role of independent directors - enhancing or otherwise of...
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Role of Independent Directors - Enhancing or Otherwise of the Shareholders Wealth- An Empirical Investigation
Palanisamy Saravanan Associate Professor
Indian Institute of Management Shillong Shillong 793 014
Email: [email protected] [email protected]
and
Tara Shankar Shaw Assistant Professor
Department of Humanities and Social Science IIT Bombay, Mumbai
Email: [email protected] [email protected]
Under the aegis of
National Foundation for Corporate Governance
May 2014
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Role of Independent Directors - Enhancing or Otherwise of the Shareholders Wealth - An Empirical Investigation
Abstract
The present study is an attempt in establishing whether independent directors’ add any value to the firm. The study also aimed at analyzing whether higher amount of network connections amongst the independent directors have any impact on the firm value. Out study establishes that increase in the board size and duality decrease and increases performance respectively which is in contrary to the prediction of the agency theory. The degree centrality of the board, prestige centrality of the board and the proportion of directors from same industry has statistically significant positive effect on firm performance. This established that network resource of the Board of Directors and the embeddedness of the firm to its core industry through Board of Directors have significant positive effect on firm performance and thus establishing the fact that higher the average number of network connection of the directors in a board higher is the firm performance. Keywords: Independent directors, corporate governance, firm value, board of directors, networking
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1. Introduction
The role of the director in a company’s Board of Director (BOD) is to protect the interest of the
shareholder and monitor the manager such that they implement the projects to maximize the shareholders’
wealth. To fulfill the objective of the BOD the composition of the board is extremely crucial so that the
board can perform the responsibilities independently and fairly. According to (Brown & Caylor, 2004) the
BOD failed to carry out their duties towards the shareholder and reason can be attributed to weak legal
requirements for corporate disclosure, entrenchment of the board by the managers, promoter holding
major share by cross holding and restricting the board in it functionalities etc.
In the present context, there are significant evidences that relate board structure with the firm
performance and it was found that companies with strong and independent board, with better corporate
disclosure norm provide more opportunities for growth and stability, thereby adding value to the
shareholders’ wealth (Prasanna, 2006). Therefore, it was found that in order to improve the functioning
of the BOD, the board composition should be professional and independent.
Corporate Governance has received a lot of attention mainly after the high profile scandals at Enron,
WorldCom, Adelphia etc. leading to the corporate governance reform of the listed firms through the
Sarbanes Oxley Act (2002) in the United States (Gordon, 2007). Traditionally, managers have taken
decisions which benefitted them but affected the shareholders’ wealth adversely ( (Jensen & Meckling,
1976), (Fama & Jensen, 1983). Hence, greater attention was given to the autonomy of the independent
directors to set the long-term strategic goal of a firm and to monitor whether the policies taken by the
management is in synergy to this long-term strategic goal. The presence of independent directors helps in
devising an institutional mechanism to align the role of the manager towards the shareholders’ interest
and in improving the reliability of the firm’s public disclosures. Moreover, the independent directors
being external to the company can provide a credible assessment to the firm’s performance and reduce the
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information asymmetry between the management and the shareholders (Brown & Caylor, 2004). Hence,
it leads to more efficient resource allocation as firms are forced to adopt the best practices.
p
The incorporation of corporate governance codes in the Asian economies happened in different phases
and it took prominent position in the global corporate world. One of the catalysts in expediting the
corporate governance reform among the Asian economies (especially among the South-East Asian
economies) was the Asian financial crisis of 1997. The Asian crisis exposed the vulnerability of the
public firms and the shareholders wanted the BOD to take greater responsibilities so as to impede future
crisis. Post Asian crisis, the Malaysian public called for corporate governance reforms and as a response a
High Level Finance Committee was established in 1998 which recommended for the provision of
involving more non-executive and independent directors in the BOD (Abdullah, 2004). In Korea, post
Asian financial crisis, there were demands from the International Monetary Fund and the shareholder
activists for corporate reforms resulting in the requirement of minimum of 25% of outside directors in the
company’s board (Choi, Park, & Yoo, 2006).
Emerging Asian economies such as India and China opened up to the world economy with reforms
toward privatization. China started the reforms in late 1970s and India started in early 1990s. Privatization
leads to diversified ownership structure of the company that led to emergence of the concept of corporate
governance in these countries. With integration to the global market there was increased pressure for
pursuing higher governance standards.
In China, the corporate scandals and capital flight cases that emerged in 2001 led to the improvement of
governance activities by enhancing the auditing and disclosure norms. Stock exchanges mandated several
procedures for the listed companies like transparency in board selection, disclosure requirements, number
of independent directors in the board, interests of minority shareholders and allied aspects. In the Indian
context, three committees (the Chandra, the Birla Committee and the Narayana Murthy Committee) were
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established by SEBI (Securities and Exchange Board of India) for proposing governance reform. Wide
range of recommendations such as board composition, functions of audit committee, procedures in
meetings, shareholders rights were made. Based on the recommendation of these committees the Clause
49 of the listing agreement for the public limited companies was made it mandatory for the listed firms,
by the Indian Stock Exchanges in 31st December, 2005.
Corporate governance in Bangladesh has gained its significance since the early 1990s.
Bangladesh followed an open trade policy due to the small size and lack of adequate natural
resources. Securities and Exchange Commission is mainly responsible for issuing corporate
governance activities for the listed companies in Bangladesh. The corporate environment in
Bangladesh is strewed with family oriented businesses and effective corporate governance is
virtually absent in Bangladesh.
The rest of the paper is organized as follows. Section 2 documents the literature review of
previous works on corporate governance and theory development. Under section 3, we described
the research methodology, major objectives and hypotheses, section 4 documents the analysis
and discussion and section 5 describes the conclusion and directions for further studies.
