Firm Performance and Board Composition: An Empirical Study of Chinese Listed Firms
Master Thesis
MSC IE & B Li Xiang s1410075
Rijksuniversiteit Groningen
Department of International Economics & Business Landleven 5
9747 AD Groningen The Netherlands Tel: (031) 50-1234567 Fax: (031) 50-3633720
Supervisor: Dr. Gabor Peli
Table of Content
1. Abstract..………3 2. Introduction……… 3,4 3. Theoretical Background
Agency Theory……….………...4,5
Stewardship Theory………...6 4. Literature Review………...6,7 5. Board of Director’s composition………8,9 6. Hypotheses about board of directors composition and their association with Financial Performance………10, 11, 12 7. Method
Sample Selection………12-13
Measurement……….……….13-16
Regression Model………...16-17 8. Analyze Result………17-19 9. Conclusion………...19 10. Discussion and Future Research………20-21 11. References………..22-24 12. Appendix A………24-25 13. Appendix I………...25 14. Appendix II……….….26 15. Appendix II……….….27
Firm Performance and Board Composition: An Empirical Study of Chinese Listed Firms
Abstract. Since 1993, the Chinese government has made the development of modern corporate system a focus of its enterprise reform. The establishment of corporate
governance structures, primarily take the form of the Anglo-American corporate
governance model (Tam, 2000), but whether this model fits China’s current institutional and cultural contexts is still in question. Agency theory and stewardship theory are two main streams of corporate governance approach, which represent conflicting assumptions about human behavior and different prescriptions about corporate mechanisms. Based on these two theories, hypotheses about the relationships between board composition and firm performance will be developed in Chinese listed firms. As China is still in economy transition, its institutional context is different from many others and so does its influence on board composition. This study will draw a sample of Chinese publicly listed firms to test whether the hypotheses can be supported or not and thus examine the relationships between board composition and firm performance in a Chinese context.
Introduction
Corporate governance is defined as the system by which companies are directed,
controlled and evaluated. Responsibility for corporate governance lies primarily with the board of directors. The role of shareholders and other investors is to appoint directors and to ensure that a proper governance structure isin place. Another more explicit definition of corporate governance states that it is the structure whereby managers at the
organizational apex are controlled through the board of directors, its associated structures, executive incentive, and other schemes of monitoring and bonding (Donaldson, 1990).
The board of directors has been researched very often as a corporate governance mechanism in corporate governance literature (see e.g. Daily et al., 1998; Zahra and Pearce, 1989). In particular, much empirical research has been done concerning the relationship between board composition (usually defined as the proportion of outside
directors on the board) and corporate performance in different industry sectors or in different countries, the results demonstrate little consistency (Daily et. al., 1998).
Different theories have been proposed to explain how the board of directors influences organizational outcomes (Blair, 1995). There are a numbers of sometimes competing theories contribute to the corporate governance agenda, including agency theory, stewardship theory, resource dependence theory, institutional theory and stakeholder theory (Kiel & Nicholson, 2003). This study employs two competing approaches-agency theory (Fama, 1980) and stewardship theory (Davis et al.1997) as theoretical background to examine the relationship between board composition and corporate performance in Chinese context.
Agency theory which assumes that human behavior is opportunistic and self- serving in nature, therefore, the fundamental function of board of directors is to control managerial behavior and ensure that top managers act in the interests of shareholders (Fama,1980). Stewardship theory assumes that managers are good stewards of the corporation. Based on different assumptions of human behavior, agency theory and stewardship theory provides different prescriptions about effective corporate governance mechanisms. Therefore, taking these two theories simultaneously into analysis is more appealing.
This paper aims to investigate the relationships between board compositions and corporate performance in Chinese listed firms and thus testing whether these theories with regards to the board composition can apply to Chinese context or not. I assume that both theories can be applied to the Chinese context ⎯ a changing institutional framework and non-American research settings.
Theoretical background
Agency Theory
During the 1960s and early 1970s, economists explored risk sharing among individuals or groups (e.g., Wilson, 1968). This literature described risk-sharing problem as one that arises when cooperating parties have different attitudes toward risk. Agency theory broadened this risk-sharing literature to include the so-called agency problem that occurs when cooperating parties have different goals and division of labor (Jensen & Meckling, 1976; Ross, 1973). Agency theory is concerned with resolving two problems that can
occur in agency relationships. The first is the agency problem that arises when (a) the desires or goals of the principal and agent conflict and (b) it is difficult or expensive for the principal to verify what the agent is actually doing.
