order to ensure best corporate governance in a company, it is often asserted by researchers that the appointments of independent non-executive directors are crucial for mitigating risks related to corporate fraud and scandals. This is because the independent non-executive directors are appointed by the investors, and in theory, should act in the interests of the shareholders. Thus, with the presence of independent non-executive directors, managers will be less daring to out rightly engage in serious corporate fraud, or be forced to behave ethically and responsibly as their actions are being supervised. Essentially, the independent non-executive directors will serve as the watchdog to safeguard company assets and performance from potentially harmful behaviors of management, as well as to contribute their experiences and insights in managing a company (Liona et. al., 2007).

Some studies have found that the presence of independent directors will most likely reduce the risks faced by investors. Generally, the higher the proportion of independent directors in the board structure, the better the corporate governance of the particular company. Thus, the higher proportions of independent non-executive directors in a board structure, the risk faced by the investors are also lower. For instances, according to a research performed by Abdullah (2006), he discover that stock ownership of non-executive directors on a company is likely to enhance their motivation to monitor the board in a more prudent and diligent manner. Not only is that, according to Lara et. al. (2007), if the independent board of directors are acting properly by exercising their rights and independence in the board meeting, the Chief Executive Officers as well as the other management staffs are more likely to adopt prudent financial reporting standard. Such findings are also supported by a recent study performed by Benkraiem (2009). According to Benkraiem (2009), the higher the proportion of independent directors in the sample of listed companies investigated in Paris Stock Exchange, the less likely earning management of the management will occur. The degree of earning management is measured through the working capital discretionary accruals (WCDAC). Specifically, it is found that the presence of independent directors is most effective (in preventing earning managements) when at least one third of the board members are independent. Yet, in another study by McCabe and Nowak (2008) in 30 public listed Australian companies on the roles of independent directors and the respective roles in ensuring corporate governance of the corporations, it is argued that a majority non-executive directors in the board structure often able to ensure the balance of power between board members and management. It is argued that the independence of the non-executive directors have great differences and impacts to the balance of power in the board structure. It is argued that a majority of independent non-executive directors is useful way to enhance the ability of the board to think independently. However, the ability of the board to think and act independently cannot be ensured even with a majority of independent non-executive directors. Thus, it is suggested that a majority of independent non-executive directors may not be necessarily contributing to the best corporate governance practices, and there are many other factors to be considered in ensuring better corporate governance structure in an organization.

Empirical Evidences on Board Structure to Firm Performance

Apart from the argument that the presence and importance of independent directors in ensuring better corporate governance of a firm, as well as lowering the risks faced by investors in the listed companies, there are also arguments and evidences showing that the presence of independent directors indeed add value to the firm performance. For example, according to several studies by Ameer et. al. (2010), McKnight et. al. (2009), Mura et. al. (2007), as well as Shah et. al. (2008), it is found that the proportion of independent non-executive directors in the board structure is significantly and positively related to the company performance. The company performance may be measured by several criteria as follow: return on equity, return on assets, stock prices performance, growth or company profitability in the past few years. There are many reasons to which the presence of truly independent and powerful may positively affect firm performance. Firstly, as independent directors play their roles properly, management team can be better monitored to work effectively in the best interest of the shareholders. Thus, better monitoring process will often ensure the management team able to work for the benefits of shareholders, and hence, the better stock prices of the company. Apart from that, it is also argued that the independent non-executive directors are beneficial and valuable in providing to the broad their extensive and comprehensive experiences and insights. Through their experience and knowledge, it is expected that they can add-value to the strategic management or execution of the firms they are serving.

Interestingly, there are also studies on the death of independent directors to the stock prices performance in the United States. According to a survey performed by Nguyen and Nielsen (2010), it is discovered that in event of the death of independent directors, the stock price of the particular dropped by an average of 0.85%. Following such findings, the authors investigate further on the contribution of independent directors to the shareholders. Overall, it is found and suggested that independent directors indeed provide valuable services to shareholders.

However, not all studies performed shows that independent directors have significant statistical relationships with the firm performance. For example, in a recent study by Prabowo and Simpson (2010), it is found that the share of independent directors on the board structure has no statistical significant relationship with firm performance, in a sample of Indonesian non-financial companies. According to the researchers, they argued that such findings are perhaps due to the lack of institutional reforms in the context of appointment of independent directors. Another study by Chin-Jung and Meng-Je (2007) provide some explanation on the issues that the observations that linkages between independent directors and firm performance are not conclusive. According to these authors, the mixed evidences on the linkages between independent directors to firm performance are largely due to the real ‘independence’ of the independent directors; or the historical performance of the firms under researched. In their study on listed companies in Taiwan, they found that outside independent directors indeed have positive effects on a firm’s performance after controlling for the firm’s past performance. Thus, from such study, there are some evidences showing that aside from the issues of independent directors in the board structure, other business or economic related issues may also affect the performance of the firm. The magnitude of influence from these other factors may affect the research findings if highly independent board structure is indeed useful to firm performance because the impacts form business environment, industry structure and trends may not be easily separated in the investigation of proportion of independent directors in board structure to firm performance.