2. Literature Review and Theory Development:
Traditionally the role of independent director has been to provide expertise in his own field and enhance
reputation of the firm. But with increasing scandals and acts, shareholders have begun to take active
interest in company's policies (Treadwell, 2006), board composition and director’s appointment. The
shareholders expects the BOD as a whole should be more demanding and proactive in company’s
policies. Thus, it requires the independent directors to be diligent, flexible (Bhagat & Black, 1999) and
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willing to devote more time on a regular basis for the companies affairs and assume greater
responsibilities.
From the existing literature we see that there has been a huge debate on the board characteristics like
composition, duality etc. on the firms performance. There is no conclusive evidence has been arrived at
the relationship between the board composition and firm performance (Hermalin & Weisbach, 1998). In
the Indian context (Garg, 2007) found that board size and board independence are inversely related with
the firm’s performance at lower board size. He documented that the optimum proportion of independent
directors was found out to be between 50 to 60 per cent of the total board size. This study is in line with
the findings in Ireland where the ICT sector of Irish SME’s showed an average of 5 members in a board
with varying demographics (Regan, Donell, Kennedy, Bontis, & Cleary, 2005) maximized the value of
the firm. Further the proportion of executive directors was around 40 per cent which showed that Irish
firms are ahead in recognizing the importance of independent directors than any other countries.
Considering developed countries, scenario is a bit different in developing countries. An interesting study
(Brown & Caylor, 2004) wherein the corporate governance of a firm is measured through governance
score, through a culmination of 51 factors (Garg, 2007). He found that the Governance score was
correlated with the industry adjusted performance variables and then the firms with very high or very low
scores were correlated to establish any difference in characteristics. Most of the variables showed positive
correlation with the governance score as expected barring sales growth.
In the Asian context, various studies ( (Rajagopalan & Zhang, 2008); (Chowdhury, 2010) were conducted
to understand the composition of shareholder on the monitoring role of the board and a common
observation is that large investors have more power to monitor the board rather than small dispersed
investors. On the other hand (Patibandla, 2005) found that the government control listed firms are less
efficient in its monitoring role.
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Rashid et.al. (2004) claimed that independent directors have insignificant role in the corporate
governance of Bangladesh. But there were certain caveat in their finding. Some of them are 1) The time
period under consideration did not reflect the general economic conditions of Bangladesh.2) the sample
was very skewed in the sense that about 94% of the observations were from only three years (2006-2008).
The effect of board independence and CEO duality on firm’s performance in Malaysian context was
documented (Abdullah, 2004) but the result was inconclusive it was documented that neither board
independence nor firm’s structure affects performance.
Looking into the Korean economy, studies (Choi, Park, & Yoo, 2006) showed that that effect of
independent directors on firm’s performance is dependent on market condition. They also stated that
outside directors have a significant impact on firm's performance in Korea which contrasts with that of
the earlier documentation. The effects are stronger for independent directors than for gray directors.
In the Indian and Chinese context, corporate governance reforms are generally quite different from the
West. Privatization and globalization are identified to be two major factors responsible for corporate
governance. In Indian context various metrics like independent directors, independent leadership of
governance committees, participation in board meetings and annual general meetings, participation in
audit committee meetings were studied (Prasanna, 2006) and the empirical results did not support the
notion that independent directors enhance firm’s performance.
The survey of the existing literature depicts that the role and composition of independent directors varies
across economies. As the concept of corporate governance is fairly new in emerging economies like
India, there is not much literature available to delineate the causal effect of BOG composition and firm
performance. Even amongst the available literature no empirical work is done with reference to the role of
independent directors in enhancing or otherwise for the shareholders wealth.
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Theory Development:
Agency Theory
The separation of ownership and management of publicly traded companies leads to conflict of
interests between the owners and the managers known as the principal-agent problem whereby
the managers have an incentive to pursue objectives contrary to those of the owners (Jensen &
Meckling, 1976). The conflict of interest coupled with the inability to costlessly write a perfect
contract between the owners and the managers reduces the value of the firm (Denis &
McConnell, 2003). In the world of incomplete contract with agency problem corporate
governance aids in allocating residual rights over the firm's non-human assets (Hart, 1995). The
role of governance becomes more pertinent in publicly traded companies where the agents i.e.
the managers who look after the daily functioning of the company are not the residual claimants.
Therefore the managers have incentives to use their discretion to benefit themselves in number of
ways (Shleifer & Vishny, 1997), like empire building (Jensen, 1974; (Williamson, 1964), rent
seeking activities leading to extra perks, higher pay (Hart, 1995), or entrenching themselves so as
to avoid getting fired when the firm performs poorly ( (Shleifer & Vishny, Management
entrenchment: The case of manager-specific investment, 1989); (Hart, 1995). The principal i.e.
owners of the company who are the residual claimants are so disperse that individually each
owner do not have the incentive to monitor the managers. Therefore under this scenario the
corporate governance is designed to provide checks and balances on the managers' actions (Hart,
1995).
Development of the theoretical literature on corporate governance can be divided into the first
generation research and the second generation research (Denis & McConnell, 2003). In the first
generation models the BOD is identified as the primary non-market monitoring device to protect
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the shareholders' interest (Fama & Jensen, 1983). The basic idea is that the board with larger
proportion of independent directors, who are objective and are focused towards shareholders'
interests, are able to monitor managers better and thus increases the value of the firm (Walsh &
Steward, 1990; Cohen, Frazzini, & Malloy, 2012). Beside board's independence the monitoring
role of the board is improved if there is a separation between the role of the Board's chairman
and the CEO of the firm (Fama & Jensen, 1983; Finkelstein & D'Aveni, 1994), since the
arrangement protects the board being entrenched by the CEO. Beside the BOD the agency
theorists also argue that the presence of large shareholders is an effective corporate governance
tool since they have an incentive to monitor the managers (Alchian & Demsetz, 1972; Shleifer &
Vishny, 1997; Hill & Snell, 1988; Ramaswamy, Li, & Veliyath, 2002).