Agency theory structure is applicable in a variety of settings, ranging from macro- level issues such as regulatory policy to micro-level dyad phenomena such as blame, impression management, lying and other expressions of self-interest. Most frequently, agency theory has been applied to organizational phenomena such as acquisition and diversification strategies (e.g.Amihud & Lev, 1981), board relationships (e.g.Fama &
Jensen, 1983), ownership and financing structure (e.g. Argawal & Mandelker, 1987;
Jensen & Meckling, 1976), vertical integration (Anderson, 1985; Eccles, 1985), and innovation (Bolton, 1988; Zenger, 1988). Overall, the domain of agency theory is relationships that mirror the basic agency structure of a principal and an agent who are engaged in cooperative behavior, but having differing goals and differing attitudes toward risk.
The relationship between stockholders and the manager of a firm has been described as the “pure agency relationship”, because it is associated with the separation of ownership and control (Jesen & Meckling, 1976). Based on the assumption that the principal (stockholder) and agent (top executives) are likely to have conflicting goals, agency theory describes the board of directors as an information system that the stockholder within large corporations could use to monitor the opportunism of top
executives (Eisenhardt, 1989). Since information systems inform the principal about what the agent is actually doing, they are likely to curb agent opportunism because the agent will realize that he or she cannot deceive the principal. The objective in agency theory is to reduce the agency costs incurred by principals by imposing internal controls to keep the agent’s self-serving behavior in check (Davis, 1997). Agency theory stress that board independence has a positive effect on board effectiveness (Huse, 1994).
Although agency theory appears to be the dominant paradigm underlying most governance research and prescriptions, researchers in psychology and sociology have suggested theoretical limits of agency theory (Hirsch, Michaels, & Friedman, 1987;
Perrow, 1986). In particular, assumptions about individualistic utility motivations in agency theory resulting in principal-agent interest divergence may not hold for all managers. Therefore, exclusive reliance upon agency theory is undesirable because the
complexities of organizational life are ignored. Additional theory is needed to explain other types of human behavior, and this is found in literature beyond the economic perspective.
Stewardship theory
In comparison, stewardship theory has its roots in psychology and sociology and was designed for researchers to examine situations in which executives as stewards are motivated to act in the best interests of their principals (Donaldson & Davis, 1989). In stewardship theory, the model of man is based on a steward whose behavior is ordered such that pro-organizational, collectivistic behaviors have higher utility than
individualistic, self-serving behaviors. Given a choice between self-serving behavior and pro-organizational behavior, a steward’s behavior will not depart from the interests of his or her organization. According to stewardship theory, the behavior of the steward is collective, because the steward seeks to attain the objectives of the organization (e.g.
sales growth or profitability). This behavior in turn will benefit principals such as outside owners (through positive effects of profits on dividends and share prices) and also
principals who are managerial super ordinates, because their objectives are furthered by the steward.(Donaldson and Davis, 1997). Stewardship theorists assume that managers are good stewards of the corporation. They are trustworthy and work diligently to attain high levels of corporate profit and shareholders’ returns. (Donaldson and Davis, 1994) In Comparison with agency theory, stewardship theory focuses on the positive performance implication of the corporation between the board and the firm managers (Davis et al., 1997).
Literature review
Outside directors are positively related to firm profitability (Agency theory) Some empirical research has found that effective board will be comprised of outside directors. For example, Ezzamel and Waston (1993), found outside directors were positively associated with profitability among a sample of U.K. firms. In an examination of 266 U.S. corporations, Baysinger and Bulter (1985) found that firms with more outside board members realized higher return on equity. Several other researchers have also noted a positive relationship between outside director representation and firm
performance (Pearce and Zahra, 1992; Rosenstein and Wyatt, 1990; Schellenger, Wood, and Tashakori, 1989)
Inside directors are positively related to firm profitability (Stewardship theory) Some researchers also found that inside directors were associated with higher firm performance. In an examination of Fortune 500 corporations, Kenser (1987) found a positive and significant relationship between the proportion of inside directors and returns to investors.
Board composition has no effect on firm performance
Another additional stream of research found that there is no relationship between board composition and firm performance (Chaganti, Mahajan, and Sharma, 1985; Daily and Dalton, 1992, 1993; Zahra and Stanton, 1988). A recent meta-analysis based on 159 samples of board composition found that there is no substantive relationship between board composition and firm performance (Dalton et. Al., 1998)
This overview demonstrates that there is little consistency in the research findings for board composition and financial performance. It also illustrates the importance of considering multiple theoretical perspectives in explaining this complex relationship.
Why many researchers have different findings concerning the relationship between board composition and firm performance? There is an explanation:
“ It is reasonable to believe that the inclination of individuals to act as stewards or self-seeking agents may be contingent on the institutional context (Turnbull, 1997).”
