CORPORATE BOARD CHARACTERISTICS AND THE FINANCIAL PERFORMANCE OF NIGERIAN FIRMS

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CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Corporate governance is the oversight mechanisms which include the processes, structures and

information for directing and overseeing the management of a company (Canadian Office of the

Superintendent of Financial Institutions, 2008). It encompasses the means by which members of

the board of directors and senior managers are held accountable for their actions, and the

establishment and implementation of oversight functions and processes. Corporate governance

is holding the balance between economic and social goals and between individuals and

communal goals (Cadbury, 1992). Rodgers (2008) posits that corporate governance â€•is

concerned with the appropriate structuring of corporations and enterprises, with the fundamental

importance to the performance of the economies, particularly in developing and transition

economiesâ€".

Recent focus on the corporate governance has accentuated due to two key factors. First, the

corporate scandals in different countries such as Enron, WorldCom, Tyco International in the

United States, HIH Insurance in Australia, Paramalat in Italy have highlighted the inadequate

role played by the boards and failure of corporate governance processes (France and Carney,

2002; Bosner and Fisher, 2007, Byron, 2007). Second, the ongoing crisis in the financial

markets has increased public scrutiny of financial institutions boards as effective monitors of

management (Hagendorff and Keasey, 2008).

The public disquiet after the Enron collapse led to the enactment of â€�”The Sarbanes-Oxley Act

2002‘ in the US (Moeller, 2004) and similar regulations (e.g., stock exchange rules or codes) in

many other countries. The objective of these regulations has been to improve the effectiveness of

boards and other corporate governance practices. Several developments in other areas also

contributed to renewal of interest in understanding the role of board and top management. First,

there has been a deep sense of dissatisfaction amongst shareholders regarding the poor

performance of corporations, raising questions regarding the competency of the boards,

corporate greed and falling shareholder value (Sherman and Chaganti, 1998; Vint, Gould and

Recaldin, 1998). Second, there has been a phenomenal growth in the number of institutional

investors such as pension funds, mutual funds, banks, and insurance companies, who have the necessary resources and expertise to perform their fiduciary duty of ensuring good returns by

monitoring the board decisions (Hawkins, 1997; Sherman and Chaganti, 1998; Becht, Bolton,

and Roell, 2005). Third, there has been an increasing realisation on the part of corporations that a

good board is a source of strength in several ways such as attracting investment capital,

improving valuations and share price performance, and providing better long-term shareholder

returns (Vint et al., 1998; Lee, 2001; Carlsson, 2001). Good corporate governance practices are

now recognised and advocated for, globally as source of effective firm performance and

economic growth (Healy, 2003).

It is widely accepted that the composition of the board of directors could play a vital role in

determining corporate financial performance. Board of directors is an important element of

corporate governance, most especially in developing economy like Nigeria where external

governance mechanisms are weak. Board role can be even more important, because of the

relative weakness of other governance mechanisms and institutions, such as market for corporate

control, financial markets, regulatory monitoring and legal system.

Boards are by definition the internal governing mechanism that shapes firm governance, given

their direct access to the two other axes in the corporate governance triangle: managers and

shareholders (owners). Fama (1980) argues that the composition of board structure is an

important mechanism because, the presence of non-executive directors represents a means of

monitoring the actions of the executive directors and of ensuring that the executive directors are

pursuing policies consistent with shareholders' interests. Furthermore, boards of directors are one

of the centerpieces of corporate governance reform. In effect, the board of directors has emerged

as both a target of blame for corporate misdeeds and as the source capable of improving

corporate governance (Carter, D‘Souzaa, Simkinsa and Simpsona, 2007). Much of the weight in

solving the excess power within corporations has been assigned to the board of directors and,

specifically, to the need for non-executive directors to increase executive accountability.

The purpose of boards of directors is defined in many different ways. Shleifer and Vishny

(1997) feel that the sole responsibility of the board of directors is to ensure a return on

investment for investors and shareholders. Gillian and Starks (1998) define corporate

governance as a control of company operations through a system of rules, laws and governance, by boards of directors who sit on the border of internal and external

operations of a firm. The board is influenced by outside shareholders to increase firm

value, which increases return on investment. Shareholders‘ investment interests depend

largely on how the board controls the company internally. Jensen (1993) believes that

the most important part of the board of directors‘ internal responsibilities is to regulate

and monitor senior management. It is up to the board to decide how much to

compensate managers, as well as evaluate their performance

Corporate governance and board research have been mainly influenced by a combination of

agency theory, stewardship theory and dependency theory. Agency theory begins with the fact

that many corporate managers are not owners but agents of owners, contracted to manage the

company on their behalf. Since they are not direct owners but managers, and thus have less

personal wealth at stake, their natural pursuit of self-interest could result in them taking riskier or

even dishonest actions, which could bring harm to the firm or its owners. (Jensen and Meckling,

1976).