The legal and regulatory rules play no role in the first generation models since they were
developed to explain the corporate governance of the Anglo-Saxon countries like UK and USA.
Therefore these models' predictability was questioned when they were applied in the context of
emerging economies. Many researchers (Porta, Silanes, Shleifer, & Robert, 2000) in their series
of articles looked into the effect of the country's contextual framework of legal and regulatory
rules on investors' rights, ownership structure, equity holding and ultimately how it shaped the
corporate governance and the corporate finance environment of the country. According to
(Chakrabarti, Subramanian, & Tung, 2012) India being a common law country the de jure
protection provided by the legal system is high but the de facto protection due to the weak
institutional set up is low due to corruption, embezzlement of public wealth etc. The weak
institutional setup results in costly enforcement of contractual agreement ( (North, 1990), Wright
et. al (2005) and higher information asymmetry leading to more serious agency problems (Gul
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and Qin, 2002). Under this situation where weak institutional setup does not provide effective
investors protection, concentrated ownership is the reasonable response of the market
(Dharwadkar, Geogre, & Brandes, 2000). This results in frequent conflicts between the
controlling shareholder and the minority shareholders (Morck, Wolfenzon, & Yeung, 2005) and
it is known as the principal-principal (PP) problem. Under PP problem there are at least three
ways through which the controlling shareholders expropriates value of the firm. First the
controlling shareholder can transfer assets and profits from a controlling firm on which it has low
cash flow rights know as tunneling (Porta, Silanes, Shleifer, & Robert, 2000). There are
significant evidences of tunneling in India among the firms in a business group ( (Bertrand,
Mehta, & Mullainathan, 2002) (Kali & Sarkar, 2011). Second in a model developed by Burkhart
et al. (2003) it was shown that in a regime with weak investor protection, the controlling
shareholder has an incentive to appoint family owner with heirs as managers and it was
empirically shown that this is true among the emerging economies (Lins, 2003). Third in an
economy with poor legal institutions the owner controlled firms will be reluctant to divulge
strategic information to unfamiliar parties due to lack of trust ( (North, 1990), (Bardhan, 2001).
Therefore in an emerging economy like India the owners will be reluctant to divulge any
information1 with the BOD and therefore the boards are less likely to play the role of monitors.
In this scenario the independence of the BOD will have no perceptible effect on the firm's
performance.
Hypothesis1: Board size and board independence have no significant effect on firm performance.
1 In a qualitative study by Khanna and Mathew (2010) consisting of interviews with independent directors of India it was revealed that very less information is shared with the BOD.
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Resource Based View
According to the resource based view the BOD as the boundary spanners provides scarce
resources which originates from the firm's external environment (Pfeffer, Size and composition
of corporate boards of director: the organization and its environment., 1972; Pfeffer & Salancik,
The External Control of Organizations: A Resource Dependence Perspective, 1978) that
increases the firm's value (Zara and Pearce, 1989). These scarce resources includes business and
financial sector knowledge (Kakabadse, Ward, Korac-Kakabadse, Bowman, 2001) (KaKabadse,
Ward, Korch-Kakabadse, & CliffBowman, 2001), strategic expertise ( (Zahar & Pearce, 1989),
(Golden & Zajac, 2001)) , link to external informal networks (Hambrick & D'Aveni, 1992),
signal of legitimacy of the organization (Certo, 2003) (Certo, Daily, Jr, & Dalton, 2003) and
better governance (Khanna & Palepu, Globalization and Convergence in Corporate Governance:
Evidence from Infosys and the Indian Software Industry, 2004). According to (Pfeffer &
Salancik, The External Control of Organizations: A Resource Dependence Perspective, 1978) the
BOD provide these resources in the form of a) advice and counsel b) access to information
channel between firm and external contingencies c) preferential access to resources and d)
legitimacy. The prominence of the resource based view of the BOD is more pertinent in
emerging economies with changing institution where BODs are seen as a vehicle of legitimacy
and signal of good governance. From their (Khanna & Palepu, Globalization and Convergence
in Corporate Governance: Evidence from Infosys and the Indian Software Industry, 2004) study
of the Indian software industry, especially Infosys, concluded that the strict corporate governance
codes was adapted to attract skilled labor from global market to face the fierce product market
competition. Similarly, (Afsharipour, 2011) showed that the corporate governance reforms in
India was to attract global capital and foreign direct investment. Increasingly it has been found in
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the Indian case that the independent directors views their role as that of strategic advisor and to
the promoters / managers (Khanna & Mathew, 2010) rather than that of a monitor.
An important resource provided by the directors are the relational capital which comprises of
various formal and informal ties of the directors. A well-connected director have better access to
the information which helps the firm in strategic decision making ( (Mizruchi, 1990) and also
aids in disseminating information across firm ( (Useem, 1984), Burt 1980) through which value
improving business innovation can spread (Haunschild & Beckman, 1998). For example the
networked directors can bring information about effective corporate governance, efficiency-
enhancing technology, innovative compensation structure to the firm (Lacker et al. 2013).
Network ties of a director can also help a firm by leveraging their social and business contact for
resource exchange (like personal and political favors) and facilitate collusive competitive
behavior among closely linked firms (Pennings, 1980). Sometimes networked directors can
adversely affect the firm performance if misleading or incorrect information spread through the
network (Lacker et al. 2013) or if multiple directorship adversely affect the monitoring role of
the director (Fich & Shivdasani, 2006). The net effect is ambiguous. Studies in other emerging
economies like Thailand (Peng, Au, & Wang, 2001), Hong Kong (Au, Peng, & Wang, 2000)
have found that the board with high networked directors have positive on performance. Helmers
et al. (2013) showed that interlocking of board among Indian firms enhances Research and
Development (R&D) investment and patenting of firms. (Sarkar & Sarkar, 2000) found that in
Indian context multiple directorship has positive effect on firm performance. As we saw in the
previous section in the emerging economies the monitoring role of the directors are not that
predominant so the promoter chooses those directors in the board that have more network
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connection to the external environment. This move is not only value enhancing but also a
substitute to an environment where market mechanism cannot ensure free flow of information.
