Does an Independent Board Matter for Leveraged Firm?

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1 Does an Independent Board Matter for Leveraged Firm? Dr Janet Lee School of Business and Information Management Faculty of Economics and Commerce The Australian National University Refereed Paper

2 Does an Independent Board Matter for Leveraged Firm? ABSTRACT This study investigates the extent to which the decision to structure an independent board by Australian companies which use debt finance might affect company financial performance. Applying the agency and debt contracting theory, data from 75 top Australian listed companies was analysed for the period 2002 to The study found that when firms experiencing high level of debt finance, they would be likely to achieve better financial performance if more independent directors were brought in earlier. Introduction This paper examines the role of an independent board adopted by Australian leveraged companies in monitoring the performance of the firm. Specifically, the paper addresses the issue: When a firm experiences a high level of debt, will more independent directors on the board contribute to better company financial performance? The recent corporate failure and in particular the scandal of Parmalat, an Italian food and dairy company, has alerted debt financiers the need to protect their rights. Australia is a country with low legal protection of creditors rights (La Porta, Lopez-de-Silanes, Shleifer and Vishny, 1998). Companies are therefore likely to incur high cost of debts if they are perceived as posing high risk to debt financiers in terms of, for example, weak corporate governance. As a response to the heightened public awareness in corporate governance, the Australian Stock Exchange (ASX) Corporate Governance Council has recently issued a best practice guide including ten essential corporate governance principles. A fundamental principle is to structure an effective board through enhancing the independence of the board so as to add value and effectively discharge the board s responsibilities and duties. The ASX recommends that an effective board should consist of a majority of independent directors. The recommendations are not mandatory. However, companies not following the principles are required to provide an explanation for any departure from best practice recommendations. This paper focuses on one aspect of board independence, the proportion of independent board of director members.

3 Corporate governance issues arise from the continuous interests in reducing agency problems as a result of the separation of management from finance providers of the companies. Obligations to creditors, as a major finance provider, could be an important factor influencing a firm s decision to improve governance control system. There is limited empirical research on firm s obligations to creditors and related corporate governance. This paper is motivated to fill this literature gap, using agency and debt contracting theory as analytical framework. Based on debt contracting theory, Dechow, Sloan and Sweeney (1996) found that highly leveraged firms were more likely to manipulate earnings due to their obligations to creditors in terms of the need for external financing and the closeness to debt covenant constraints. These firms were more likely to have weak internal corporate governance mechanisms. In view of the critical motivation served by debt obligations, it is important to have a deeper understanding of how a firm s decision to structure an independent board might be affected by its leverage level. This study aims to address this issue in Australian context. One of the main purposes of structuring effective governance control system is to ultimately improve firm performance and add value to shareholders. Hence it is of primary importance to address the question of whether a particular governance mechanism has a significant impact on firm performance (Denis, 2001). A review of the corporate governance literature by Denis (2001) found that existing evidence failed to establish a convincing link between various governance mechanisms and firm performance. Denis (2001:208) suggests that it is possible that various corporate governance mechanisms interact in complicated ways with each other and with other aspects of firms. This paper seeks to address such endogeneity issue by examining the interaction between independent directors and debt obligations and the subsequent effect on firm financial performance. 2. Independent Directors, Debt Finance and Performance The need for an effective board is often associated with agency and contracting issues. A greater proportion of independent directors on the board is considered an essential monitoring mechanism based on agency theory due to asymmetry of information. A major function of the board of directors is to reduce agency problems arising from the conflicts of interests between management and finance

