Board governance and corporate performance

• Published date: 01 January 2018
• Date: 01 January 2018
• Author: Grzegorz Trojanowski,Amama Shaukat
• DOI: http://doi.org/10.1111/jbfa.12271

DOI: 10.1111/jbfa.12271

Board governance and corporate performance

Amama Shaukat1Grzegorz Trojanowski2

1BrunelBusiness School, Brunel University

London,Uxbridge, UB8 3PH, United Kingdom

2BusinessSchool, University of Exeter, Exeter,

EX44ST, United Kingdom

Correspondence

GrzegorzTrojanowski, Business School, Univer-

sityof Exeter, Xfi Building, RennesDrive, Exeter,

EX44ST, UK.

Email:G.Trojanowski@ex.ac.uk

Abstract

We examine the link between the monitoring capacity of the board

and corporate performance of UK listed firms. We also investigate

how firms use the flexibility offered by the voluntary governance

regime to make governance choices. We find a strong positiveasso-

ciation between the board governance index we construct and firm

operating performance. Our results imply that adherence to the

board-related recommendations of the UK Corporate Governance

Code strengthens the board's monitoring capacity, potentially help-

ing mitigate agency problems, but that investors do not value it cor-

respondingly. Moreover, in contrast to prior UK findings suggesting

efficient adoption of Code recommendations, we find that firms at

times use the Code flexibility opportunistically, aiming to decrease

the monitoring capacity of the board, which is followed by subse-

quent underperformance. This finding questions the effectiveness of

the voluntary approach to governanceregulation followed in the UK

and in many countries around the world.

KEYWORDS

agency theory, board committees, board independence, board of

directors, comply or explain, corporate governance, corporate gov-

ernance codes, firm performance, managerial opportunism, non-

executivedirectors

1INTRODUCTION

According to agency theorists, there are two main functions of the board: decision management, i.e. initiation and

implementation of decisions, and decision control, i.e. ratification and monitoring of decisions (Fama & Jensen, 1983).

The UK Corporate Governance Code (henceforth, the Code) reflects this distinction by stating that “[c]orporate gov-

ernance is the system by which companies are directed and controlled” and “[b]oards of directors are responsible for the

governance of their companies” (Financial Reporting Council, 2016, p. 1). While the primary responsibility for provid-

ing direction that is “setting the strategic aims of the company” and “providing the leadership to put them into effect”

(Financial Reporting Council, 2016, p. 1), i.e. decision management, rests with managers (i.e. executive directors), the

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and repro-

duction in anymedium, providedthe original work is properly cited.

c

2017 The Authors Journal of Business Finance & Accounting Published by John Wiley& Sons Ltd

184 wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2018;45:184–208.

SHAUKATAND TROJANOWSKI 185

primary responsibility for decision control or “supervising the management of the business” (Financial Reporting Council,

2016, p. 1), i.e. monitoring, rests with outside directors (Fama & Jensen, 1983), termed independent non-executive

directors by the Code. From its inception in the form of the Cadbury Report in 1992, the Code, implicitly draw-

ing on the insights from agency theory, has encouraged firms to strengthen the monitoring capacity of their boards.

This is to be achieved by avoiding CEO-Chair duality and by promoting independence of the board and its keymon-

itoring committees. Hence, in theory, one can expect greater adherence to the Code's board-related recommenda-

tions to be associated with reduced agency problems, and hence superior operating performance and firm value (cf.

Adams, Hermalin, & Weisbach, 2010; Renders, Gaeremynck, & Sercu, 2010). This is the first proposition tested in this

study.

The Code is based on the principle of voluntary compliance and mandatory disclosure. Hence, the second and more

novel question we address in this study is how the flexibility in the choice of governance arrangements offered by

the Code is used. It has been argued that the underlying reason for the flexibility offered by the voluntary nature of

the Code is to allow for sound deviations from recommendations where these are warranted (Arcot, Bruno, & Faure-

Grimaud, 2010). While the emphasis of the Code is on strengthening the monitoring capacity of the board (as per

agency theory: Fama & Jensen, 1983; Jensen & Meckling, 1976), there is also an implicit recognition that there may

be times when the directing, i.e. what agency theorists consider the decision initiation and implementation capacity

of the board (Fama & Jensen, 1983), may need to be strengthened. A voluntary approach to governance favoured by

regulators in the UK as in many other countries (European Corporate Governance Institute, 2017), puts power in the

hands of the corporate board to choose its structure and composition as it deems appropriate at a particular point

in time (MacNeil & Li, 2006). Hence, firms may deviate from full adherence to boost the board's directing capacity.

For instance, they mayaim to strengthen the leadership structure by combining the CEO and chair positions (Donald-

son & Davis, 1991). They may induct more insiders or non-independent outsiders (like past employees)on the board.

Such individuals, by virtue of possessing firm-specific knowledge, may then play a more effective advisory role, thus

assisting managerial decision making (Fahlenbrach, Minton, & Pan, 2011; Fama & Jensen, 1983; Klein, 1998). Based

on the above rationale, we first argue that the weakening of board monitoring capacity,if driven by efficiency rea-

sons, should be associated with subsequent superior firm performance. Alternatively, if driven by managerial self-

interest(as per agency theory; Jensen & Meckling, 1976),reductions in board monitoring capacity should be associated

with subsequent underperformance. We examine the evidenceto discern which of these two alternative propositions

holds.

To test our hypotheses we develop a board governance index which captures the overall monitoring capacity

of the board and is based on the extent of adherence to the Code's key board-related recommendations. Prior

international evidence shows that the strengthening of the board independence and reduction of duality (consis-

tent with the Code recommendations) are generally associated with a more effective board oversight function (e.g.

Beasley,1996; Boeker & Goodstein, 1991; Chan & Li, 2008; Conyon & Peck, 1998; Core, Holthausen, & Larcker, 1999;

Dahya, McConnell, & Travlos, 2002; Weisbach,1988; Yeh, Chung, & Liu, 2011). Hence the board governance index

we develop is rooted in agency theory predictions (Fama & Jensen, 1983) and is supported by relevant empirical

evidence.

Employing a large panel dataset on board characteristics of UK listed companies spanning the years 1999–2008,

we find a strong positive association between the board governance indexand various measures of a firm'soperating

performance. This finding implies that stronger monitoring capacity is likely associated with better oversightfunction

and hence better operating performance. This result challenges some of the prior UK findings (e.g. Arcot et al., 2010;

Vafeas & Theodorou, 1998; Weir,Laing, & McKnight, 2002). However, consistent in essence with prior US evidence

on the governance–performance link (Gompers, Ishii, & Metrick, 2003), we find that investors in the UK also do not

seem to be recognising the value of governance: subsequent stock returns are higher for firms with stronger board

monitoring arrangements.

In terms of the second set of competing propositions, we find decreases in the board governance indexto be associ-

ated with higher managerial power and higher information asymmetries. This gives a first indication regardingthe pos-

sible motive, namely managerial opportunism (cf.Boone, Field, Karpoff, & Raheja, 2007; Linck, Netter, & Yang, 2008).