Thus, we hypothesize that:
Hypothesis 2: Higher the average number of network connection of the directors in a board higher is the firm performance.
The resource based view of the BOD hinges on the idea that the directors provides resources and
information external to the firm, reduce environmental dependency and establishes legitimacy
(Daily & Dalton, 1994). Then a simple question arises is whether the independent director and
the executive director are homogenous with respect to these roles. The executive directors who
are mostly insiders of the firm scans the internal resources which are internalized in its decision
making. Even though they might have specific type of linkages and relationship with
environmental contingencies, the primary resource they provide are internally focused (Hillman,
Cannella, & Paetzold, 2000) . Therefore if the role of the BOD is to access the external linkages
from the firm's environment the independent director plays a better role (Johnson, Daily, &
Ellstrand, 1996; Hillman, Cannella, & Paetzold, 2000). (Khanna & Palepu, Is Group Affiliation
Profitable in Emerging Markets? An Analysis of Diversified Indian Business Groups, 2000)
attributed relational capital of the independent directors to be important resource for firms in the
emerging economies with weak institutional protection for efficient markets. According to
(Haleblian & Finkelstein, 1993) firms in a high growth path, independent director increases the
diversity of the board and increase the information assimilation capabilities of the board. In the
same line (Hillman, Cannella, & Paetzold, 2000) characterizes different attributes of the
independent director like business expertise, support specialist and community influential to be
valuable when a firm moves from regulated to deregulated environment.
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The effectiveness of the BOD in monitoring and in provision of resources depends upon the
interpersonal and group relationship between the executive and the independent directors
determined by the process of accountability within the board. Roberts et al. (2005) found that
these accountability is realized through range of behavior like debating, challenging, questioning,
probing, discussing, testing, informing and exploring. In any society the interaction within an
organization is determined by its social-cultural setting. This aspect is much important in India
where organization hierarchy determines much of the interactions between different ranks of
firms managers. In Indian society where it is consider imprudent to question once authority it is
less expected that the dependent director will question or challenge the CEO of a firm. So in the
board the accountability of questioning, probing, exploring etc. is set by the dependent director.
Thus from the forgoing discussion one can conclude that the resource provision role of the
independent director is significantly associated with the firm performance than the dependent
director.
Hypothesis 3: Higher number of network connections of Independent Directors higher is the performance of the firm Methodology
Our sample consists of any non-financial firm which was in the BSE500 index between the years
2005-2012. These firm constitutes more than seventy percent of the market capitalization of
Bombay stock exchange (BSE). Among the non- financial firms we have dropped those firms
which got merged with other firm between the above year and we were left with 651 firms in the
sample. For all these firms data was collected for the year 2005-2012 amounting to total 4050
unique firm-year. The financial data were extracted from Prowess (Release 4.12) maintained by
Center of Monitoring Indian Economy. Prowess includes information of around 25,000 firms
(both listed and unlisted) based on their annual report. Director level information related to age
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of the directors, number of different firm's directorship held by the individual, education, etc.
was collected from the website of director database. The director database was discontinued and
thereafter the relevant data were collected from the annual report of the firms. All the data that
were hand collected was cross referenced and validated with the data from Prowess. A major
problem of collating the director level information was that the reporting of the name of directors
was not same for different year or across different firms in the same year. For, example
sometime the full name of the director was given other time only the acronym of the first and the
middle name was given. In some cases the last name was given first and sometimes it was given
in the last. To maintain consistency across firms and years all these names were manually
checked to make the coding error free.
In this section we describe the variables, data used and the method employed to test the
hypotheses developed.
Variable
The dependent variable is the performance of the firms. It is measured as the return on assets
(ROA) calculated as profit before interest and tax divided by total assets (Sarkar & Sarkar 2009).
Several studies in governance/performance relationship used market based performance like
Tobin's Q as measure of firm’s performance. We have avoided using the Tobin Q measure for
number of reason. First in India the capital market is not well developed therefore the market
based return will be volatile and it may not reflect the firms' true performance (Peng M. W.,
2004). Second in India like other emerging economies the market of the debt is not well
developed and most of the corporate debt are held by institutions so they are not actively traded
in the market. Thus, it is difficult to get a true market value of the debt. Moreover most
companies report the asset value using historical cost and not on the replacement cost in India
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(Ghosh, 2010) . Thus, it is difficult to calculate the true Tobin's Q. In absence of a proper
measure of Tobin' Q one uses a proxy measure as by (Khanna & Palepu, Is Group Affiliation
Profitable in Emerging Markets? An Analysis of Diversified Indian Business Groups, 2000)
which resembles market-of-book ratio which is proxy for growth opportunities. There are
theoretical reason to expect the growth opportunity as a cause rather than an effect of governance
structure of the firm (Wintoki, Linck, & Netter, 2012). For the purpose of robustness we have
replicated the result using Return on Sales (ROS) calculated as profit before interest and tax
divided by total sales.
The independent variables related to the governance of the firm is the board size, proportion of
independent director and duality of the board, which is dummy variable taking a value one if the
chairman of the board and the CEO are the same individual. The independent variables related of
connectedness of BOD constitutes network connections which brings relevant information. We
define two types of network connections. First we focused on the network of directors and
construct various measure of connectedness by using the technique developed in social network
analysis. Second we focused on the embeddedness of the director to the focal industry.
Unlike previous work (Larcker, So, & Wang, 2013; Horton, Millo, & Serafeim, 2012; Peng, Au, & Peng,
2001) where network was created among firms sharing directors we constructed the network map of
directors individually. While constructing the director's network map for a given year we included all the
other directors of the listed firms (both in and out of our sample) is whose board the director is a member.