4 providers. Finance providers delegate decision making and internal control responsibilities to the board of directors who act on behalf of the finance providers (Fama, 1980; Fama and Jensen, 1983; Beasley, 1996). While the board delegates most of the management and control responsibilities to top management, it retains the important function of monitoring the behaviour of top management who may not have the incentive to maximize finance providers utility (Beasley, 1996). The independence of board of directors becomes important to fulfil the effective monitoring function (Fama, 1980; Fama and Jensen, 1983). Under debt contracting theory, accounting-based covenants or accounting-based performance indicators is often used in a debt contract. Management may have an incentive to undertake opportunistic activities in order to reduce the cost of capital (Sweeney, 1994; Dechow, et al., 1996; Lehavy, 1999). Dechow, et al. s (1996) study highlights a potential link between debt finance and effective internal corporate governance mechanisms. Under a debt contract, in order to mitigate firm s opportunistic behaviour, lenders are likely to demand higher interest rate for high risk firms, which engage in high level of external debt, are close to violation of debt covenants or experience poor performance. In order to reduce the cost of debt, firms in need of external funding are likely to establish mechanisms to monitor management actions associated with the contracts. Various characteristics of board of directors have been discussed in the literature, including board size, composition and structures (Weisbach, 1988; Rosenstein and Wyatt, 1990; Hermalin and Weisbach,1991; Beasley, 1996; Dechow, et al, 1996; Core, Holthausen and Larcker, 1999; Kakabadse, et al., 2001; Goyal and Park, 2002; Xie, Davidson III and DaDalt, 2002; Eng and Mak, 2003; Hutchinson and Gul, 2003). However, empirical evidence regarding the relationship between corporate governance mechanisms and company performance is unclear. Rosenstein and Wyatt (1990) found a positive effect of the proportion of outside directors on shareholder wealth. Other studies also found that higher proportion of independent directors contributed to better performance (Baysinger and Butler, 1985; Byrd and Hickman, 1992; Beasley, 1996). On the other hand, Dalton, et al. (1998) conducted a meta-analysis of 54 empirical studies found no significant relationship between

5 board composition and firm financial performance. Judge, et al. s (2003) study also failed to find a significant negative relationship between the proportion of inside directors and firm performance. The mixed results could be a consequence of the limited attention directed to the possible interaction of variables affecting firm performance in previous research (Denis, 2001). Hence a specific governance mechanism may have a positive effect on firm performance under particular circumstances while the same mechanism may not be effective under the other situations. Empirical research addressing such potential endogeneity issue are still scant (e.g. Core et al 1999; Klapper and Love, 2003; Hutchison and Gul, 2003). This study examines the relationship between company financial performance and the proportion of independent directors on the board when firms experiencing high level of debts. Consistent with the agency and debt contracting theory discussed above, since the adoption of an effective board is likely to mitigate agency problems and enhance firm s value, it is expected that a firm s financial performance will be positively related to the proportion of independent directors on the board for firms with high level of debt finance. Therefore the following hypothesis is tested: There is a positive association between financial performance and the proportion of independent directors when firms experiencing higher level of debt finance. 3. Sample and Data The sample includes 75 companies listed on Australian stock exchange during the year 2002 to The selection process includes the following steps. Firstly, the top 100 companies were initially selected based on their market capitalisation available in the Osiris database which contains company information in different countries. Secondly, companies which did not have information on independent directors and non-executive directors were eliminated, resulting in a sample of 77 companies. Thirdly, a screening of data indicated the existence of two outliers which were also eliminated. The final sample includes 75 companies which reported information on both independent directors and non-executive directors, together with complete data on variable measurement. Data

