independent study - ninad mba.doc

Ninad MhadolkarMBA 533

Corporate Governance and Firm Value: a study of board composition in the healthcare sector

I. Introduction

Enormous amount of research has been done in the field of corporate governance and its

importance in the development of financial markets. Numerous studies have linked

different factors to resulting firm value, Jae-Seung Baek, Jun-Koo Kang, Kyung Suh Park

(2002) have demonstrated the results of external shock on firm value depending on

corporate governance metrics, they study effects on firm value in the Korean market in

the event of an external economic shock based on controlling rights, cash flow rights and

board composition and compare various factors of owner-manager control rights versus

those in widely diversified firms. Several studies establish a link between corporate

governance and corporate valuation, Claessens et al. (2002) show that higher cash flow

rights of the controlling shareholder are associated with higher market valuation, but

higher voting rights correspond to lower market valuation. La Porta, Lopez-de-Silanes,

Shleifer, and Vishny (2000) show that firms in countries with better shareholder

protection have higher Tobin’s q than those where such protection is weaker. Another

important characteristic that contributes to firm valuation is ownership structure; many

large investors with no affiliations and therefore have strong financial incentives to

monitor financial behavior, while affiliated investor may have different monitoring

incentives as argued by Shleifer and Vishny (1986), Barclay et al. (1993) argue that large

shareholders can extract private benefits that are not available to diffuse stockholders.

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In this study I explore the role of different investors on the board and the effects of this

composition on firm value. A sample of 50 firms is examined in the healthcare sector and

information regarding the number of ‘Doctors of medicine’ on the board is an important

characteristic whose link to firm valuation will be studied.

Before we go into more details for this specific sector let’s review some trends in

corporate boards as stated by Robert Monks &Nell Minow in their book Corporate

governance (2004):

Size: According to research conducted by executive search firm Spencer Stuart, the

average size of the board has shrunk from 15 in 1998 to 10.9 in 2002 and a quarter of the

S & P 500 boards have between 8 and 9 directors as to compared 16 earlier. As boards

have shrunk, there has been a reduction in inside directors.

Inside/Outside mix: Spencer-Stuart’s 2002 study found that in nearly 1/3rd of S&P 500

firms, the CEO is the only inside director. Less than 10 percent of firms had that board

configuration in 1992. The most common job of new directors is still CEO /chair /

president of another public company as found by the research.

Diversity: The study found that most corporate directors are still middle-aged white

males. However 16 percent of new outside directors were now women and 12 percent of

new directors were academics or from non-profit organizations suggesting a shift towards

looking beyond the standard candidates. There is similar steady progress in the

recruitment of directors from ethnic minorities as well.

Ownership: Spencer-Stuart concluded that the idea of paying outside directors wholly in

stock was a ‘non-factor’ in its analysis. More than half of the S&P 500 firms offer outside

directors stock options and many firms have now included retainer in either stock or cash,

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reinforcing the message that if directors do their jobs well, their efforts will be

handsomely rewarded.

Governance: According to the survey conducted by Korn/Ferry governance standards in

the boardroom had transformed over time. Korn/Ferry asked directors for their views on

what were the most important development in board structure and practice in recent years

and nearly half identified the increase in independent audit, compensation and

nominating committees. It is now considered best practice to have all three committees

made up exclusively of outside directors. Meetings follow an agenda compiled by

management, though directors can ask for items to be included, the agenda and relevant

information is typically sent to directors a couple of days before the meeting. A meeting

may feature a special presentation by a non-board insider, such as a division head, etc.

Board duties:

As per Monk and Minow, the board of directors has five primary functions:

1. Select, regularly evaluate, and if necessary, replace the chief executive office.

Determine management compensation. Review succession plan.

2. Review and where appropriate, approve the financial objectives, major strategies, and

plans of the corporation.

3. Provide advice and counsel to top management.

4. Select and recommend to shareholders for election an appropriate slate of candidates

for the board of directors; evaluate board processes and performance.

5. Review the adequacy of the systems to comply with all applicable laws/regulations,

etc.

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The existence of boards, according to both the legal and definition and the description

given above is based on the premise that the board oversees management, selects

executives who will do the best job and may fire them when they don’t. The fact of the

matter is that in reality this is totally opposite. Directors are obliged to management for

nomination, compensation and information. Moreover many directors are either

unwilling or unable to devote the time or energy to oversee the operations of the

company or to make a financial commitment to its success.

A large proportion of the regulatory changes have focused on boards of directors. (Beth

Young , Ivey business journal online, Sept/Oct 2003), given the critical functions

performed by the board and its key committees as we discussed earlier is quite

predictable. Many prominent witnesses testified before Congress and the national stock

exchanges, that captive boards were a major contributing factor in the corporate scandals,

and that reforms designed to increase the independence and competence of boards were

crucial to restoring investor confidence. The Sarbanes-Oxley legislation marked the first

time federal legislation imposed an independence requirement on public company boards,

requiring companies to have an audit committee composed exclusively of independent

directors and defining independence more narrowly than previous regulatory provisions.

It also prohibited new company loans to directors, proposed changes to the listing

standards of the New York Stock Exchange and Nasdaq and required a majority of

directors on listed company boards to be independent, including all directors on key

committees strengthening the independence definition. It is natural, that a director with

ties to a company or its CEO would find it more difficult to turn down an excessive pay

request, challenge the rationale behind a proposed merger or bring to bear the skepticism

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necessary for effective monitoring. Despite the consensus that has developed around

director independence, however, there is limited evidence that the so-called “resume

independence”-defined as the absence of familial, employment and financial relationships

between directors and the company promoted through both the reforms to date and codes

of governance best practice actually improves corporate performance. With one

exception, empirical studies have not found a statistically significant positive relationship

between the degree of board independence and better financial performance. In a recent

study, Sanjai Bhagat of the University of Colorado at Boulder and Stanford’s Bernard

Black found no correlation between the degree of board independence and four measures

of firm performance, controlling for a variety of other governance variables, including

ownership characteristics, firm and board size, and industry.