In a similar vein, whether the board acts as an effective monitor or an ineffective “rubber stamp” depends on the institutional context in which it plays its role.
Based on this assumption, this paper is designed to answer the research question:
How is the relationship between board composition and firm performance characterized in Chinese firms? Which theory fits Chinese context?
The ongoing corporate governance reform in China is aimed to duplicate the stylized Anglo-American corporate governance model in the SOEs and enhance board independence (Wu et al.,1998). That means China’s board reform philosophy is
consistent with agency theory. However, this reform has been carried out in a transition economy framework and a collectivist cultural context (Tam, 1999). Stewardship theory which focus on social and psychological dynamics of board-management relationship seems to be an appropriate theory for examining Chinese corporate boards of directors as
well. Given this background, I assume that agency theory and stewardship theory can fit Chinese modern corporate governance model concerning the relationship between board composition and corporate performance.
Board of Directors’ Composition
Research results suggest that board composition is an important variable in understanding directors’ performance of their responsibilities and contribution to corporate financial performance. Board composition refers to the number of directors (board size) and type of members as determined by the usual insider or outsiders classification (Pearce & Zahra 1992). Insiders are current members of the top management team and employees of the company or its subsidiaries. Outside directors have no association with the company or its subsidiaries, but are further grouped as affiliated or non-affiliated (independent).
Affiliated outsiders are not members of the current management or employees of the company but have close links with the firm (Pearce & Zahra 1992), as in the case of former executives or consultants. Non-affiliated outsiders are usually referred to as independent directors. They have no any link with the operation of the company. They are recruited primarily because of their expertise, name recognition and skills (e.g.
famous professors, experts in some specific fields). In theory, these independent directors are not under the control of the company’s executives.
Daily et al. (1999) suggests that researchers should match the measurement of board composition with the theoretical thesis about board role and effectiveness.
Following this advice, I will define board composition under Chinese context in order to capture the characteristics of the institutional framework.
China’s economic reform has been a gradual and evolutionary process based on experiences from experimentation. Many Chinese enterprises (especially those in manufacturing industries) experienced a restructuring process before going public. A SOE must be converted into a limited liability shareholding company before it can issue shares to the public. Under planning economy system, the government requires SOEs to provide an expensive array of benefits for their workers and their families, including housing, health care, pensions, vacations and education. In the process of market economy, many SOEs have in effect been privatized by issuing shares of stock and by having some or all of their welfare obligations moved to other entities. Hence, it is
necessary to “ carve out” its nonproductive and unprofitable units and keep only profitable business units in the shareholding company in order to attract investors (Aharony et al., 2000) Since 1993, the corporatisation of SOEs and their listing on stock markets was carried out very quickly. The key features of this initiative were the approval of diversified forms of ownership by State, private and foreign investors, which would compete on equal terms in the marketplace, and the introduction of a framework for the modern corporate governance of State-owned firms (Jian Chen & R.Strange 2004).
Notwithstanding the requirement that the fraction of shares offered to the public during the IPO (initial public offering) should be at least 25 percent, the Chinese government still maintains control over many previously State-owned firms. As a result of such restructuring, the old SOEs often becomes the only or the leading sponsor of the new share-holding company. The shareholding company and the old SOEs are affiliated in the sense that the latter continues to provide various services to the former, and the former may rent land (in a very preferential price) or production facilities from the latter. An examination of the annual reports of Chinese listed firms reveals that such link between share-holding companies and old SOE is very common.
Having introduced the unique Chinese corporate context, I define the fully independent directors (non-affiliated) as directors who are not employed by the share- holding company and its old SOE (including its subsidiaries). Thinking of the link between the share-holding company and the old SOE, I define the affiliated directors as the directors who represent the sponsor enterprises (the old SOE) of the share-holding company. The affiliated directors constitute a special social group that has close connection with the share holding company, and is worth scrutiny under the lens of stewardship theory.