Proponents of this view have long supported the idea of a board of directors dominated or at least

strongly influenced by people not otherwise employed by the organization. They also argue for a

separation of the functions of chief executive officer and board chairperson. Conceptually,

separating these functions, and increasing outside influence should both monitor and moderate

the natural self-promoting efforts of managers, and thereby protect the owners (shareholders

wealth). In fact, moderating the risk of unethical or improper management behaviour is one of

the key arguments made by stockholder activists (Corporate Governance, 2005).

In contrast to agency theory stands another point of view, represented by the stewardship theory.

Stewardship theory supports the concept that managers are essentially worthy of trust. The

assumption in this case is that the managers of a corporation will apply their efforts and skills

conscientiously to achieve profitability and earn returns for the shareholders. Clearly, this point

of view would tend to favor a board of directors dominated, or at least more heavily influenced,

by insiders, that is, members who are also employed by the corporation in addition to their board

duties. In addition, this school of thought points to the merits of having one person serve as both

CEO and board chair. Examples of the benefits of this duality include a greater familiarity with the workings of the business itself, as well as the industry in which it operates. Essentially the

argument comes down to whether and how much the degree of board and/or CEO independence

helps or hinders the corporation.

Dependency theorists examine the provision of resources as the main function of the boards of

directors and they explore the relationship of the board capital, as the antecedent of this function

with firm performance. Provision of resources refers to the ability of board members to bring

resources to the firm. The activities of the board related to the provision of resources are:

providing legitimacy/bolstering the public image of the firm, providing expertise, administering

advice and counsel, linking the firm to important stakeholders or other important entities,

facilitating access to resources such as capital, building external relations, diffusing innovation,

and aiding in the formulation of strategy or other important firm decisions. Board capital consists

of human capital (experience, expertise, reputation) and relational capital (networking to other

firms, and external contingencies) (Hillman and Dalziel, 2003). Board capital has been positively

associated with the provision of advice and counsel, the provision of firm legitimacy and

reputation, the provision of channels of communication and the acquirement of resources

elements outside the firm.

Opponents and proponents of either of these opposing theories can – and do - each quote several

research studies to support their very different points of view. This shows that empirical results

along this line yield to controversies. Review of extant literature reveals a large number of

studies examining the role of boards on firm strategy and performance. For example, Lorsch and

MacIver (1989), Daily and Dalton (1997), Muth and Donaldson (1998), Bhagat and Black

(1999), Forbes and Milliken (1999), Kula (2005) and Gabrielsson (2007) have covered aspects

such as board composition, characteristics, and their impact on firm performance. The literature

has identified the transparency, independence of the board, Chair-CEO separation, board

diversity, board remuneration, alignment of interests through shareholding, and active

participation of strategic decision making as the key factors to increase the effectiveness of

boards. Many other aspects of the board are also considered by other scholars. Some examples

include separation of the board chair and CEO positions (Lorsch and MacIver, 1989; Daily and

Dalton, 1997), non-executive directors (Bhagat and Black, 1999; Roberts et al., 2005),

interlocking directorates and director selection (Zajac and Westphal, 1996; Kiel and Nicholson, 2004), interlocked firms and executive compensation (Hallock, 1997; Geletkanyez, Boyd and

Finkelstein, 2001), director ownership (Bhagat, Carey and Elson, 1999; Kapopoulos and

Lazaretou, 2007), women on the boards (Burke, 1997; Singh and Vinnicombe, 2004; Huse and

Solberg, 2006), performance assessment of board (Lorsch, 1997), and external networks on the

board decision making processes (Carpenter and Westphal, 2001).

These studies can be divided along two streams; one stream of extant research examines discrete

decisions that involve a potential conflict of interest between management and shareholders

(Mallaette and Fowler, 1992; Sundaramurthy, 1996; and Deutsch, 2008). Another stream of

research with mixed and inconclusive results suggests that, rather than examining board

effectiveness using critical decision making, a more accurate evaluation can be gained by

examining the impact of board characteristics on firm performance (Dalton, Daily, Ellstrand and

Johnson, 1998; Finkelstein and Hambrick, 1996; and Zahra and Pearce, 1989). For example,

Dalton, Daily, Ellstrand and Johnson (1998), Weir and Laing (1999) and Weir, Laing and

McKnight (2002) find little evidence to suggest that board characteristics affect firm

performance. However, other studies have found a positive relationship between certain

characteristics of board and firm performance (Bhagat and Black, 1999; Kiel and Nicholson,

2003; Bonn, 2004). Nevertheless, the role played by the board is critical to firm performance as

the boards discharge their fiduciary responsibilities of leading and directing the firm (Abdullah,

2004). Given the inconclusive findings in the extant research, the present study used a wider

array of board structure (board size, board duality, board nationality, board ethnicity, board

gender and board skill) to examine the impact of board characteristics on corporate financial

performance in Nigeria.