If a director is a board member of a firm not in our sample (but listed) we have ensured that the directors
network of the other directors should at least include all the board members of that firm. We do not have
the information if the other board members are connected to other firms not in our sample but if they are
connected to firms in out sample we have included the director of those firms in the network. Given the
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network map we construct two measures of connectedness; degree centrality and prestige centrality. The
idea behind degree centrality is that a director is well connected to a network map if it possesses relatively
many connections with other directors. To measure degree centrality for a director ′ ′ a indicator variable
, is constructed which takes the value one if director ′ ′ and director ′ ′ shares a board. The
normalized degree centrality for a director is
∑ , (1)
where is the maximum possible degree for a director.
The degree centrality weights all connections between two directors equally. But in reality a director 's
connectedness to director who is in turn connected to more number of director will be higher than the
connectedness resulting from director who is connected to less number of director. Thus concept of
multiple round of connection was capture in prestige centrality (Bonacich, 1972). Let be the prestige
centrality of director and is proportional to the linear combination of the prestige centrality of the other
directors connected to . Thus
⋯ (2)
Where is an indicator variable which takes the value one if director and are connected and zero
otherwise. For directors there will be equations the ′ can be solved by solving the above linear
system of equations. Bonacich (1972) has shown that in the above system of equation has a solution with
positive and non-negative , which will be out Prestige centrality. The degree/prestige centrality of the
firm's board is the average of the degree/prestige centrality of the directors in the board.
The embeddedness of the board in the focal firm's industry is defined as the proportion of director in a
firm sits on a BOD of another firm from the same industry. We have defined industry by two digit NIC
classification. Industry embeddedness of director aids in accessing better information and enables the
firms to cushion the impact of uncertainty arising its immediate industry environment. In other words a
firm whose board member has ties to other firms from the focal industry it is better equipped to survive
and thrive because it can more quickly understand industry event and trends (Haynes & Hillman, 2010).
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The other control variables that are included are taken from the literature. They include log of total sales
to control for size, debt equity ratio, R&D and advertisement intensity, percentage of share owned by
individual family promoters to control for family ownership and percentage of shares hold by institutional
investors.
In the first stage to test for the hypothesis 1 we estimate a fixed effect regression model
(3)
Where are the other control variables, are the time dummies and is the unknown fixed effect. The
independent variables in the LHS are lagged by one period to control for endogeneity. Hypothesis 1
implies that , and are not statistically significant and hypothesis 2 implies that and to be
positive. To test for the hypothesis 3 we estimate the above model but we have taken the Centrality and
the embeddedness for the dependent and independent director separately. Hypothesis 3 implies that the
coefficient of the centrality and embeddedness for the independent directors will be statistically
significant but not for the dependent director.
Analysis and Discussion
The result of the univariate result is given in Table 1.
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Table 1 Descriptive Statistics
Variable Name Mean Median Standard Dev ROA 0.088 0.082 0.087 ROS 0.149 0.108 0.228 Board Size 9.986 10.000 3.412 Proportion of Ind Dir 0.492 0.500 0.171 Duality 0.321 0.000 0.467 Avg Normalized Deg Centrality 0.047 0.044 0.024 Avg Normalized Deg Centrality of Ind Dir 0.058 0.051 0.036 Avg Normalized Deg Centrality of Non-Ind Dir 0.036 0.030 0.023 Avg Normalized Eig Centrality 1.339 0.765 1.675 Avg Normalized Eig Centrality of Ind Dir 1.694 0.934 2.154 Avg Normalized Eig Centrality of Non Ind Dir 0.996 0.449 1.582 Prop of Dir from Same Industry 0.187 0.125 0.209 Prop of Ind Dir from Same Industry 0.205 0.143 0.252 Prop if Dep Dir from Same Industry 0.169 0.000 0.249 Prop of Dir from Same Business Group 0.184 0.000 0.239 Average age of the Board 59.947 60.286 6.254 Proportion of Institutional Investor's Share 17.524 15.255 13.453 Prop if Family Promoter Share 9.852 0.110 17.788 Advertisement Intensity 0.013 0.000 0.062 R&D Intensity 0.009 0.000 0.222 Debt-Equity Ratio 1.346 0.629 5.566 Firm Size 9.433 9.323 1.514
The descriptive statistics are generated on 651 firms and 4050 firm-year data. The measure of board monitoring are Board Size, Proportion of Independent Director, Duality. 'Ind Dir' stands for independent director, 'Non Ind Dir' stands for non-Independent director, 'Deg Centrality' stands for degree Centrality and' Eig Centrality' stands for Eigen value centrality estimated by the method of Bonacich (1972). The BOD resource is measure by the following variables 'Avg Normalized Deg Centrality', is the average degree centrality of the BOD, 'Avg Normalized Deg Centrality of Ind Dir' is the average degree centrality of the independent directors, ' Avg Normalized Deg Centrality of Dep Dir' is the average degree centrality of the dependent directors, ' Avg Normalized Eig Centrality' is the average degree centrality of the Eigen value centrality of the BOD, 'Avg Normalized Eig Centrality of Ind Dir' is the Eigen value centrality of the independent director, 'Avg Normalized Eig Centrality of Dep Dir' is the Eigen value centrality of the dependent director, 'Prop of Dir from Same Industry' proportion of director in the board from same industry, 'Prop of Ind Dir from Same Industry' is the proportion of the independent director from the same industry, ' Prop if Dep Dir from Same Industry' proportion of dependent director from the same industry. Other variables are control variables. Log of the Total asset of the firm is the Firm Size.
