Board Characteristics of Firms Leading to Better Corporate Governance

Board Characteristics of Firms Leading to

Better Corporate Governance

Author:

D. A. de Lijster

Supervisor:

Dr. F. M. de Poel

Co-assessor:

Dr. I. Kalinic

August, 2011

University of Groningen

Faculty of Economics and Business

ABSTRACT

Improving the quality of corporate governance improves the performance of the firm. In this thesis paper, industrial firms from the U.S. and the U.K. are analysed to see whether characteristics of corporate governance that are in place will improve firm value. The results indicate that the size of the board of directors, and the independency of the board are related to firm value and levels of CEO compensation. Ownership structure also relates to CEO compensation levels. Strong independent boards are more adept to monitor management in favour of the shareholders and keep CEO compensation levels under control.

Keywords: Corporate Governance, Firm Value, CEO Compensation, Board Independency, Ownership Structure

David de Lijster

daviddelijster@gmail.com

TABLE OF CONTENTS

TABLE OF CONTENTS ...3

INTRODUCTION ...5

Measuring Corporate Governance ...6

Main Research Question ...7

LITERATURE REVIEW ...7

Origin of Corporate Governance ...7

Separation of ownership and control & agency conflicts....7

Reduce conflicts and align interests and objectives. ...7

Firm Value ...8

Factors Internal to the Firm ... 10

Board structure and characteristics. ... 10

CEO compensation.... 10

CEO-chairman duality. ... 11

Independent directors. ... 12

Factors External to the Firm ... 13

Ownership structure. ... 13

Institutional influence on CEO compensation. ... 15

Table 1 Overview Hypotheses ... 16

Conceptual Model ... 17

Figure 1 Conceptual Model ... 17

METHODOLOGY ... 18

Descriptions of Variables ... 18

Firm value. ... 18

Board independency. ... 19

Size of board of directors.... 19

CEO Duality. ... 19

Independency of the remuneration committee. ... 19

CEO compensation.... 19

Ownership structure. ... 19

RESULTS ... 21

Table 2 Total Descriptive Statistics ... 21

Correlation and Regression Analyses ... 21

Table 4 Regression Model 1 Summary ... 23

Table 5 Regression Model 1 Coefficients ... 23

Analysing per sample group. ... 24

Table 6 Regression Model 1 per Group; Summary ... 24

Table 7 Regression Model 1 per Group; Coefficients ... 24

CEO compensation tests. ... 25

Table 8 CEO Compensation Correlation Coefficients ... 25

Table 9 Regression Model 2 Summary ... 26

Table 10 Regression Model 2 Coefficients ... 26

Ownership structure and blockholders. ... 27

Table 11 Regression Model 3 Summary ... 27

Table 12 Regression Model 3 Coefficients ... 27

Summary of Results ... 28

DISCUSSION ... 29

Corporate Governance Characteristics ... 29

Board size. ... 29

Board independency. ... 30

CEO compensation.... 30

CEO duality. ... 31

Ownership structure. ... 31

The relation to firm value. ... 32

Practical Implications ... 32

Limitations... 33

Suggestion for Further Research ... 33

CONCLUSION ... 34

REFERENCES ... 36

APPENDIX ... 42

INTRODUCTION

Corporate governance has been subject of public discussion ever since corporate scandals (e.g. Enron, WorldCom, Parmalat) and when excessive executive compensation figures hit the news. According to Shleifer and Vishny (1997) corporate governance deals with the way in which the suppliers of capital (principal) to corporations get managers (agents) to return profits back to these suppliers. If corporate governance works fine it is all good and well, however, the recent 2007 financial crisis refuelled the governance discussion as it showed that in banks, certain corporate governance aspects were not working well. It showed that if some characteristics internal to the company (e.g. board structure) and some external to the company (e.g. legislation, shareholder protection) are not designed well enough, some potential risk exists and corporate governance might fail to establish what it is designed for (e.g. see Heremans, 2007).

The corporate governance systems of these banks and financial institutions were extensively reviewed and researched (e.g. Bebchuk & Spamann, 2009; Heremans, 2007; Mülbert, 2009; Wymeersch, 2008), and alterations and improvements were advised that they could make to their corporate governance systems. Such advice and the lessons that were learned in that industry of banks and financial institutions, might also be of practical relevance for ‘regular’, non-finance industry, firms. By using characteristics that are of importance in corporate governance, the corporate governance systems of these regular firms can be analysed and useful recommendations for improvements of their systems can be made, which is practical to managers.

Previous studies into the effect of good corporate governance practices on firm valuation have focussed on relating governance reforms and firm performance over a period of time to measure changes in firm valuation (e.g. Henry, 2008). Other studies focussed on the impact of corporate governance on executive compensation (e.g. Sapp, 2008), or on the impact of firm valuation in countries with less developed corporate governance codes and legislation (Black, 2001; Klapper & Love, 2002). After the governance scandals in the previous decade and before the financial crisis, many governments had already introduced rules and regulations to improve corporate governance. However, it still showed that established firms and banks collapsed or needed government aiding (e.g. Fanny Mae, Freddie Mac, Ford) during the 2007 financial crisis. Clearly, one can wonder whether the corporate governance of established firms relates to better firm performance.

This paper will contribute to the existing corporate governance literature in the following way. I will analyse two groups of firms from developed countries that are already required by their exchange commissions to have good corporate governance characteristics in place. The firms, all from the same industry, are taken from an U.S. and an U.K. stock exchange list. Using previous studies findings of which characteristics are found to be related to good corporate governance, the current structure of the firms will be analysed to find whether such structures relate to better corporate governance.

Measuring Corporate Governance

Main Research Question

The findings of this paper will aid in answering the following main question:

What recommendations can be made to improve the corporate governance systems of firms, when considering the relation to firm value enhancements?