Board Composition under Chinese Context Outside Directors Inside Directors Fully Independent directors(Non-
Affiliated)
Affiliated directors Directors who are current
members of the top management team and
employees of the company or its subsidiaries
Directors who are not currently employed by the focal
shareholding and its affiliated companies (including sponsor enterprises and its subsidiaries)
Directors who represent the sponsor
enterprises of the shareholding company
Hypotheses about board of directors composition and their association with financial performance
Agency theory (Eisenhardt, 1989; Jensen and Meckling, 1976) has been a dominant approach in the economics and finance literatures. Agency theory is concerned with aligning the interests of owners and managers (Fama, 1980) and is based on the premise that there is an inherent conflict between the interests of a firm’s owners and its
management. The clear implication for corporate governance from an agency theory perspective is that adequate monitoring or control mechanisms need to be established to protect shareholders from management’s conflict of interest –the so-called agency costs of modern capitalism (Fama and Jensen, 1983). Agency theory leads to normative recommendations that boards should have a majority of outside and ideally, independent directors and the position of chairman and CEO should be held by different persons (OECD, 1999). The standard view in agency theory is that the degree of board independence is closely related to its composition (John and Senbet, 1998). Based on these approaches, agency theorists highlight the positive effect of greater proportion of outside directors on corporate performance. In Chinese companies, the fully independent directors may be invited for personal reputation or their expertise on specific fields.
Therefore, in align with agency theory, a hypothesis can be derived as the following:
H1a : The high representation of fully independent directors on the board are associated positively with the financial performance of Chinese listed companies.
As affiliated directors have connections with the operation of the company, e.g.
they work in the same enterprises with most of the top management of the share-holding company. Therefore, the more affiliated directors present on the board, the less
independence of the board is. According to agency theory, the affiliated directors are more likely to be manipulated by the self-serving managers with various entrenchment practices (Walsh and Seward, 1990). According to this approach, a hypothesis as the following can be derived:
Hypothesis 1b: The high representation of affiliated directors on the board are associated negatively with the financial performance of Chinese listed companies.
Although agency theory appears to be the dominant paradigm underlying most governance research and prescriptions, researchers in psychology and sociology have suggested theoretical limits of agency theory ( Hirsch, et al., 1987). In particular, assumptions made in agency theory about individualistic utility motivations resulting in principle-agent interest divergence may not hold for all managers (Davis & Donaldson, 1997). Stewardship theory has been introduced as a means of defining relationships based upon other behavioral premises. In stewardship theory, the model of man is based on a steward whose behavior is ordered such that pro-organizational, collectivisitc behaviors have higher utility than individualistic, self-serving behaviors (Davis, 1997).
Individualism is characterized as the emphasis of personal goals over group goals.
Collectivists subordinate their personal goals to the goals of the collective (Triandis, 1995). Individualism is a cultural pattern found in United States, Canada and Western Europe. Collectivism is common in Asia, South America, and southern Europe. China is generally known as a collectivism country, the self is defined as a part of the group.
Under Chinese culture context, the assumption of stewardship theory can be supported. In addition, the independent directors representing other minority institutional shareholders,
it is suspected that they lack either motivation to monitor the top managers. Stewardship theory argues that managers are inherently trustworthy and not prone to misappropriate corporate resources (Donaldson, 1990). Consistent with stewardship theory, some researchers have found that inside directors were associated with higher firm
performance. In an examination of Fortune 500 corporations, Kesner (1987) found a positive and significant relationship between the proportion of inside directors and returns to investors. Therefore,
Hypothesis2a : The high representation of fully independent directors on the board are associated negatively with the financial performance of Chinese listed companies.
In the Chinese context, personal relationship and common work experience are especially important factors that influence interpersonal dynamics (Tsui and Farh, 1997).
In a sense economic transactions in China may be governed by social relationships rather than by formal contracts (Tam, 1999). According to stewardship theory, affiliated
directors have social relationships with top managers and they are familiar with each other. This social network would enable them to work together efficiently to reach in- depth understanding of the corporation’s external and internal strengths or weaknesses.
Hence:
Hypothesis 2b: The high representation of affiliated directors on the board are associated positively with the financial performance of Chinese listed companies.
Method
Part I: Sample selection
This paper is designed to test the relationship between board structure and listed firms’
performance. My research subjects are Chinese listed companies, which have available data set such as board composition, firms’ financial report since their initial public offering. I choose firms, which are listed on Shanghai Stock Exchange as my research
observations. There are totally 997 firms listed on Shanghai Stock Exchange, considering Chinese SOEs are very representative enterprises in Chinese economy, so my research observation will focus on Chinese listed companies, which are former SOEs. It is also important that SOEs which has experienced the process of restructuring before IPO(initial public offering) would have formalized the composition of the boards of the new
shareholding companies. Further, firms in manufacturing industries are characterized by heavy capital investment and relatively complicated technology and production
processes, they have been through such large scale restructuring that make the restructuring practices interesting. Based on these considerations, I select heavy manufacturing industries as my final research data set.