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In the equation 3 we do not have any apriori information to assume that the fixed
effect are uncorrelated to the independent variables. Therefore, we have estimated
the above model using fixed effect panel data regression. Moreover, Hausman test was
also conducted and it was found that fixed effect estimation was a valid approach
compared to the random effect estimation. Table 2 shows the estimation result with
ROA as the dependent variable and Table 3 shows the estimation result with ROS as
the dependent variable. The results in both the estimation are quiet similar. Column 1
and 2 test hypothesis 1 and hypothesis 2. In column 1 we have included the degree
centrality and in column 2 we have included Eigen value centrality as a measure of
boards network capital. Proportion of directors from same industry is used as a
measure of industry embeddedness of the directors in column 1 and column 2. In
column 3, 4 and 5 we have included the resources of the independent and dependent
directors stepwise. In column 3 we have included the proportion of independent and
dependent directors from the same industry separately and average degree centrality of
the board. In column 4 we have included the average degree centrality of the
independent and dependent directors separately and the proportion of director in the
board from same industry. In column 5 we have included average degree centrality of
the independent and dependent directors and proportion of independent and dependent
directors from the same industry separately. The same stepwise inclusion is followed
in column 6,7 and 8 but here with Prestige centrality, i.e. the Eigen value centrality.
Among the governance variables proportion of independent directors in the
board have no significant effect on the performance. Increase in the Board Size and
21
Duality decrease and increases performance respectively which is in contrary to the
prediction of the agency theory. The degree centrality of the board, prestige centrality
of the board (measured by Eigen value centrality) and the proportion of directors from
same industry has statistically significant positive (at 5% level of significance) effect
on firm performance. This established that network resource of the BOD and the
embeddedness of the firm to its core industry through BOD have significant positive
effect on firm performance and thus establishing validity of hypothesis 2. Column 3, 4
and 5 shows that the average degree centrality of the independent directors and the
industry embeddedness of the independent director to the firm's focal industry
positively affects the firms performance (the affect is statistically significant at 5%
level of significance) but the effect do not holds for dependent directors. We get the
similar results when we use Prestige centrality as the measure of network capital and
the results are given in column 6, 7 and 8. This establishes the validity of hypothesis 3.
Conclusions:
The present study is an attempt in establishing whether independent directors’
add any value to the firm. The study also aimed at analyzing whether higher
amount of network connections amongst the independent directors have any
impact on the firm value. Out study establishes that increase in the Board Size
and Duality decrease and increases performance respectively, which is in
contrary to the prediction of the agency theory. The degree centrality of the
board, prestige centrality of the board and the proportion of directors from
same industry has statistically significant positive effect on firm performance.
22
This established that network resource of the BOD and the embeddedness of
the firm to its core industry through BOD have significant positive effect on
firm performance and thus establishing the fact that higher the average number
of network connection of the directors in a board higher is the firm
performance.
Table 2: Result of Fixed Effect Panel Regression
(1) (2) (3) (4) (5) (6) (7) (8) Board Size -0.0036** -0.0025 -0.0035** -0.0032** -0.0031* -0.0023 -0.0023 -0.0022
(0.002) (0.002) (0.002) (0.002) (0.002) (0.002) (0.002) (0.002) Proportion of Ind Dir -0.0142 -0.0111 -0.0091 -0.0034 0.0055 -0.0053 -0.0095 0.0000
(0.022) (0.022) (0.026) (0.022) (0.026) (0.026) (0.022) (0.026) Duality 0.0391*** 0.0402*** 0.0365*** 0.0393*** 0.0365*** 0.0366*** 0.0393*** 0.0367***
(0.013) (0.013) (0.013) (0.013) (0.013) (0.013) (0.013) (0.013) Avg Normalized Deg Centrality 0.8656*** 0.8977***
(0.303) (0.308) Avg Normalized Deg Centrality of Ind Dir 0.4158** 0.4246**
(0.168) (0.171) Avg Normalized Deg Centrality of Non-Ind Dir 0.1762 0.1677
(0.240) (0.248) Avg Normalized Eig Centrality 0.0037 0.0045
(0.003) (0.003) Avg Normalized Eig Centrality of Ind Dir 0.0052** 0.0053**
(0.002) (0.002) Avg Normalized Eig Centrality of Dep Dir -0.0028 -0.0029
(0.003) (0.004) Prop of Dir from Same Industry 0.0498* 0.0604** 0.0537* 0.0586*
(0.030) (0.030) (0.031) (0.031) Prop of Ind Dir from Same Industry 0.0139 0.0110 0.0190 0.0159
(0.021) (0.021) (0.021) (0.021) Prop if Dep Dir from Same Industry 0.0251 0.0275 0.0274 0.0305