Previous literature will provide the basis for the characteristics of corporate governance that potentially relate to firm value. The next section deals with the literature review.

LITERATURE REVIEW Origin of Corporate Governance

Separation of ownership and control & agency conflicts. First of all, it is necessary to address what corporate governance is about. When owners of a firm (principals or shareholders) hire managers (agents) to run the firm they are delegating the control to these agents. Berle and Means (1932) first pointed out that this separation of ownership and control in a firm may lead to conflicting interests between the shareholders and the managers. Divergent shareholder and management objectives, and the information asymmetry between these parties are additional agency conflicts (Jensen & Meckling, 1976). An underlying assumption of this agency theory is that executives are rational individuals who make decisions that are in their own self-interests and a conflict arises when their interests are not aligned with shareholder interests. The shareholders incur costs to mitigate the agency problems, so called agency costs.

and management. As set forth in the introduction, corporate governance acts a system that deals with the way in which the suppliers of capital (shareholders) to corporations, get the managers (agents) of these corporations to return profits back to these suppliers (Shleifer & Vishny, 1997).

Firm Value

If the corporate governance system works well it is found to improve the performance and valuation of the firm. Ammann et al. (2010) showed, that good corporate governance will improve firm value. They showed that for the average firm in their sample, the costs of the implementation of the corporate governance mechanisms seem to be smaller than the monitoring benefits, resulting in higher cash flows accruing to investors and lower costs of capital for the firms.

Chen, Chung, Hsu, and Wu (2010) found that it is suggested that firms which consistently pursue good corporate governance practices will be more capable of mitigating the conflicts of interests that arise between shareholders and managers, and the corresponding agency costs. This is backed up by findings in prior empirical studies of the relationship that exists between firm performance and corporate governance, in which it is noted that higher firm value and or stronger shareholder rights are readily noticeable in those firms with better governance practices than in those firms with relatively poor governance practices. (See for example, Bebchuk and Cohen (2005); Bebchuk, Cohen, and Ferrel (2009); Core et al. (2006); Gompers et al. (2003)). In fact, Gompers et al. (2003) demonstrate that firms with better governance practices will have higher stock returns than firms with weaker governance practices, arguing that firms with better governance have higher firm value, higher profits, higher sales growth and lower capital. Dittmar and Mahrt-Smith (2007), and Masulis, Wang, and Xie (2007), find that in cases where corporate governance practices are qualitatively weaker, this can ultimately lead to the destruction of shareholder value.

appointing outside directors. Then again, Yermack (1996) reports a significant negative correlation between the proportion of independent directors for one performance variable (Tobin’s Q) but not for other performance variables (sales/assets, operating income/assets, operating income/sales). Yermack (1996) also documents an inverse relation between board size and profitability, asset utilization, and Tobin’s Q.

Agrawal and Knoeber (1996) report a negative relation between the proportion of outside directors and Tobin’s Q. Klein (1998) does not find a significant relation between firm performance and board structure as a whole, but documents that inside director representation on a board’s finance and investment committees correlates with improved firm performance. She finds little evidence that the audit, compensation, and nominating committees, which are usually dominated by independent directors, affect performance.

Chen et al. (2010) emphasize that the positive relationship between corporate governance practices and firm performance is already widely recognized, however, questions still remain as to the ways in which governance works, how it can enhance firm value, and it remains unclear as to whether this relationship is causal. Demsetz and Lehn (1985) suggested that firms may go for firm value enhancement and better governance practices simultaneously. Thus, not only are firm values affected by governance practices, but they will also actively improve their governance practices to achieve higher valuation (Bhagat & Bolton, 2008; Black, Jang, & Kim, 2006; Chen, Chen, & Wei, 2003; Durnev & Kim, 2005; Himmelberg, Hubbard, & Palia, 1999; Palia, 2001).

Factors Internal to the Firm

Board structure and characteristics. Hermalin and Weisbach (1988, 2003) suggest that boards of directors are an endogenous response to agency problems. The board of directors is installed by shareholders to overview the executive management. The board is also responsible for installing auditing and remuneration committees. The Audit committee may assist the board of directors by providing oversight on financial reporting and accounting controls that could alleviate information asymmetry between insiders and outsiders (Klein, 1998; Setia-Atmaja, 2009). The remuneration committee designs the executive compensation packages. When compensation packages for executives are designed as a way to align the interests and objectives of management with that of shareholders, then executive compensation plays a key role as governance mechanism (Sapp, 2008). Therefore, the CEO salary, or better stated as CEO compensation, will also be part of the analysis.

CEO compensation. There are two dominant views as to how executive compensation packages are designed. Under one view of executive compensation, the optimal contracting view, executive compensation packages are designed through arm’s length negotiations to align the executives’ actions with the firm’s business strategy and objectives (Murphy, 1999). In other words, executive compensation is just and instrument, reducing agency conflicts. An alternative view is the managerial power model which highlights the potential role for inter-personal relationships in the negotiations and therefore the ultimate design of executive compensation packages so there may exist a difference between the actual package and the optimal contract (Bebchuk & Fried, 2004). In reality the package design is usually a mixture of the two models (Sapp, Bryant, & Cotte, 2006).

board. In this manner, CEO compensation can act as a further proxy of corporate governance. I expect CEO compensation to relate to the independency and size of the board. Therefore, the first hypothesis can be described as follows:

Hypothesis 1. The size of the board of directors is related to CEO compensation.