6 required for measuring dependent, independent and control variables were obtained from the Osiris database, Connect4 database which is an Australian company database, company annual reports and websites. Research Design The hypothesized relationship between company financial performance and the proportion of independent directors for firms with high leveraged is tested by the following two multiple regression models. Where ROE y0 ROE y0 = B 0 + B 1 INDD% + B 2 (INDD% x DEBT y -1 ) B 4 (INDD% x INVEST) + B 5 (INDD% x GROPP) + NEXD + SIZE + e (1) ROE y0 = B 0 + B 1 INDD% + B 2 (INDD% x DEBT y -2 ) B 4 (INDD% x INVEST) + B 5 (INDD% x GROPP) + NEXD + SIZE + e (2) = financial performance measured by the ratio of accounting returns on equity for the base year ( ); INDD% y0 = the percentage of board members who are identified as independent directors by the company during the base year ( ); DEBT y-1 = accounting-based debt level measured by the ratio of total debts to total assets at book value one year prior to the base year; DEBT y-2 = accounting-based debt level measured by the ratio of total debts to total assets at book value two years prior to the base year; INVEST = the percentage of company s total shares owned by the largest shareholder of the company during the base year; GROPP = growth opportunity for the base year, measured by the market valuation of the firm, calculated as the ratio of (book value of assets minus book value of equity plus market value of equity) to book value of assets. INDD% x DEBT y-1 = interaction between INDD% and DEBT y -1 ; INDD% x DEBT y-2 = interaction between INDD% and DEBT y -2 ; INDD% x INVEST = interaction between INDD% and INVEST; INDD% x GROPP = interaction between INDD% and GROPP; NEXD = the percentage of board members who are identified as non-executive directors by the company during the base year; SIZE = firm size measured by total operating revenue for the base year. Model (1) tests the effect of (INDD% x DEBT y-1 ) on ROE y0, while Model (2) tests the model again by replacing (INDD% x DEBT y-1 ) with (INDD% x DEBT y-2 ). DEBT is measured by the debt to assets ratio which is a commonly used accounting-based covenant in debt contract (Dechow, et al., 1996). Previous two years debt levels are used as there is often a lag time in modifying internal control mechanisms (Beasley, 1996). The effect of DEBT y-1 and DEBT y-2 is tested separately due to a

7 multicollinearity problem between these two variables. Model (1) therefore tests a shorter time lag period than Model (2). This provides a deeper understanding of the effect of time lag on the relationship between independent board and firm s financial performance. There are three possible interpretations of the model testing. First, if the results show no significant relationship between firm performance and the two variables, it would indicate that the need for independent directors would be mainly driven by the firm s motivation to structure an independent board so that it is perceived by creditors as an effective monitoring control. Second, if the effect of (INDD% x DEBT y-1 ) is significant in Model (1), it is likely that firms with high leverage would perform better if they bring in more independent directors earlier. Third, if the effect of (INDD% x DEBT y -2 ) is significant in Model (2), it would imply that firms often take a longer lag period to appoint independent directors, but once the independent directors are brought in, it can be expected that firm performance would be improved. The dependent variable is return on equity, which is used to capture the financial performance of the firm. Hutchison and Gul (2003) argued that accounting-based performance measures could best reflect the outcomes of a firm s internal control and management decisions, compared to market-based measures, which are subject to influences external to the firm s control. The independent variables are (INDD% x DEBT y-1 ) for Model (1) and (INDD% x DEBT y-2 ) for Model (2). They are used is to test the extent to which proportion of independent directors relates to performance when the firms has committed a particular level of debt. The interaction of the two variables can be interpreted as: for firms with a higher level of debt, the adoption of more independent directors on the board will contribute to better financial performance than those with a lower proportion of independent directors. An alternative interpretation can be that: there is a greater need for independent directors for firms with higher level of debts than those with a lower debt level in order to achieve better financial performance. Four control variables are included. (INDD% x INVEST) and (INDD% x GROPP) are used to control for the possible intervening effect of major investor and grow opportunity on the relationship between

8 the independent directors and firm performance. NEXD and SIZE are included to control for its possible effect on performance. 5.2 Empirical Results A preliminary examination of the initial sample of top 100 companies showed that 80 companies (80% of the initial sample) had identified and disclosed the number of independent directors on the company s board (see Table 1, Panel A). Out of those 80 companies, 70 companies (87.5%) had 50% or more of the board members as independent directors, while 37 companies (46.2%) had 75% or more of the board member as independent directors. Out of the final sample of 75 companies, 66 companies (88%) had 50% or more of the board members as independent directors, while 35 companies (46.6%) had 75% or more of the board member as independent directors. This highlights that a high proportion of the top Australian companies have already put in place ASX recommendation on independent directors before it takes effect. On the premises that independent directors contribute to effective governance, there is still a need to further enhance the independence of the board of directors in Australian companies given that only 46% of the sample companies have more than threequarters of the board members as independent directors. TABLE 1 Independent Directors and Debt Finance: Descriptive Statistics Panel A: Independent Directors Companies disclosing data about independent directors Companies with 50% or more of board members as independent directors Companies with 75% or more of board members as independent directors Initial sample N=100 Final sample N=75 Number % Number % Panel B: Descriptive Statistics Final Sample N=75 Mean Std Dev Minimum Maximum INDD% y DEBT y DEBT y