(0.021) (0.022) (0.021) (0.021) Prop of Dir from Same Business Group -0.1266*** -0.1112*** -0.1235*** -0.1219*** -0.1178*** -0.1141*** -0.1166*** -0.1149***
(0.042) (0.041) (0.043) (0.042) (0.043) (0.042) (0.041) (0.042) Average age of the Board 0.0024** 0.0025** 0.0028** 0.0025** 0.0029** 0.0028** 0.0024** 0.0029**
(0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001)
24
Proportion of Institutional Investor's Share 0.0007* 0.0007* 0.0006 0.0007* 0.0006 0.0006 0.0006 0.0006 (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Prop if Family Promoter Share 0.0005* 0.0005* 0.0004 0.0005* 0.0004 0.0004 0.0005 0.0004 (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Advertisement Intensity 0.0215 0.0194 -0.0848 0.0179 -0.0859 -0.0309 0.0590 -0.0344 (0.195) (0.195) (0.199) (0.195) (0.199) (0.200) (0.196) (0.200)
R&D Intensity -0.1151 -0.1192 -0.1343 -0.1219 -0.1467 -0.1047 -0.0984 -0.1178 (0.346) (0.346) (0.346) (0.346) (0.347) (0.347) (0.347) (0.347)
Debt-Equity Ratio 0.0005 0.0005 0.0005 0.0005 0.0005 0.0005 0.0005 0.0005 (0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001)
Firm Size -0.0256*** -0.0250*** -0.0294*** -0.0258*** -0.0296*** -0.0155* -0.0118 -0.0159** (0.007) (0.007) (0.007) (0.007) (0.007) (0.008) (0.008) (0.008)
Constant 0.2067** 0.2141** 0.2151** 0.2042** 0.2111** 0.1184 0.1087 0.1149 (0.092) (0.093) (0.095) (0.092) (0.095) (0.098) (0.095) (0.097)
Observations 4050 4,022 3,953 4,022 3,953 3,953 4,022 3,953 R-squared 0.021 0.020 0.021 0.021 0.021 0.016 0.017 0.016 Number of cmiecode 651 651 651 651 651 651 651 651
p-value for F-test of 1st Ord Auto Corr 0.2069 0.2091 0.2509 0.2060 0.2488 0.2525 0.2091 0.2526
The table reports the result of fixed effect Panel regression. The dependent variable is ROS winsorized at 1%. All the independent variables are lagged by one period. The regression includes the dummy variable for the year effect. The last row gives p-value of the result of the test for serial correlation in the idiosyncratic errors of a linear panel-data model Wooldridge (2002) and implemented by Drukker (2003) in Stata. Standard error are given in the parenthesis and the level of significance are indicated by ***, ** and * for 1%, 5% and 10% respectively
25
Table 3: Result of Fixed Effect Panel Regression
Hypothesis 1 & 2 Hypothesis 3 With Degree Centrality With Prestige(Eigenvalue) Centrality
VARIABLES ROA ROA ROA ROA ROA ROA ROA ROA (1) (2) (3) (4) (5) (6) (7) (8)
Board Size -0.0025*** -0.0022*** -0.0023*** -0.0024*** -0.0023*** -0.0020*** -0.0021*** -0.0020***
(0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001) Proportion of Ind Dir -0.0081 -0.0073 -0.0000 -0.0048 0.0040 0.0015 -0.0063 0.0035
(0.009) (0.009) (0.010) (0.009) (0.010) (0.010) (0.009) (0.010) Duality 0.0127** 0.0130*** 0.0128** 0.0127** 0.0127** 0.0130** 0.0131*** 0.0130**
(0.005) (0.005) (0.005) (0.005) (0.005) (0.005) (0.005) (0.005) Avg Normalized Deg Centrality 0.2522** 0.2488**
(0.120) (0.123) Avg Normalized Deg Centrality of Ind Dir 0.1201** 0.1089*
(0.061) (0.065) Avg Normalized Deg Centrality of Dep Dir 0.0712 0.0989
(0.095) (0.099) Avg Normalized Eig Centrality 0.0011 0.0011
(0.001) (0.001) Avg Normalized Eig Centrality of Ind Dir 0.0023** 0.0021**
(0.001) (0.001) Avg Normalized Eig Centrality of Dep Dir -0.0019 -0.0016
(0.001) (0.001) Prop of Dir from Same Industry 0.0319*** 0.0350*** 0.0328*** 0.0353***
(0.012) (0.012) (0.012) (0.012) Prop of Ind Dir from Same Industry 0.0170** 0.0164** 0.0186** 0.0173**
(0.008) (0.008) (0.008) (0.008) Prop of Dep Dir from Same Industry 0.0070 0.0068 0.0078 0.0092
(0.008) (0.009) (0.008) (0.008) Prop of Dir from Same Business Group -0.0542*** -0.0495*** -0.0554*** -0.0532*** -0.0545*** -0.0505*** -0.0499*** -0.0511***
(0.017) (0.016) (0.017) (0.017) (0.017) (0.017) (0.016) (0.017) Average age of the Board 0.0009* 0.0009** 0.0011** 0.0009** 0.0011** 0.0011** 0.0010** 0.0011**
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) Proportion of Institutional Investor's Share <0.0001 0.0001 0.0001 <0.0001 0.0001 0.0001 0.0001 0.0001
26
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) Prop if Family Promoter Share <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) Advertisement Intensity 0.0070 0.0039 -0.0105 0.0053 -0.0113 -0.0128 0.0005 -0.0151
(0.085) (0.085) (0.086) (0.085) (0.086) (0.086) (0.085) (0.086) R&D Intensity 0.0836 0.0823 0.0795 0.0817 0.0769 0.0775 0.0769 0.0715
(0.138) (0.138) (0.138) (0.138) (0.138) (0.138) (0.138) (0.138) Debt to Equity Ratio 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) Market to Book Ratio 0.0053*** 0.0053*** 0.0050*** 0.0053*** 0.0051*** 0.0051*** 0.0053*** 0.0051***
(0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001) Firm Size -0.0153*** -0.0150*** -0.0159*** -0.0152*** -0.0158*** -0.0157*** -0.0153*** -0.0159***
(0.003) (0.003) (0.003) (0.003) (0.003) (0.003) (0.003) (0.003) Constant 0.1823*** 0.1845*** 0.1728*** 0.1808*** 0.1707*** 0.1745*** 0.1840*** 0.1735***
(0.037) (0.037) (0.038) (0.037) (0.038) (0.038) (0.037) (0.038)