On Shanghai Stock Exchange market, heavy manufacturing industries are coded as C6 &
C7. There are 197 listed firms belong to these two categories, All data needed in this paper are collected from every sample firms’ annual report and firms’ prospectus. These 197 firms are approximately one-fifth of the whole listed firms on Shanghai Stock Exchange, they represent metal and non-metal manufacturing industries, machinery, equipment and meter manufacturing industries. They are heavy industries and previously SOEs, the majority of listed shares are still held in State’s hand after initial public
offerings. Generally speaking, firms in these industries are characterized by heavy capital investment and relatively complicated technology and production processes. Thus, relative to services industries and light manufacturing industries, they are more vulnerable to reform (more difficult to catch up the market economy development because of heavy burden, such as very over-dated production line, too much employees’
benefit burden etc.) and offer a research sample more relevant to theoretical concerns.
Therefore, the performance implications of the reform measures are expected to be more obvious.
Part II: Measurement Independent variables (IVs)
The board data are obtained from the company’s prospectus for share offering. First, the sponsor enterprise was identified from the section about the firm’s incorporation process in the prospectus or IPO statement. Those directors who are employed by the sponsor enterprise as affiliated directors. The directors who are employed by the share-holding
company or its subsidiaries are defined as inside directors. Those directors who have no any employment relationship with the share-holding company nor with its subsidiaries are independent directors.
According to hypotheses developed above, two measures are defined as independent variables, the proportion of fully independent directors, and the proportion of affiliate directors.
The proportion of fully independent directors is calculates as the ratio of the number of independent directors to the total number of board directors;
The proportion of affiliate directors is calculated as the ratio of the number of affiliated directors to the total number of board directors.
Dependent variables (DVs)
This research paper is trying to test the relationship between board structure and firms’
performance. There are many measures of firm performance such as stakeholder
satisfaction (Clarkson, 1995). I follow the predominant approach and use three financial measures of firm performance, namely Return on Assets (ROA), Returns on Equity (ROE), Share holder’s right ratio.
Return on Assets (ROA) measures a firm’s efficiency in utilizing its assets.
ROA= Net income / Total assets;
Return on Equity (ROE) is a conventional measure of shareholders’ gain.
ROE= Net income / Owner’s equity;
(Both ROA and ROE gauge effectiveness in using corporate resources)
Shareholders right ratio is an indicator of the firm’s financial strength. It is calculated as the ratio of owner’s equity to total assets.
Shareholders right ratio = Owner’s equity / Total assets.
In China, the regulatory body uses the shareholder’s right ratios as a special
performance indicator of listed companies. A firm that has relatively high shareholder’s right ratio will be in a better position to meet its liabilities. Since most SOEs have suffered from heavy debt burden, the financial strength measures have been increasingly used as a criteria for loan qualification and to meet requirement of the Company Law ( The World Bank, 1997). Therefore, this variable is used as an indicator of sound
operation of the firm. These three performance criteria – ROA, ROE, Shareholders right ratio are selected because they centered on corporate profitability.
In the mean time, because I defined dependent variables in 2000-2001 year, my sample has to be re-selected again. (The reason that I choose these two years as my research period is because China economy reform has been through nearly one decade, listed companies have been relatively stable, not only their organization but also their financial performance.) The listed firms, which were listed after 2001year will be left out.
After re-selection of data, there are 28 firms listed after 2000year obliterated from category C6, 43 firms are obliterated from category C7. Therefore, the final observations are 126 firms.
Control variables
• Firm age
The old Chinese enterprises are characterized by both resource advantage and social burden. As earlier market-entrants, old firms have built up reputation, social networks etc, meanwhile as an former SOEs, these firms also had heavy burdens such as all kinds of benefits paid to employees. Given the possible influences of firm age on firm
performance, it is included as a control variable.
• Firm size.
An obvious assumption implicit in board composition / performance relationships is that the choice of the various governance options could be associated with changes in
organizational strategy and firm performance. It has been argued that firm size could be an important factor in such an assumption. It may be, then, that the scale and complexity of the large firm would cloud any relationship between board composition and
performance. It has been observed, for example, that CEOs and directors are less constrained by organizational systems and structures in the smaller firms and may have far more discretion as compared to their large-firm counterparts (Daily and Dalton, 1992, 1993). Under the suggestions that firm size may influence board composition and firm’s performance, I take this variable as a control variable. The firm size in this research paper is measured as the size of the company’s total assets at the time of IPO and took natural logarithm of the original measure due to the skewness of the data.
• State share ownership
One important question about the ownership structure of Chinese firms is whether the degree of state ownership is related to enterprise performance. Previous findings generally suggested that a negative relationship between state share ownership and performance (The World Bank, 1997). Given these implications, I take the percentage of State share ownership at the time of Initial Public Offering as a control.