CEO-chairman duality. CEO duality is when the CEO also holds the title of Chairman of the Board. This structure is viewed by many as giving CEOs greater control at the expense of other parties, including outside directors (Adams, Hermalin, & Weisbach, 2010). To mitigate the consequent problems, many observers of corporate governance have called for a prohibition on the CEO serving as chairman (Jensen, 1993; Adams et al., 2010). Similarly, Adams, Almeida, and Ferreira (2005) find evidence consistent with the view that CEOs also holding the chairman title appear to hold greater influence over corporate decision making. CEO duality can thus be viewed as decreasing independency and hampering the monitoring ability of the board. If there is CEO duality, the board is weaker and less independent. If the board is large (with or without CEO duality) then it is less powerful too and the monitoring ability decreases. I expect that more independent boards, those with a greater number of outside directors, and without the existence of CEO-chairman duality, have greater ability and propensity to monitor the executive management, therefore increasing the effectiveness of corporate governance. The size of the BoD is the first attribute of corporate governance that I expect to be related to firm value. Hypothesis two is constructed:

Hypothesis 2. The size of board is related to firm value.

It is possible to look at board structures in annual reports and investigate traits of CEO duality. My expectation therein are that with CEO duality, the board is weaker and less independent, and executive compensation packages will be relatively larger. Consequently, this is bad for corporate governance and it decreases firm value.

Hypothesis 3. CEO duality negatively relates to corporate governance and (decreases) firm value.

Hypothesis 4. Firms with CEO duality are likely to have higher CEO compensation.

Independent directors. Directors are typically divided into two groups: inside directors and outside directors. Generally, a director who is a full-time employee of the firm in question is deemed to be an inside director, while a director whose primary employment is not with the firm is deemed to be an outside director. Outside directors are often taken to be independent directors. Financial economists generally suggest that the representation of independent directors on boards increases the effectiveness of boards in monitoring managers and exercising control on behalf of shareholders (Fama & Jensen, 1983; Weisbach, 1988). The most widely discussed question regarding board composition is therefore whether having more independent directors on the board enhances firm performance. A number of studies have been conducted in the U.S. on this issue. For example, a study by Baysinger and Butler (1985) found that the proportion of independent directors was positively correlated with accounting measures of performance. In contrast, Bhagat and Black (2001), Hermalin and Weisbach (1991), and Klein (1998) have found that a higher percentage of independent directors on the board does not have a significant impact on accounting measures of firm performance. A study by Agrawal and Knoeber (1996) show that the proportion of independent directors has a negative relationship to market measures of performance.

One possible explanation for these mixed findings is that most of the corporate governance variables are endogenous (Setia-Atmaja, 2009). For example, firm performance is both a result of the decisions made by previous directors and, itself a factor that potentially affects the choice of subsequent directors. Studies of boards often neglect this issue and therefore produce confusing results (Hermalin & Weisbach, 2003).

Therefore, I expect that:

Hypothesis 5. The presence of independent directors enhances monitoring, and is positively related to firm value.

So far, the relevant characteristics of corporate governance internal to the firm, are the structure, the role, and the independency of the board of directors, and the design of executive compensation contracts. I expect these characteristics to influence firm value and thus be indicators of strong or poor corporate governance (as hypothesised). However, there are factors external to the firm that can influence the above characteristics. Ownership structure is the key factor.

Factors External to the Firm

Ownership structure. The analysis of the ownership structure gives insight over where shareholder control is embedded and how it is divided (Demsetz, 1983). The focus lies on how diversified ownership levels are, how concentrated the ownership is, and whether insider or outsider shareholders dominate. Family firms with family members as both owners as well as managers will be known as firms with insider shareholders. However, firms who’s managers have equity in the firm can be some sort of inside ownership as well. It depends on ownership concentration however, to gauge the degree of influence by the owners. Ownership is concentrated when there are fewer and larger shareholders. These larger shareholders are then also known as blockholders. If there are many smaller shareholders it is known as dispersed ownership. Blockholders can be (large) investing institutions (like banks, investment funds, pension funds) and then it is known as institutional ownership. Blockholders can also be individuals having a stake of more than 20% of all stakes in the company. They will have significant influence on the company management (especially if this individual is part of management or board) or they could have superior influence over other (minority) shareholders, which is bad for corporate governance.

that include share ownership as (bonus) pay. When this occurs, and executives get to own shares, it is known as insider ownership. That is good for corporate governance as it aligns the objectives of managers and shareholders (Dahlquist, Pinkowitz, Stulz, & Williamson, 2003; Erkens, Hung, & Matos, 2009).

The presence of blockholders may also enhance corporate governance. Since blockholders hold a significant percentage of firm equity, they have an incentive to collect information and monitor management (Shleifer & Vishny, 1986) as well as have enough voting power to force management to act in the interest of shareholders (La Porta, López-de-Silanes, & Shleifer, 1999). Therefore, the classic agency conflict described by Berle and Means (1932) should be lower in closely-held firms (concentrated ownership) than in widely-held firms (dispersed ownership) (Setia-Atmaja, 2009).

Ownership concentration can either mitigate or exacerbate agency problems and consequently may affect the composition and effectiveness of the internal governance mechanisms. For example, to facilitate their opportunistic behaviour large controlling shareholders may prefer boards and audit committees that have fewer independent directors (Setia-Atmaja, 2009).

Agency theorists also suggest independent directors can serve to protect minority shareholders against expropriation by large shareholders. Raheja (2005) hypothesizes that the optimal number of independent directors on the board increases as the private benefits to insiders increase. This is because minority shareholders rely on independent boards that have greater power relative to controlling blockholders (Anderson & Reeb, 2004; Westphal, 1998).

An agency theory perspective thereby suggests that controlling blockholders seeking to extract rent for their private benefits are unlikely to assemble boards or audit committees that can limit their control of firms, which implies that a negative relation exists between ownership concentration and board and audit committee independence.

Based on the above I expect the following:

Hypothesis 6 is tested by analysing the relation between ownership concentration with outsider ratio (more outsiders means higher independency) and CEO duality (no is more independent).