9 The profile of the sample companies is shown in Table 1, Panel B. The sample companies have an average of 65% of independent directors on the board, and no single company has a board of directors who are all independent. The average debt level is 52% of total assets one year prior to the base year, and 56% of total assets two years prior to the base year. This indicates that the sample companies are incurring slightly more debts in earlier years. The normality of the variables was checked. The variables GROPP and SIZE were transformed using natural logarithm to reduce the degree of skewness. No multicollinearity problem among variables for these two models was found. The results for Model (1) are presented in Table 2, Panel A. The model is significant at the level. The results show that INDD% alone is not significant. The proportion of independent directors, as an exogenous factor, does not appear to have a significant association with firm s performance. On the other hand, the coefficient for (INDD% x DEBT y-1 ) is positive and statistically significant at the 0.01 level. This is consistent with the hypothesized relationship. It indicates that when firms experience a high level of debt, the adoption of more independent directors on the board will contribute to better financial performance compared to those with less independent directors. Alternatively, it is possible that the need for independent directors is greater for firms with higher level of debts than those with a lower debt level in order to achieve better financial performance. With respect to the control variables, (INDD% x GROPP) is positively related to ROE y0 and statistically significant at the level. This is consistent with the expectation that when firms are in need of external financing due to growth opportunity, a more independent board is likely to contribute to better financial performance (Hutchinson and Gul, 2003). However, other control variables, (INDD% x INVEST), NEXD and SIZE are not significantly related to performance.

10 TABLE 2 Company Financial Performance and Independent Directors: Regression Results Predicted relation Estimated coefficients t-statistics p-value Panel A: Model 1 Intercept None INDD% INDD% x DEBT y ** INDD% x INVEST INDD% x GROPP ** NEXD SIZE R 2 = Adjusted R 2 = F = Sig = Panel B: Model 2 Intercept None INDD% INDD% x DEBT y INDD% x INVEST INDD% x GROPP ** NEXD SIZE R 2 = Adjusted R 2 = F = Sig = * Statistically significant at less than the 0.05 level ** Statistically significant at less than the 0.01 level The results for Model (2) are reported in Table 2, Panel B. The model is also significant at the level. Contrary to Model (1), no significant relationship is found between (INDD% x DEBT y-2 ) and ROE y0. The only significant variable is (INDD% x GROPP). Comparing the results for Models (1) and (2), company financial performance is only significantly related to the interaction of independent member on board and debt commitment one year prior to the base year rather than two year prior to the base year. This can be interpreted as: when firms experience high level of debt obligations, more independent directors on the board will contribute to better performance and would be more effective only if they are brought in to the company at an earlier stage. While there is often a time lag for change in internal control to take effect, it appears that under the debt contracting environment, when firms incur a higher debt level, they will perform better if they bring in more independent directors earlier.

11 Conclusion This paper addresses an important corporate governance issues: When a firm experiences high level of debt finance, will more independent directors on the board contribute to better company financial performance? The results provide an indication that highly leveraged firms are more likely to achieve better financial performance if more independent directors are brought in earlier. The results are consistent with previous studies (Dechow, et al., 1996; Hutchinson and Gul, 2003) arguing that firms which are in need of external financing would have greater motivation to improve internal corporate governance mechanisms. The results also highlight that a firm s decision to structure a more independent board can be explained by the extant agency and debt contracting theory. The study provides supporting evidence that an independent board do matter for leveraged firms. It relates to firm s financial performance if an independent board is structured earlier. This highlights possible implications for the implementation of ASX corporate governance principles. The findings support the importance of ASX s recommendations for maintaining a majority of independent directors on the board. This is likely to be particularly effective for firms with high leverage. This study provides preliminary findings on the role of debt finance in corporate governance mechanisms and firm performance. However, some limitations of the study should be addressed. The study is based on a small sample size due to its exploratory nature, which may limit the generalization of the results to other situations. In addition, this study only focuses on the previous two years debt ratios as proxies for debt financing structure. Future research can be expanded to test the effect of other relevant debt contract variables, or the effect of a longer time horizon to provide further evidence on the need to introduce independent directors into the board earlier. More research can also be conducted to analyse the effectiveness of independent board for specific types of firms, such as firms with growing debt levels, high growth firms or declining firms. This would provide better understanding of the role of an effective board under different contextual environment.