Board size
Empirical research on the relationship between current board size and future company performance has addressed a significant, positive association between board size and different measures of financial performance. (see Chaganti et al., 1985). This positive association resulted from several sources. Large board size permitted inclusion of multiple perspectives on corporate strategy and operations which were likely to lead to high financial performance. Larger boards permitted inclusion of directors with diverse educational and industrial experiences. Large boards allowed the representation of diverse stakeholder on the board, thereby enabling a firm to respond effectively to their demands (see Zahra and Pearce, 1992). However, other research (Yermack, 1996), reported a strong inverse relationship between board size and firm performance as measured by Tobin’s Q. Given this suggestions, board size is related to firm’s performance, therefore, this paper will include this variable as a control.
Regression model Model 1:
ROA= α + β1Firm age (x1)+ β2 Firm size (x2) + β3 State share owner ship (x3) + β4 Board size (x4) +ε (1)
ROE= α + β1Firm age (x1)+ β2 Firm size (x2) + β3 State share owner ship (x3) + β4 Board size (x4) +ε (2)
Shareholder’s right = α + β1Firm age (x1)+ β2 Firm size (x2) + β3 State share owner ship (x3) + β4 Board size (x4) +ε (3) Model2:
ROA= α + β1Firm age (x1)+ β2 Firm size (x2) + β3 State share ownership (x3) + β4
Board size (x4) + β5 Proportion of Independent directors (x5)+ β6 Proportion of
Affiliated Directors (x6) +ε (1)
ROE= α + β1Firm age (x1)+ β2 Firm size (x2) + β3 State share ownership (x3) + β4 Board size (x4) + β5 Proportion of Independent directors (x5)+ β6 Proportion of
Affiliated Directors (x6) +ε (2)
Shareholder’s Right = α + β1Firm age (x1)+ β2 Firm size (x2) + β3 State share Owner ship (x3) + β4 Board size (x4) + β5 Proportion of Independent directors
(x5)+ β6 Proportion of Affiliated Directors (x6) +ε (3)
Model 3:
ROA= α + β1Firm age (x1)+ β2 Firm size (x2) + β3 State share ownership (x3) + β4
Board size (x4) + β5 Squared terms of the proportion of Independent directors (x5)+ β6 Squared terms of the proportion of Affiliated Directors (x6) +ε (1)
ROE= α + β1Firm age (x1)+ β2 Firm size (x2) + β3 State share ownership (x3) + β4 Board size (x4) + β5 Squared terms of the proportion of Independent directors (x5)+ β6 Squared terms of the proportion of Affiliated Directors (x6) +ε (2)
Shareholder’s Right = α + β1Firm age (x1)+ β2 Firm size (x2) + β3 State share Owner ship (x3) + β4 Board size (x4) + β5 Squared terms of the proportion of Independent directors (x5)+ β6 Squared terms of the proportion of Affiliated
Directors (x6) +ε (3)
Analyze Results
The hypotheses are tested by regressing the three Dependent variables respectively on the control variables and the Independent variables. I developed three models to test the hypotheses. Model 1 only takes the control variables into regression. Model 2 includes both control and independent variables. Some studies on board composition also reported curvilinear relationship between board composition and corporate performance (Barnhart et al.,1994; Byrd and Hickman, 1992; Wagner et al., 1998). I also take the possible curvilinear effect into account, including the squared terms of both the proportion of independent directors and the proportion of affiliated directors into model 3. Table 1 , table 2, table 3 are respectively presented in appendix 1, 2, 3.
---Table 1 (See Appendix 1)--- Result interpretation
Table 1 presents the regression results about ROA of 2000 and 2001year. From the model1 figures, it indicates that control variables have no significant effect on ROA except firm size (the coefficient is –0.23, -0.39 related to ROA 2000, ROA 2001 respectively). Seeing the results from the model 2, the proportion of affiliated directors has a predictive power on dependent variable ROA (R square change =.12 and .05, and the coefficient =0.37 and 0.27). It indicates that one of the stewardship hypothesis (H2b) is supported. It appears that the firms with more affiliated directors on the board have better financial performance. This result also indicates that the affiliated directors on the board composition have significant linear effect on firm performance. Meanwhile, seeing from the regression coefficients of the proportion of independent variables, no significant linear effect is found on ROA (the coefficient =0.06 and 0.05). Therefore, Hypothesis 1a and 2a are not supported. However, the relationship between the independent variables and the dependent variable (ROA) is positively related as agency theory proposed.