Institutional influence on CEO compensation. When blockholders are powerful they are said to have great institutional influence. This spills over to decision-making processes regarding executive compensation as well. The ownership structure should influence the way in which a firm is governed, however, relatively few studies have considered the relationship between executive compensation and ownership structure. According to Core and Guay (1999), and Cyert, Kang, & Kumar (1997), ownership structure is an important determinant of executive compensation because it determines the owners’ incentives to monitor the managers’ performance and set their compensation. The presence of a large shareholder for example, is likely to result in closer monitoring (Shleifer & Vishny, 1986), and therefore less influence for top managers’ over their compensation (Sapp, 2008). Consistent with this observation, other studies find that more concentrated shareholders result in significantly smaller option grants to top executives (Benz, Kucher, & Stutzer, 2001; Cyert et al., 2002). The type of shareholder also plays a significant role in their incentives to monitor and influence executive compensation. For example, Hartzell and Starks (2003) find that more concentrated institutional ownership is related to lower executive compensation and more performance-sensitive compensation. The design of executive compensation packages are thus influenced by ownership structure. The whole structure, design, and ownership concentration are to be considered when analysing these packages to make inferences about the power of the corporate governance system in place.

Therefore I expect that:

To sum up, all hypotheses are shown in table 1 below.

Table 1 Overview Hypotheses

Hypothesis Independent

Variable

Expectation

signa Dependent Variable

1 The size of the board of directors is related to

CEO compensation Size of BoD - CEO Compensation

2 The size of board is related to firm value Size of BoD + Firm Value (Tobin’s Q)

3 CEO duality negatively relates to corporate

governance and (decreases) firm value CEO Duality - Firm Value (Tobin’s Q)

4 Firms with CEO duality are likely to have

higher CEO compensation CEO Duality - CEO Compensation

5 The presence of independent directors enhances monitoring, and is positively related to firm value

Outsider Ratio + Firm Value (Tobin’s Q)

6 Board independence is lower in firms with concentrated ownership

Ownership

Concentration -

Outsider Ratio and CEO duality

7 Firms with concentrated ownership have lower CEO compensation

Ownership Concentration and #of blockholders

- CEO Compensation

a

Conceptual Model

Figure 1 Conceptual Model

Source: Author

METHODOLOGY

The data sample comprises firm data from 72 firms, all from the industrials sector industry. 35 of those firms stem from the Standard and Poor’s 500 list (S&P500) and are mainly firms from the U.S.A. that could be operating internationally. The other 37 firms are from the London Stock Exchange (LSE) and consists of mainly firms that are from the U.K. and could also be operating internationally. From each of the firms data is collected from their annual reports or from their security and exchange commission proxy statements. Data is collected regarding the size of the board, whether they have CEO duality, the ratio of non-executive to non-executive directors that sit on the board, and whether their remuneration committee comprises of non-executive directors. In addition, data regarding CEO compensation is collected, namely the total CEO compensation, how much in % is rewarded in stocks or options, the performance bonus awarded, and the % in of total compensation that is awarded in bonus is calculated. Via DEF 14A SEC filings all the S&P500 firms data are retrieved regarding executive compensation. For the LSE firms, this information is available through their annual reports. These attributes are relevant for the characteristics internal to the firm. The characteristics external to the firm is the ownership concentration and amount of blockholders the firm has. Furthermore, for firm value the Tobin’s Q of each firm is calculated. The sample is in some test divided into the two groups by a dummy variable group. The first group (Gr0) being the firms listed on the U.S. S&P 500 stock exchange and the second group (Gr1) consisting of the firms listed on the London Stock exchange, mainly U.K. firms. This dummy can act as a control variable. In the dataset, it is noted for each firm from which group they stem and this is included in the regression models as independent variable named ‘group’.

Descriptions of Variables

share*total number of outstanding shares. For Tobin’s Q that number is then divided by total assets. Labelled in the paper as ‘Firm value (Tobin’s Q)’.

Board independency. Board independency is measured by looking at the number of independent directors on the board relative to the total number of board members (Henry, 2008). Usually the independent directors are denoted as non-executive directors. Labelled in the results as ‘BoD outsider ratio’.

Size of board of directors. The total number of directors, executive and non-executives sitting on the board. Labelled as ‘Size of BoD’.

CEO Duality. There is CEO Duality if the CEO is also the chairperson of the board of directors (Henry, 2008). Prior studies (e.g., Hermalin & Weisbach, 1998) suggest that board independence diminishes as CEO’s influence increases. If there is CEO duality then an indicator variable is coded 1, if there is not then it is coded 0. Labelled as ‘CEO duality’.

Independency of the remuneration committee. An indicator variable coded 1 means that the remuneration committee (responsible for CEO compensation) consists of only non-executive members of the board of directors and would be 100% independent. If the CEO for example sits on this committee then it is not fully independent and an indicator variable coded 0 will be given. Labelled as ‘Ind. of rem. committee’.

CEO compensation. Data is collected of the total CEO compensation for the year 2010 and the bonus amount received. Labelled as ‘Tot. CEO Compensation’.

more than 2 blockholders = 1. Labelled as ownership concentration and #of blockholders for the amount of blockholders.

Some of the data could be imported into the statistical processing program SPSS as scaled data. Other data had to be standardized. The following variables were standardized to z-score values in order to conduct better data analyses for correlations: BoD outsider ratio; #of blockholders; firm value (Tobin’s Q); tot. CEO compensation; bonus. In the regression models unstandardized data is used.

To test for relations between variables Pearson correlations are run and for ordinal data comparisons spearman correlations are run. The following formula regression models are used for the equations of testing the relation between independent variables on the dependent variables. A relation is expected between CEO duality, the independency of the remuneration committee, board size and board independency. The effect of those on firm value are tested in by regression model 1.