12 References: ASX Corporate Governance Council (2003), Principles of Good Corporate Governance and Best Practice Recommendations, Australian Stock Exchange, March. Baysinger, B.D. and Butler, H.N. (1985), Corporate Governance and Board of Directors: Performance Effects of Changes in Board Composition, Journal of Law, Economics and Organisation 1, Beasley, M.S. (1996), An Empirical Analysis of the Relation Between the Board of Director Composition and Financial Statement Fraud, The Accounting Review 71(4), October, Byrd, J. and Hickman, K. (1992), Do Outside Directors Monitor Managers, Journal of Financial Economics 32, Commonwealth of Australia (2002), Corporate Disclosure: Strengthening the Financial Reporting Framework, CLERP Paper No. 9. Core, J., Holthausen, R. and Larcker, D. (1999), Corporate Governance, Chief Executive Officer Compensation, and Firm Performance, Journal of Financial Economics 51, Dechow, P.M., Sloan, R.G. and Sweeney, A.P. (1996), Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the SEC, Contemporary Accounting Research, Spring 13(1), Dalton, D., Dailly, C., Ellstrand, A. and Johnson, J. (1998), Meta-analytic reviews of Board Composition, Leadership Structure, and Financial Performance, Strategic Management Journal 19, Denis, D.K. (2001), Twenty-five Years of Corporate Governance Research and Counting, Review of Financial Economics 10, Eng, L.L. and Mak, Y.T. (2003), Corporate Governance and Voluntary Disclosure, Journal of Accounting and Public Policy 22, Fama, E.F. (1980), Agency Problem and the Theory of the Firm, Journal of Political Economy 88, Fama, E.F. and Jensen, M.C. (1983), Separation of Ownership and Control, Journal of Law and Economics 26, June, Goyal, V.K. and Park, C.W. (2002), Board Leadership Structure and CEO Turnover, Journal of Corporate Finance 8, Hermalin, B. and Weisbach, M.S. (1991), The Effects of Board Composition and Direct Incentives on Firm Performance, Financial Management 20, Winter, Hutchinson, M. and Gul, F.A. (2003), Investment Opportunity Set, Corporate Governance Practices and Firm Performance, Journal of Corporate Finance 182, Judge, W.Q., Naoumova, I. and Koutzevol, N. (2003), Corporate Governance and Firm Performance in Russia: An Empirical Study, Journal of World Business 38, Kakabadse, N., Kakabadse, A and Kouzmin, A. (2001), Board Governance and Company Performance: Any Correlations?, Corporate Governance 1(1), Klapper, L.F. and Love, I. (2003), Corporate Governance, Investor Protection, and Performance in Emerging Markets, Journal of Corporate Finance 195, La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny, R. (1998), Law and Finance, Journal of Political Economy, 106, Lehavy, R., (1999), The Association Between Firm Values and Accounting Numbers After Adoption of Fresh Start Reporting, Journal of Accounting, Auditing and Finance 14, Rosenstein, S. and Wyatt, J. (1990), Outside Directors, Board Independence and Shareholder Wealth, Journal of Financial Economics 26, Shleifer, A. and Vishny, R.W. (1997), A Survey of Corporate Governance, Journal of Finance 52, Sweeney, A. (1994), Debt-Covenant Violations and Managers Accounting Responses, Journal of Accounting and Economics 17, Weisbach, M. (1988), Outside Directors and CEO Turnover, Journal of Financial Economics, January/March, Xie, B., Davidson III, W. and DaDalt, P. (2002), Earnings Management and Corporate Governance: The Role of the Board and the Audit Committee, Journal of Corporate Finance 150, 1-22.

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