---Table 2 (See Appendix 2)---
Seeing from the results on table 2, again the affiliated variables shows explanatory power on ROE in 2000 (R Square change =0.09 and 0.05, the coefficient =0.32 and 0.29 respectively). The hypothesis 2b is supported again. Same results as shown in table 1, there are no significant effect found between the proportion of independent directors and firm financial performance ROE. It indicates that the agency hypotheses are not
supported.
---Table 3 (See Appendix 3)---
The table 3 shows that firm size has a significant and negative effect on
shareholder’s right ratio. It appears that larger firms have lower shareholder’s right ratio.
The state ownership also shows a negative relationship with the shareholder’s right ratio.
That means the larger of the state ownership, the lower of the shareholder’s right ratio. As for the independent variables, we can see that the proportion of affiliated directors is significantly and positively related to the shareholder’s right ratio in this regression model. Thus, the hypothesis 2b is supported again. Looking at the coefficients of the
proportion of independent directors, no significant effects can be found (the coefficient
=0.06, -0.01). Therefore, hypotheses 1a and 1b are not supported in this model.
In sum, seeing through the table1, 2, and 3, the results show that hypothesis 2b is supported always. This means the proportion of affiliated directors is positively related to the organizational performance and the stewardship theory is therefore partly supported.
However, no significant relation was found between the proportion of independent directors and firms’ financial performances, this result indicates that the agency theory is not applicable to Chinese corporate governance system. In table 2 and 3, the coefficients of the proportions of affiliated directors in model 3 are fluctuated a lot, it might because in 2001, the board composition have been changed or firms’ ROA or ROE were
fluctuated due to shareholder’s investment change. Finally, no curvilinear effect was shown through the regression analysis (R Square change is near to 0).
Hypotheses Test Summary
Hypotheses Sign (hypothetical) Sign (empirical) Supported or not
H1a + +
Not significantly supported
H1b – + Not supported
H2a – + Not supported
H2b + + Significantly supported
Conclusion
This paper studied the board composition effects on the Chinese listed firms’
performances. The empirical findings show that board composition has effects on Chinese shareholding companies. Part of the stewardship theory is supported under Chinese context. These firms with more affiliated directors seem to report better
organizational performance. Meanwhile, no significant effects are found concerning the relationship between the proportion of fully independent directors and organizational performance. Therefore, agency theory is not supported by this research result.
Discussions and future research
This paper employed two contrastive approaches (agency theory and stewardship theory) to corporate governance as theoretical background. The empirical findings contribute to the corporate governance research, because at the methodological level I refined the measurement of board composition with consideration of the unique Chinese institutional context. The distinction between independent and affiliated directors is meaningful because these two measures represent the differences among directors in terms of firm- specific knowledge, their motivations, information advantage, social net work,
interpersonal relationship with the top managers, and mutual trust with the managers. By distinguishing two different types of directors, the concepts of different corporate
governance theories are better developed by the board composition measure under the Chinese context.
However, the effect of independent directors on firm’s financial performance remains unidentified. Neither the Agency theory nor the stewardship theory is supported.
Agency theory assumes that independent directors would be effective controllers because they care about their reputation as professional referees (Fama, 1980). Given transparent and accurate information provided by well-developed capital market, independent directors may perform their monitoring role more effectively. However, China is a
developing country, its capital market is not completely mobile and still under-developed.
For example, currently only individual shares are tradable on the securities markets. The fact that State shares and legal person shares are not traded on the securities markets means that more than 60% of the outstanding shares have been excluded from the market.
This has reduced the liquidity of the secondary market and has become the main obstacle of operating the market efficiently. This underdeveloped institution may explain why agency hypotheses are not supported in Chinese corporate governance system.
Researchers have also noticed that underdevelopment of market institutions is a
characteristic of transitional economies. (Hoskisson et al., 2000; Ramamurti, 2000). An inadequately developed institutional framework cannot guarantee that truly motivated directors be selected to the boards.
This paper has captured the transitional characteristics of the corporate governance arrangement in Chinese listed firms. However, whether and how the corporate governance system would evolve over time as the capital market develops
further and the corporation reform goes further is still at issue. Previous studies mostly focused on the static structure of the board of directors, with little attention given to the time-developing nature of the corporate governance system in transition economies like China. With institutional market developing and changing, the patterns of corporate governance and their effects on organizational performance might be changed too.
Therefore, longitudinal research is needed to testify this changing process.
Board composition research can be linked with in-depth investigation of board processes, e.g., cohesiveness, norm, and cognitive diversity (Forbes and Milliken, 1999).
Especially when the organizational factors are experiencing a shift from the state
ownership to the private ownership institutional template, this direction of research would be interesting. It would be interesting to further explore how the different groups of directors (independent directors, affiliated directors etc.) interact with each other and how such interactions would influence board effectiveness. It is suggested that the future research should also explore the interaction processes between directors and managers and between different groups of directors, which might impact on board composition and its’ effectiveness.