Regression Model 1: Tobin’s Q = f (CEO Duality; Ind. of rem. committee; Size of BoD; BoD outsider ratio).

The expected relation of board size, and board and remuneration independency on total CEO compensation are tested in regression model 2.

Regression Model 2: Tot. CEO compensation = f (Size of BoD; CEO duality; BoD outsider ratio; Ind. of rem. committee).

Lastly, the expected effects ownership structure on the total CEO compensation is tested in regression model 3.

RESULTS

First of all the descriptive statistics are relevant, which are summarized in table 2.

Table 2 Total Descriptive Statistics

Total LSE S&P500

Variable Mean (N=72) Std. Dev. Mean (N=37) Std. Dev. Mean (N=35) Std. Dev.

BoD outsider ratio 0.69 0.23 0.52 0.18 0.88 0.06

Size of BoD 8.63 2.98 6.38 1.50 11 2.20

Firm value (Tobin’s Q) 1.55 3.03 1.37 4.02 1.73 1.41

Tot. CEO Compensation($) 5,762,700 6,679,200 920,739 1,306,320 10,881,000 6,234,410

What stands out from the descriptive statistics, is that the firms from the S&P 500 list have larger board sizes in general relative to the firms from the LSE. Furthermore, they have higher total CEO compensation (mean of $10,881,419.94 for S&P versus $920,738.80 for LSE), almost 12 times bigger. Higher CEO compensation for U.S. firms thus might be because of other factors as well such firm size, maybe a higher standard salary for CEOs in the U.S., or because of larger profits for those firms. Such factors are not included in this paper’s analysis.

Regarding the independency of the boards, it can be noted that the mean ratio of outsiders (non-executives) relative to insiders (executive directors) sitting on the board is 88% for U.S. firms compared to 52% for U.K. firms. From the data it was noticeable that the firms from the LSE list, included 7 firms out of 37 whom where closely held compared to 0 from the S&P list. Furthermore, there are just 4 firms out of 37 the LSE list that had CEO duality situation occurring compared to 24 out of 35 for the S&P lists.

Summarizing, CEO duality is more prevalent in the U.S.A., CEOs in the U.S.A. get paid more, and there are less closely held firms in there, and the ratio of non-executive directors on the board in U.S. firms is higher than on boards of U.K. firms (mean ratio of outsiders on the board).

Correlation and Regression Analyses

coefficients for the variables is provided in table 3. For testing the relationships between to variables containing ordinal data, the Spearman rho test is used. The Spearman rho test is used for the analysis between two ordinal variables and tests for a Non-parametric correlation between two ordinal variables. The correlation between each independent variables and against firm value and CEO compensation as dependent variables is tested for the whole sample (all firms from both the LSE and S&P500). The results are summarized in table 3 below.

Table 3 Correlation Coefficients

Firm value (Tobin’s Q) CEO Duality Size of BoD BoD outsider ratio Ind. of Rem. Committee CEO Compensation Firm value (Tobin’s Q) 1 CEO Duality -0.01 1 Size of BoD 0.34** 0.39** 1 BoD outsider ratio 0.44** 0.32** 0.80** 1 Ind. of Rem. Committee 0.10 -0.17 0.35** 0.60** 1 CEO Compensation -0.41 0.50** 0.77** 0.62** 0.25** 1 N=72

** Correlation is significant at the 0.01 level (2-tailed).

The largest correlation of the independent variables is 0.80 between the size of the board and the ratio of outsiders to insiders on the board. Other significant correlations are 0.60 and 0.44 between the outsider ratio and the independency of the remuneration committee, and the outsider ratio and firm value respectively. Furthermore, it stands out that the size of the board is related to the independency of the board, independency of the remuneration committee, and whether CEO duality is prevalent or not. In the same manner, the independency of the board relates heavily to the independency of the remuneration committee as could be expected.

CEO compensation as independent variable does not seem to correlate with firm value in my sample. More CEO compensation analysis will be discussed further down in this paper. The findings of the above correlation tests also infer that for my sample, a larger board size increases the independency of both the BoD and that of the remuneration committee. A BoD with a higher outsider ratio (more independent BoD) also increases the independency of the remuneration committee.

Using regression analysis, the firm value can be stated as the dependent variable and tested to each of the independent variables. Regression model 1 is tested to see if there is a significant effect of the size of the BoD, the independency of the board, and CEO duality, on the firm value. I expected these indicators of firm side corporate governance characteristics to have an effect on the firm value expressed in Tobin’s Q.

Regression Model 1: Tobin’s Q = f (CEO Duality; Ind. of rem. committee; Size of BoD; BoD outsider ratio).

Table 4 Regression Model 1 Summary

R² R² Change F Sig. F Change Sig. F Change

0.04 0.04 0.59 0.704 0.59 0.704

The model summary shows a fit of just 4% reflected by the R² which is really weak. Looking at coefficients below in table 5, it can be concluded that the independency of the board does not seem to be reflected in the valuation of the firm in terms of Tobin’s Q.

Table 5 Regression Model 1 Coefficients

Independent variable Beta Sig.

Constant 3.79 0.271

Size BoD -0.30 0.141

CEO Duality? -0.25 0.812

BoD outsiders ratio 0.41 0.910

Ind. of Rem. Committee 1.08 0.569

Group (as control variable) -1.58 0.370

Analysing per sample group.

Table 6 Regression Model 1 per Group; Summary

Group R² R² Change F Sig. F Change Sig. F Change

LSE 0.02 0.02 0.13 0.971 0.13 0.971

S&P 500 0.33 0.33 5.01 0.006 5.01 0.006

Table 7 Regression Model 1 per Group; Coefficients

Independent variable LSE S&P 500

Beta Sig. Beta Sig.