(Journal of Corporate Law, Winter 2002). Bhagat and Black did find that poorly

performing firms were more likely to increase the independence of their board. Earlier

meta-analyses similarly failed to find a correlation between board independence and

various measures of corporate performance. One study, by Paul MacAvoy and Ira

Millstein, did find a positive relationship between a novel measure of independence and a

measure of firm performance related to economic value added (EVA™). However,

monitoring is only one of a board's roles. Directors also contribute to a firm's success by

advising senior management, channeling outside resources to the firm and relating to

stakeholders such as communities and employees. Researcher Jill Fisch has theorized that

while independence may improve directors' performance as monitors; it may be

counterproductive with respect to managerial tasks. Similarly, Lynne Dallas has argued

that the board's multiple roles and the differing significance of independence with respect

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thereto, support the use of a dual board structure. The lack of a relationship between

board independence and performance across a large number of companies does not,

however, mean that increased independence is not the right prescription for any

individual company's board. When a board is falling short of fulfilling its monitoring

duties-for example, where executive compensation is excessive in relation to

performance or where the integrity of financial controls has been compromised in the

past-increasing the number of independent directors on the board could reduce the

likelihood of the problem recurring. But increased board formal independence should not

be viewed as a panacea for poor corporate performance or board failure.

The focus of this paper is on board composition and the contribution of directors to board

and governance effectiveness. Firms have in recent years been increasingly pressured by

institutional investors and shareholder activists to appoint directors with different

backgrounds and bases of expertise, under the assumption that greater diversity should

lead to less insular decision making processes and greater openness to change (Westphal

and Milton, 2000). Companies must structure their boards to serve their needs and boards

need to think about whether they have the right composition to provide the diverse

perspectives that today's businesses require (Biggins, 1999; Grady, 1999). Board

composition will vary according to the differing governance, performance and social

requirements of organizations pertaining to the type of ownership structures (Van der

Walt et al., 2002), and the strategic nature of the environment within which they operate.

Board composition involves more, however, than director selection and achieving the

right skill mix, important as these elements are in building better balanced boards. It is

also important to consider group process, especially when diverse perspectives are

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introduced into the boardroom, and to question what happens to the dynamics of the

board when such appointments are made.

Important also in relation to group process is the ability of directors to influence

boardroom debate and decision making when, because of their background, they are

prone to recommend and channel the firm to a particular direction in which they have

technical superiority as compared to others on the board. Thus, how board dynamics and

group process are managed is a key aspect of board effectiveness.

Two criteria of board effectiveness highlighted by Forbes and Milliken (1999) are board

task performance and board cohesiveness. Task performance relates to the board's ability

to perform its control (hiring, compensation and replacement of senior managers, and

approval of major initiatives proposed by management) and service tasks (providing

expert and detailed insight during major strategic events such as acquisition or

restructuring, informal and ongoing activities such as generating and analyzing strategic

alternatives during board meetings). Forbes and Milliken (1999) identify these two

measures as classic "task" and "maintenance" criteria common to many models of group

effectiveness. The converse applies when a group of people, assembled for their

knowledge and competence, is unable to utilize that expertise because of process issues

that disable individuals and sub-groups and prevent them from making a full contribution

to the work of the group. This can be experienced as a destructive process that requires a

strong maintenance culture just to keep the group operating at a level that is typically

sub-optimal. Recent attention has been directed in the corporate governance literature to

board dynamics with particular regard to diversity in the boardroom. Factors associated

with individual directors and their contribution to the board include professional

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reputation, qualifications, experience, knowledge, expertise, remuneration, motivation,

attendance, participation, committee involvement. Those factors associated with the role

of the board include CEO selection, risk management, shareholder value, and firm

survival, while factors relating to board composition include skill mix, the proportion of

non-executive and executive directors, and level of experience.

Elements affecting board effectiveness that are relatively uncontrollable by the board

include external factors such as legislation, economic conditions, industry complexity,

and industry ethos (Van der Walt and lngley, 2001).

With corporate governance the concept of diversity relates to board composition and the

varied combination of attributes, characteristics and expertise contributed by individual

board members in relation to board process and decision-making. In the widest sense, the

various types of diversity that may be represented among directors in the boardroom

include age, gender, ethnicity, culture, religion, constituency representation,

independence, professional background, knowledge, technical skills and expertise,

commercial and industry experience, career and life experience (Milliken and Martins,

1996). Boardroom diversity, thus, refers to the mix of human (intellectual and social)

capital - where human capital is defined as the skills, general or specific, acquired by an

individual in the course of training and experience (Dictionary of Business, 1996) - that a

board of directors comprises collectively and draws upon in undertaking its governance

function.

This paper considers the selection and appointment of directors with regard to their

contribution to the board as a strategic resource of the organization. Companies cannot

take the risk of having directors who cannot contribute and directors, themselves, must be

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comfortable that they have the experience and knowledge to serve, not only considering

educational expertise but also business acumen. Of particular consideration in this paper

are issues relating to efforts to examine the technical make up of the board, wanting to

benefit from a wider range of perspectives in decision making and gauge the impact of

Doctors of medicine on the board of healthcare firms.

2. Hypothesis:

The hypothesis I want to test is that a corporate governance characteristic – board

composition plays an important role in changes in firm valuation as a result of the

concentration of ‘doctors of medicine’ on firm boards in the health care sector.

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