The Independence of Independent Directors

Indeed, it is a well known fact and frequently argued issue that not all independent directors are truly independence. This is not something hard to comprehend. Firstly, many of the independent directors have personal relationships of friendships with the management team, and thus, they may be subjected to the friendships influence in performing their duties and tasks. Their decision making process may not be truly objective and rational. Besides, it is also reasonable to believe that management has the chance to persuade the independent director in certain controversial issues in a particular organization. Thus, independent directors may subject to persuasion and influences from key management in the company, and ultimately buy into certain projects or ideas that do not really profitable or in the best interests of shareholders. Under such issue, Chouchene (2010) performed a study to investigate the degree of independence of independent directors in French. It is found that two variables significantly affect the independence of the board from management. The two variables are: ownership structure and the size of the company. Ownership structure is important because, when the participation of institutional ownership is present in a particular listed company, the independent directors are often more powerful and thus more independent. This is probably due to the fact that many of these independent directors are appointed by the institutional investors.

Research Related to Independent Directors in Malaysia

There are some studies being done in researching independent directors in Malaysia. Chee-Wooi and Chwee-Ming (2010), performed an analysis to understand the pay-performance and monitoring issues in Malaysian government linked companies. Generally, it is found that the CEO pay and the firm performance are not statistically related in those Government linked companies. Thus, majority of the CEO pay is not aligned to the firm performance. However, the situation differs when the sample of companies used in the research consisted only of those firms with more than 50% of independent directors in the board structure. In those board structures with more than 50% of independent directors, the CEO pay is statistically significantly related to the firm performance. Such findings suggest that the degree of independence of board structure is crucial in monitoring of the CEO pay and performance. However, there are relatively few researches investigating the impacts of board structure, or the proportion of independent directors to the company performance in Malaysia. This is one of the key reasons leading to this research, to close the knowledge gap on if the board structures have any statistically significant impacts on firms in Malaysia.

Concluding Remarks

To summarize, it can be pointed out that corporate governance related issues are pressing topics to be emphasized and monitored effectively today. The recurrences of corporate scandals from time to time indicate that there is a real need to study on the issues related to corporate governance and risk management. In the context of corporate governance, it is illustrated and discussed that independent directors play crucial roles in safeguarding the company assets and resources from potential misappropriation or manipulation of management. Besides, they are also burdened with the need to participating in the leadership of the organization for better performance in the competitive business landscape. There many roles, duties and responsibilities placed upon independent directors. In times of crises, they are often to be blamed. In fact, it is not hard to observe that people expectation on independent director to ensure effective corporate governance and risk management of a particular corporation has become highly demanding. It is argued that the public and investors should not rely solely on independent directors for safeguarding their interests. Very often, the independent directors have their respective limitations in performing their duties and jobs effectively.

Then, it is presented many empirical studies on the topic of independent directors, to risk management or firm performance. In the first part, it is discussed that there are some evidences supporting the notion that the higher the proportion of independent directors in the board structure, the lower the risk faced by the corporation. The risks can be mitigated when the management is less daring in out rightly involve in earning management, misappropriation of company resources or assets, undertaking projects not in the best interests of shareholders, or simply to not carrying out their duties and tasks in prudent manners. Yet, from another perspective, it is also shown that there are some evidences suggesting that the existences of independent directors, particularly when the proportion of the independent directors is high in the board structure, the better performance of a corporation can be expected. Empirical evidences derived from several stock exchanges around the world, recording positive relationships between proportions of independent directors in board structure to firm performance can be found. However, the findings are never conclusive, as there are other mixed results that cannot be identify statistical significant relationships between proportions of independent directors in board structure to firm performance. There are many reasons suggested by researchers or scholars on such mixed results. Firstly, it is suggested that in certain cases, the independent directors may not be truly independent. The independence of independent directors, however, can be affected by other factors, such as the institutional ownership as well as the firm size. This is easy to understand as when the independent directors are appointed by the institutional invested, and they are made to answer to the institutional investors, they are more likely to act in the best interests of these institutional investors. Secondly, it is also suggested that there are simply too many factors possibly affecting the firm performance, aside from the existence or characteristics of independent directors. For example, other relevant factors that can affect firm performance include macro-environment factors, industry structure, business or economic trends, opportunities in the market place, strategic directions of the firm, or simply some degree of luck factors. All these may cause the research on proportions of independent directors in board structure to firm performance hard and unreliable.

Lastly, research on the topic of independent directors in the context of Malaysia is also discussed. It is found that there are few researches on the country, as many of the research heavily concentrated in countries such as United States, United Kingdom, France, Germany, China, India and Korea. Thus, there is a gap to understand the situation in Malaysia, if the proportions of independent directors in board structure have real and easily observed impacts against firm performance in that country. In order to close the knowledge gap, such a research as presented in this dissertation is relevant and timely.

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