Constant 1.17 0.780 10.13 0.004

Size BoD -0.24 0.647 -0.30 0.005

CEO Duality? 0.39 0.917 -0.43 0.344

BoD outsiders ratio 1.48 0.788 -5.51 0.154

Ind. of Rem. Committee 1.07 0.762 ---* ---*

Dependent variable: Firm value reflected by Tobin’s Q

* This variable was constant in sample group S&P 500 and therefore deleted from the analysis

When tested for both groups separately, U.K. firms from the LSE and U.S. firms from the S&P500 list, the results show that in the model from LSE the independent variables explain just 2% of model 1 for the firm value. Shown by R² of 0.02. It also shows in the non-significant values of beta for each variable. For the group of firms from the S&P500 lists however, the model explains 33 % which is quite stronger.

When analysing the beta coefficients, it shows that the only significant value is the size of the BoD and that seems to be the only variable related to firm value. Comparing the groups, I can infer that the board size of U.S. firms from the S&P500 lists, whom in the sample have predominantly larger boards than the LSE firms, is related to firm value. The Beta coefficient is negative (-0.30) thus I expect size of BoD to be negatively related to corporate governance shown by a decrease in firm value. What stands out is, that in the group regression analysis, it shows that for the U.S. firms, the size of the board is significantly negatively related the firm value. However, none of the other variables seem to have significantly impact on firm value. The results do indicate that size of the BoD is significantly related to firm value. I therefore accept Hypothesis 2: The size of the board of directors is related to firm value. A larger board has higher independency from executive directors, which relates positively to firm value.

The direct relation of CEO duality and firm value cannot be significantly identified. Hypothesis 3: CEO duality negatively relates to corporate governance and (decreases) firm value, can therefore not be accepted.

Considering the independency of the board reflected by the ratio of outside directors, they were expected to enhance monitoring and increase firm value. From the results it shows that there is a significant relation between outsider ratio and firm value, leading to the acceptance of hypothesis 5: The presence of independent directors enhances monitoring, and is positively related to firm value.

CEO compensation tests. In order to test the hypotheses concerning the influences on CEO compensation, I created a model with CEO compensation as dependent variable.

In table 3 the correlation coefficients were given, however the variables for ownership structure were not included. Those are included in table 8 below, which summarizes the correlation results of all independent variables correlation towards CEO compensation. The correlations that are blanks are not relevant and not tested.

Table 8 CEO Compensation Correlation Coefficients

CEO Compensation CEO Duality Size of BoD BoD outsider ratio Ind. of Rem. Committee #of blockholders Ownership concentration CEO Compensation 1 CEO Duality 0.50** 1 Size of BoD 0.77** 0.39** 1 BoD outsider ratio 0.62** 0.32** 0.80** 1 Ind. of Rem. Committee 0.25** -0.17 0.35** 0.60** 1 #of blockholders -0.232 1 Ownership concentration -0.27* -0.07 -0.37** -0.24* 0.87** 1 N=72

** Correlation is significant at the 0.01 level (2-tailed). * Correlation is significant at the 0.05 level (2-tailed).

independency of the remuneration committee correlate so strongly with CEO compensation, shows that the independency of the board is greatly related to the total compensation of the CEO. Ownership concentration is dealt with separately after this sub part about CEO compensation.

Next are the results of the regression model for CEO compensation: Regression Model 2: Tot. CEO compensation = f (Size of BoD; CEO duality; BoD outsider ratio; Ind. of rem. committee).

Table 9 Regression Model 2 Summary

R² R² Change F Sig. F Change Sig. F Change

0.67 0.67 26.23 0.000 26.23 0.000

Table 10 Regression Model 2 Coefficients

Independent variable Beta Sig.

Constant -2,173,903.57 0.627

Size BoD 1,126,313.60 0.000

CEO Duality? 2,106,236.85 0.124

BoD outsiders ratio -2,226,623.78 0.641

Ind. of Rem. Committee 1,180,683.24 0.633

Group (as control variable) -4,154,158.82 0.073

Dependent variable: Tot. CEO Compensation

From the regression model I can infer that the model fits 67%, meaning it can explain the relations of the included independent variables on CEO compensation by 67%. The significant variables in the model are size of the BoD and CEO duality. This confirms the correlation findings that the size of the board is greatly related to the amount of total CEO compensation. Furthermore, the model shows that board independency (and especially considering the size of the BoD and the independency of the CEO) are related to total CEO compensation. According to these findings, hypothesis 1: The size of the board of directors is related to CEO compensation, is accepted.

Ownership structure and blockholders. As seen in table 8, the significant correlations for ownership structure are 0.87 and -0.27 between the concentration of ownership and number of blockholders and CEO compensation respectively. Moreover, correlations are found between ownership concentration and outsider ratio on the board and with independency of the remuneration committee, respectively shown by coefficient values -0.37 and -0.24. If for board independency these variables are used, then this leads to the acceptance of hypothesis 6: board independence is lower in firms with concentrated ownership. No significant correlation is found between ownership concentration and CEO duality however. The results furthermore indicate, that that no correlation exist in the sample between the concentration of ownership and firm value or between number of blockholders and firm value (both not shown in tables). The direct relation of ownership concentration and number of blockholders on firm value are thus not identified for this paper. Splitting and testing just ownership concentration on Firm value, no significant relation was found either (not shown in table).

The regression of model 3 can show more results regarding the interrelation of ownership structure on CEO compensation. In contrast to the correlation table 8, no proof of significance is found in the 3rd regression model. Regression Model 3: Tot. CEO compensation = f (#of blockholders; ownership concentration).

Table 11 Regression Model 3 Summary

R² R² Change F Sig. F Change Sig. F Change

0.56 0.56 29.36 0.000 29.36 0.000

Table 12 Regression Model 3 Coefficients

Independent variable Beta Sig.