Moreover, a reasonable argument would be that each theory has explanatory power under specific circumstances. This paper shows that the stewardship theory can capture the subtle board-management interaction dynamics and social exchanges inherent of the long-term personal relationships, which have been largely overlooked in agency literature. In this sense, stewardship theory brings in new perspective about how the directors do their work. The future research can also reveal the specific contextual factors, e.g. economic, social, cultural, and psychological, which determine the relative explanatory power of agency theory and stewardship theory. This direction of research would be helpful for the local governments and organizations to establish or develop effective corporate governance model.
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Appendix A
Legal and listing requirements imposed on Chinese firms
(1). The firms applying to be listed must submit relevant documents to the security management department of the State Council for approval. The security management department of the State Council will approve the firms that are in compliance with the listed requirement. After the firms are approved by the security management department of the State Council, the listed firms must publish their shares and related reports. The application documents of the firms must be put in the assigned place for access by the public.
(2) The listed firms must publish the financial status and operations results according to the laws and regulations. The listed firms must publish the financial reports semi- annually.
Source Shenzhen Stock Exchange Standard Operational Guide of Chinese listed Firms (June 1998).
Appendix I
Table 1. Results of regression analysis
DV: ROA 2000 DV: ROA 2001
Independent variables Model 1 Model 2 Model 3 Model 1 Model 2 Model 3 Control variables:
Firm age –.09 –.11 –.13 –.08 –.12 –.13
Firm size –.23** –.17† –.19† –.39** –.36* –.37*
State share ownership –.06 –.19† –.20† –.07 –.11 –.13
Board size .03 –.05 –.03 .07 .02 .03
Dependent variables:
Proportion of fully independent directors
.06 –.11 .05 –.13
Proportion of affiliated directors .37** .51* .27† .28 Curvilinear effect of board
composition
Proportion of fully independent directors2
.17 .16
Proportion of affiliated directors2 –.21 –.05
F value 3.59 4.42** 3.58** 5.70** 4.45** 3.45**
R square .13 .25 .26 .21 .26 .26
Adjusted R square .09 .20 .19 .17 .20 .19
R square change .12** .01 .05† .00
Values shown are the standardized regression coefficients. N = 126
†p < .10
*p < .05
**p < .01
Appendix II
Table 2. Results of regression analysis
DV: ROE 2000 DV: ROE 2001
Independent variables Model 1 Model 2 Model 3 Model 1 Model 2 Model 3 Control variables:
Firm age –.11 –.16 –.14 .08 .07 .08
Firm size –.07 –.03 –.02 –.30** –.25* –.26*
State share ownership .04 –.05 –.07 –.12 –.13 –.16
Board size .01 –.07 –.06 .10 .06 .07
Dependent variables:
Proportion of fully independent directors
.07 –.02 .10 –.09
Proportion of affiliated directors .32* .43 .29* .08
Curvilinear effect of board composition
Proportion of fully independent
directors2 .12 .19
Proportion of affiliated directors2 –.11 .01
F value 1.59 2.38* 1.90† 2.43* 1.74† 1.48
R square .07 .16 .16 .10 .12 .12
Adjusted R square .03 .09 .07 .06 .07 .04
R square change .09* .00 .05 .00
Values shown are the standardized regression coefficients N = 126
†p < .10
*p < .05
**p < .01
Appendix III
Table 3. Results of regression analysis
DV: Shareholders’ Right Ratio 2000
DV: Shareholders’ Right Ratio 2001
Independent variables Model 1 Model 2 Model 3 Model 1 Model 2 Model 3 Control variables:
Firm age .03 –.01 –.001 .03 –.02 –.02
Firm size –.49** –.41** –.44** –.39** –.31* –.34*
State share ownership –.17† –.22* –.23* –.05 –.13 –.13
Board size –.03 –.09 –.07 .03 –.03 –.01
Dependent variables:
Proportion of fully independent
directors .06 –.18 –.01 –.36
Proportion of affiliated directors .25* .54* .30* .54*
Curvilinear effect of board composition
Proportion of fully independent
directors2 .23 .34
Proportion of affiliated directors2 –.32 –.29
F value 8.91** 6.62* 5.49** 4.12** 4.1** 3.53**
R square .29 .34 .35 .16 .24 .26
Adjusted R square .26 .29 .29 .12 .18 .18
R square change .04† .01 .08* .02
Values shown are the standardized regression coefficients N = 126
†p < .10
*p < .05
**p < .01