Observations 4,050 4,050 4,050 4,050 4,050 4,050 4,050 4,050 R-squared 0.059 0.058 0.057 0.059 0.057 0.056 0.059 0.057 Number of Firms 651 651 651 651 651 651 651 651
p-value for F-test of 1st Ord Auto Corr 0.1245 0.1307 0.1747 0.1211 0.1600 0.1774 0.1286 0.1786 The table reports the result of fixed effect Panel regression to test Hypothesis 1, 2 and 3. The dependent variable is ROA winsorized at 1%. All the independent variables are lagged by one period. The regression includes the dummy variable for the year effect. The last row gives p-value of the result of the test for serial correlation in the idiosyncratic errors of a linear panel-data model Wooldridge (2002) and implemented by Drukker (2003) in Stata. Robust firm clustered standard error are given in the parenthesis and the level of significance are indicated by ***, ** and * for 1%, 5% and 10% respectively
27
Table 4: Result of Fixed Effect Panel Regression
Hypothesis 1 & 2 Hypothesis 3 With Degree Centrality With Prestige(Eigenvalue) Centrality
VARIABLES ROS ROS ROS ROS ROS ROS ROS ROS (1) (2) (3) (4) (5) (6) (7) (8)
Board Size -0.0039** -0.0028* -0.0037** -0.0035** -0.0033** -0.0026* -0.0027* -0.0025 (0.002) (0.002) (0.002) (0.002) (0.002) (0.002) (0.002) (0.002)
Prop of Ind Dir -0.0194 -0.0162 -0.0054 -0.0083 0.0092 0.0003 -0.0135 0.0056 (0.022) (0.022) (0.026) (0.022) (0.026) (0.026) (0.022) (0.026)
Duality 0.0326*** 0.0337*** 0.0313** 0.0328*** 0.0313** 0.0323** 0.0338*** 0.0323** (0.012) (0.012) (0.013) (0.012) (0.013) (0.013) (0.012) (0.013)
Avg Normalized Deg Centality 0.8772*** 0.8831*** (0.300) (0.306)
Avg Normalized Deg Centality of Ind Dir 0.4302*** 0.4300** (0.167) (0.170)
Avg Normalized Deg Centality of Dep Dir 0.1768 0.1622 (0.238) (0.246)
Avg Normalized Eig Centality 0.0034 0.0041 (0.003) (0.003)
Avg Normalized Eig Centality of Ind Dir 0.0052** 0.0054** (0.002) (0.002)
Avg Normalized Eig Centality of Dep Dir -0.0030 -0.0033 (0.003) (0.004)
Prop of Dir from Same Inustry 0.0497* 0.0570* 0.0500* 0.0577* (0.030) (0.030) (0.030) (0.030)
Prop of Ind Dir from Same Industry 0.0158 0.0127 0.0214 0.0181 (0.020) (0.021) (0.020) (0.020)
Prop of Dep Dir from Same Industry 0.0237 0.0261 0.0269 0.0301 (0.021) (0.021) (0.021) (0.021)
Prop of Dir from Same Business Group -0.1211*** -0.1052*** -0.1183*** -0.1165*** -0.1129*** -0.1018** -0.1061*** -0.1028** (0.041) (0.041) (0.043) (0.041) (0.043) (0.042) (0.041) (0.042)
Average age of the Board 0.0023* 0.0024** 0.0026** 0.0023* 0.0026** 0.0027** 0.0024** 0.0027** (0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001)
Proportion of Institutional Investor's Share 0.0007* 0.0007* 0.0006 0.0007* 0.0006 0.0006 0.0007* 0.0006
28
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) Prop of Family Promoter Share 0.0004 0.0004 0.0004 0.0004 0.0004 0.0003 0.0004 0.0003
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) Advertisement Intensity -0.2678 -0.2720 -0.2992 -0.2724 -0.3016 -0.3006 -0.2787 -0.3061
(0.215) (0.215) (0.218) (0.215) (0.218) (0.218) (0.215) (0.218) R&D Intensity -0.0432 -0.0454 -0.0609 -0.0500 -0.0730 -0.0663 -0.0566 -0.0803
(0.341) (0.342) (0.342) (0.341) (0.342) (0.342) (0.342) (0.342) Debt to Equity Ratio 0.0005 0.0005 0.0005 0.0005 0.0005 0.0005 0.0005 0.0005
(0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001) Market to Book Ratio 0.0151*** 0.0152*** 0.0152*** 0.0153*** 0.0155*** 0.0154*** 0.0152*** 0.0155***
(0.003) (0.003) (0.003) (0.003) (0.003) (0.003) (0.003) (0.003) Firm Size -0.0268*** -0.0263*** -0.0297*** -0.0271*** -0.0299*** -0.0292*** -0.0267*** -0.0296***
(0.007) (0.007) (0.007) (0.007) (0.007) (0.007) (0.007) (0.007) Constant 0.2164** 0.2234** 0.2166** 0.2139** 0.2128** 0.2227** 0.2212** 0.2188**
(0.092) (0.092) (0.094) (0.092) (0.094) (0.095) (0.092) (0.095)
Observations 4,050 4,050 4,050 4,050 4,050 4,050 4,050 4,050 R-squared 0.028 0.026 0.028 0.028 0.027 0.026 0.027 0.026 Number of cmiecode 651 651 651 651 651 651 651 651
p-value for F-test of 1st Ord Auto Corr 0.2069 0.2091 0.2509 0.2060 0.2488 0.2525 0.2091 0.2526 The table reports the result of fixed effect Panel regression. The dependent variable is ROS winsorized at 1%. All the independent variables are lagged by one period. The regression includes the dummy variable for the year effect. The last row gives p-value of the result of the test for serial correlation in the idiosyncratic errors of a linear panel-data model Wooldridge (2002) and implemented by Drukker (2003) in Stata. Robust firm clustered standard error are given in the parenthesis and the level of significance are indicated by ***, ** and * for 1%, 5% and 10% respectively
29
Figure 1
Figure 2
9.8
9.9
10
10.
11
0.2
Ave
rag
e B
oard
Siz
e
2005 2006 2007 2008 2009 2010 2011 2012Year
Average Board Size Per Year
4.4
4.6
4.8
55
.2A
vera
ge
Nu
mbe
r o
f In
depe
nden
t Dir
ecto
rs
2005 2006 2007 2008 2009 2010 2011 2012Year
Average Number of Indiependent Per Year
30
Figure 3
.44
.46
.48
.5.5
2A
vera
ge
Pro
por
tion
of In
dep
ende
nt D
irect
ors
2005 2006 2007 2008 2009 2010 2011 2012Year
Average Proportion of Indiependent Per Year
31
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