Constant 1.09 0.000

#of blockholders 67,105.99 0.978

Ownership Concentration -807,154.00 0.826

Group (as control variable) -9,824,299.41 0.000

Dependent variable: Tot. CEO Compensation

number of blockholders. It seems that the group (LSE or S&P500) matters in this analysis, which is why an additional test per group was run (not shown in tables). Looking at the results of those tests the model for each group show no significant values either. No test was possible for the S&P 500 group since all values where constant (i.e., the firms in the S&P 500 group all had dispersed ownership concentration and no blockholders). For the LSE group, the model just explained 5% (R²= 0,05) so no proof for a fit there either. Because of the existence of a relation between ownership concentration and CEO compensation, hypothesis 7: Firms with concentrated ownership lower CEO compensation, can be partially accepted. This is because there is no certainty to say if concentrated ownership leads to higher or lower CEO compensation, just that is related.

Summary of Results

Summarizing the results I can say that the key findings are that:

- A larger board size relates to independency of the board, and of its remuneration committee.

- The size of the board of directors is related to the height of total CEO Compensation.

- Boards with a higher outsider ratio (more independent BoD) is related to a more independent remuneration committee.

- The independency of the board does not seem to be reflected in the valuation of the firm in terms of Tobin’s Q when considering the regression model. However, correlations show that the variables for board independency such as outsider ratio, board size, and independency of the remuneration committee, are clearly related to firm value.

- The size of the board is related to firm value.

- The independency of the board has is highly related to the total compensation of the CEO.

- There does not seem to be a relation between ownership concentration and number of blockholders on firm value.

- Ownership concentration does however relate to the total CEO compensation in a certain way.

DISCUSSION

Reviewing the results, the following findings can be summarized. The main results of the tests confirm some expectations while for other no or insufficient proof is found. Board size is of importance as it relates firm value, to the independency of the board, that of its remuneration committee, and it relates to the amount of CEO compensation. More independent boards are found to have more independent remuneration committees, creating more monitoring power and to control CEO compensation better. This could be a positive development in terms of enhancing firm value. It is not directly found in the regression model results however, that board independency or ownership structure relate to firm value. Ownership concentration does relate though to CEO compensation, however this could not be shown in the regression model either. Considering the raw data, it is noticeable that U.S. firms’ CEOs are paid higher compensation. This could be because of differences in corporate culture or differences in absolute size of the companies relative to U.K. firms. CEO duality is also more prevalent in the U.S.A. compared to almost no CEO duality in the U.K. This has to do with the differences in corporate governance codes of each exchange commission. The U.S. firms are still free to decide on the matter while U.K. codes subscribe separation of CEO and chairman of the board functions (Taylor, 2004). Firms from the U.S. are generally more widely held (dispersed ownership concentration), and the ratio of non-executive directors on the board in U.S. firms is higher than on boards of U.K. firms. Each governance characteristic deserves some food for thought and I will proceed with discussing them.

Corporate Governance Characteristics

However, in larger boards, especially prevalent in firms from the S&P500 list containing predominantly U.S. firms, the majority had CEO duality. As such the country’s corporate culture and governance regulation play a big role in board composition and it is hard to say with the attributes used in this paper, what exactly is better for firm value or a better corporate governance system. There is an excellent study by Mak and Kusnadi (2005) and they looked at board size relative to firm value in Tobin’s Q for Singapore and Malaysia. Their results indicated that a board size of around 5-6 members was optimal for firm value. However, they could not say that one size fits all and of course many other variables also play a role in determining optimal board size or optimal firm value.

Board independency. The finding in this paper that board independency is significantly related to firm value is in line with the findings of other studies. Aggarwal, Erel, Stulz and Williamson (2009) for example, compared the governance standards of non-U.S. firms with that of matching U.S. firms. They found that firms that have an independent board, audit and remuneration committees composed solely of outsiders, to have a higher value when their U.S. matching firm has these attributes as well. However, they found that neither the size of the board, nor the separation of the chairman and CEO functions to be value relevant in contrast to my sample. In my sample the size of the board seems especially value relevant. The results identifying relationships between board independency variables with firm value, seem in line with other studies that would agree on that it is generally good to have independent directors. Berle and Means (1932), Chalevas 2011, Williamson (1985), Jensen and Meckling (1976) for instance, argue that independent non-executive directors board members can control the opportunistic behaviour of management. Furthermore, Almazan and Suarez (2003), and Mehran (1995) find that the performance of executives is better evaluated and taken into consideration when designing executive compensation as the percentage of independent non-executive directors increases.

still be great, hence I expect larger boards to be weaker. There is a reflection of this in my results leading to higher CEO compensation in the firms with larger boards, however, the other factors are not included in the analysis and those could be determining for the level of CEO compensation as well. The U.S. firms could be larger, have earned higher profits or maintain higher base standards for CEO compensation for example.

CEO duality. CEO duality could be an indicator that the board is less independent and that the CEO has more power. This could mean that he has more power in influencing his compensation level. Such a board might be considered weaker vis-à-vis the CEO which is negatively related to firm value. Chalevas (2011) and Taylor (2004) proclaim that board chairmen/CEOs have the power to define executive compensation because they build a board of members over whom they hold strong influence. The same holds for decisions regarding other management projects that could be detrimental to the net expectations of shareholders. It is thus not always in the best interest of shareholders if there is CEO duality. If there is, the interests of both CEO and shareholders should be carefully aligned.

Ownership structure. How does ownership structure influence the independency of the firm and what effect does it have on CEO compensation (and or firm value)? The results suggest that ownership concentration is related to CEO compensation. This confirmed my expectation. However, I could not find sufficient significant evidence relating ownership structure and board independency. There was a limited number of firms in my sample that had a concentrated ownership structure and it occurred mainly in some U.K. family controlled firms, thus sample size issues do play a larger role for this variable. Then what is found by other studies that researched the effect of ownership structure on corporate governance?

blockholders. Thus concentrated ownership or the presence of blockholders should lead to lower CEO compensation.

The relation to firm value. The results of this paper suggested that most of the corporate governance variables are related to firm value or CEO compensation, however, the regression models generally fail to significantly find a fit in the models when multiple variables are included. According to Dey (2008), one explanation for mixed results regarding the firm value and governance relation, is that governance mechanisms are likely to positively affect overall firm performance only under certain circumstances. Dey showed that the level of agency conflicts can be determining whether certain governance mechanisms work and whether those would enhance firm performance. When the firm encounters high agency conflicts, the governance mechanisms in place are important for monitoring, while in firms with less agency conflicts, do not require as much monitoring. Whenever agency conflicts are high, Dey, found that firm value is positively associated with board composition, director compensation, and independency of the audit and remuneration committees. Executive compensation was not found to be relative to firm value however, in either case of agency conflicts in his study. Thus, for a better analysis, the state of the firm as whether they encounter high or low agency conflicts, must be examined before analysing the numbers and attributes of governance and make inferences about whether or not the (corporate governance) structure of that firm is good or bad for its performance.

Other studies have found similar results in their samples after initial expectations of correlation between the governance variables or company characteristics with valuation measures, however, fail to significantly prove it. One such study, by Setia-Atmaja (2009), explains that the impact of company or governance characteristics on firm value can be moderated by other variables. For instance, in his study, Setia-Atmaja found, that the impact of board independence on firm value is moderated by ownership concentration and dividend policy. This makes it clear that the influence of other variables have to be considered before making inferences that one or a few variables together determine firm value.

Practical Implications

improving or installing the attributes that belong to good corporate governance, enhancements in firm value can be realised. The board of directors is better capable in monitoring management if the board is more independent. Independency can be achieved by installing a board sized great enough to organise vis-à-vis the CEO, but not be too large to lose efficiency. Furthermore, CEO duality is not preferred, but a fully independent remuneration committee is. This also helps controlling the CEO compensation level in favour of a sufficient high amount to please both the shareholders as well as CEO.

If firm value is positively affected by the influences of corporate governance, then it also shows that the monitoring costs are not very high. This makes the firm more attractive for investors, which is good if one of the goals of the firms is to attract capital at lower costs.

Limitations

Some limitations of this study are the issues with sample size and both sample firms being from countries with already high standards of corporate governance reforms. The firms have to adhere to high accounting standards that for instance require a certain amount of outside directors on the board. Most of the firms if not all, subsequently had outsider ratios higher than 50%. It was a goal to look at firms that are developed in this sense, however, finding actual causal relations could be biased because of this. Other limitations may concern the fact that there are many attributes of governance out there and it was beyond the scope of this thesis to include all of them in each analysis. Aside from attributes that are good for corporate governance there are also governance practices, such as meetings, risk management, information disclosure etc. that could improve the overall corporate governance system of a firm. These are also not included in my study.

Suggestion for Further Research

form of equity shares or share options and how that relates to the independency of the directors and executives.

CONCLUSION

In this thesis paper I analysed the effects of corporate governance mechanisms both internal and external to the firm on firm value reflected in Tobin’s Q. The data sample of firms used were firms from the U.K. and the U.S.A. all from an industrial sector. I considered firm side governance attributes such as the independency of the board of directors and what effect that might have on both firm value and the total compensation for the CEO. Governance attributes external to the firm that I used were ownership structure, especially concerning the concentration of ownership and the amount of blockholders.

The main question this thesis addressed is, What recommendations can be made to

improve the corporate governance systems of firms, when considering the relation to firm value enhancements? The construction of variables and developments of the hypotheses

formed the basis of which characteristics of corporate governance expect to relate to enhancements of firm value, and by doing so, proving the value of the firms’ corporate governance. The corporate governance characteristics internal to the firm that are considered are board structure (size of the board), the independency of the board (outsider ratio, independency of the remuneration committee, and whether or not there is CEO duality). The factor external to the firm is ownership structure, looking at ownership concentration and the number of blockholders.

The size of the board of directors is related to CEO compensation and to firm value. A larger board has higher independency from executive directors, which relates positively to firm value. The direct relation of CEO duality and firm value cannot be significantly identified. It is evident however, that CEO duality relates to CEO compensation. It is likely that firms with CEO duality to have higher CEO compensation. There is a significant relation between outsider ratio and firm value, meaning that the presence of independent directors enhances monitoring, and is positively related to firm value.

independency is lower in firms with concentrated ownership. Firms with concentrated ownership have lower CEO compensation because blockholders are better able to monitor management and have control in deciding on CEO compensation.

Using firm value as a proxy for good corporate governance, it can be stated that good corporate governance characteristics are those that relate in a positive way to firm value. When corporate governance is working well, this is also reflected in a having a satisfactory control over CEO compensation from a shareholder viewpoint, which then also enhances firm value. Recommendations are to have installed an independent board in terms of more non-executive than non-executive directors, separation of the chairman of the board and CEO positions, and an independent remuneration committee consisting of non-executive directors. The size of the board is of great effect and should not be too small and preferably on the larger size but small enough to be in organised control over the CEO.

If overall corporate governance quality is high, and in adhering to good corporate-governance practices, companies can significantly improve their performance. The degree of agency conflicts has to be known in order to accurately implement corporate governance mechanisms. If there is good corporate governance in place then investors are also more likely to provide capital because they believe the cost of monitoring is lower, which means lower cost of capital for firms seeking external financing.

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