Nigeria is used as our case study because of daunting problems that are very visible in the

country‘s corporate environment, and the weakness of regulatory frameworks to protect the

entire spectrum of corporate stakeholders. The subject of corporate governance, board

characteristics and firm performance has suffered neglect both in the academia and public policy

in Nigeria. The relative neglect of corporate governance in Nigeria public policy is perhaps a

reflection of the paucity of empirical works in this area. The Nigerian Securities and Exchange

Commission Code of Best Practice for Publicly Quoted Companies 2003; and the Code of

Corporate Governance for Banks and other Financial Institutions 2003 are the main cornerstone

of corporate governance reform in Nigeria. Despite the introduction of these codes of conduct,

literature and empirical works on board characteristics and firm performance is still lacking in

the country. Using a population sample of all public limited liability companies quoted on the

Nigerian Stock Exchange for the period 1991 -2008, this study fills this important knowledge

gap.

1.2. Statement of Research Problem

There is, near lack of basic infrastructures, corporate frauds, tax evasion, inexperience

management, incessant changes in government macroeconomic and fiscal policies, communal

and civil unrest, among others in Nigeria. Governments and host communities have ways of

meddling with the affairs of firms. In some other cases, corporate owners and managers

deliberately embark on acts that serve more of self than the overall wellbeing of the affected

firms.

A priori, weak business culture and poor corporate governance are capable of creating incentives

for the appointment of wrong and dubious people into companies‘ boards (Ponnu, 2008).

Whether or not a board composition comprising such people enhances corporate performance

has remain an issue of empirical and theoretical debates. Essentially, results of previous studies

confirm that the presence of suspicious individuals into a board can exacerbate governance

problems facing the firm (Kajola, 2008). Bad corporate governance is capable of negatively

influencing corporate performance and shareholders‘ value as revealed by the works of Ponnu

(2008), Deutsch (2005) and Singh and Gaur (2008),

On the other hand, in an environment where regulations are incapable of preventing managers

and board members from appropriating earnings for selfish gains, the selfish interests of these

individuals entrusted with corporate management and control can actually be directed at profit

maximisation goals. While theoretical positions on the above issues have been historically laid

down, the practical validity of theories is yet to be reconciled with developments in some

developing economies. Studies in emerging economies have shown that the advisory role of

boards is likely to be more important than the oversight role due to several reasons (Ponnu,

2008). First, the traditional agency problems related conflict of interest between owners and

managers are less of a concern in emerging economies due to the unification of ownership and control (Dharwadkar et al, 2000). As the potential of conflict between owners and managers

reduces, so does the importance of the board‘s oversight role. Second, owners/managers of firms

in Nigerian may view board independence as a mere statutory requirements and attempt to fill it

by appointing people who considers their role ceremonial. The principle of board independence

is thus followed in letters and not in spirit. This problem is accentuated because of weak external

governance, which allows firms to get away with loose adherence to rules and regulations about

board independence.

Based on these, policy formulation using studies in developed economies might be misleading,

because those studies do not effectively take into cognizance developing economies institutional

peculiarities. This study fills this important gap by incorporating those institutional specifics in

Nigeria. Nigeria represents a good case study for exploring how a board constituted under

subjective circumstances serve or can fail to serve firm‘s interests; and whether such transmits to

the overall well being of shareholders.

To improve the robustness of the test, we lagged the endogenous variable for two years in order

to accommodate the bias lagged effect might introduce in our results. The study also conducted

another robustness test that reduced the period of the study to a short time frame of 2003- 2008.

The approach helped us accommodated predominantly small firms in our robustness test, while

examining the impact of the Code of Best Practices for Quoted on firm performance in Nigeria.

1.3 Objectives of the Study

This study examined specifically the impact of board characteristics on corporate financial

performance of listed companies in Nigeria. To achieve this objective, the study strived to;

a. Examine the impact of board size on the financial performance of quoted companies in

Nigeria.

b. Ascertain the impact of board skill on firm financial performance in Nigeria.

c. Identify the systematic interaction between board duality and corporate financial

performance in Nigeria.

d. Assess the impact of board nationality on the financial performance in Nigeria firms.

e. Determine the impact of board gender on corporate financial performance in Nigeria.

f. Ascertain the impact of board ethnicity on the financial performance of quoted companies

in Nigeria.

g. Investigate how corporate governance rules have evolved over time in Nigeria and the

underlying processes and forces that influenced such evolution.

1.4 Research Questions

This study was tailored in such a way that it provided answers to the following questions;

a. What is the impact of board size on corporate financial performance in Nigeria?

b. Does board skill promote corporate financial performance in Nigeria?

c. What is the impact of board duality on the financial performance of quoted firms in

Nigeria?

d. What is the relationship between board nationality and the financial performance of

quoted firms in Nigeria?

e. Does board gender enhance corporate financial performance in Nigeria?

f. What is the impact of board ethnicity on the financial performance of quoted companies

in Nigeria?

g. How did corporate governance rule evolve over time in Nigeria and what are the

underlying process and forces that influenced such evolution?

1.5 Research Hypotheses

To achieve the above objectives and provide answers to the research questions, the following

hypotheses were investigated;

a. Board size is not positively and significantly related to firm financial performance.

b. Board skill is not positively and significantly related to corporate financial performance.

c. Board duality is not positively and significantly related with firm financial performance.

d. Board nationality is not positively and significantly associated with firm financial

performance.

e. Board gender is not positively associated with corporate financial performance.

f. Board ethnicity is not positively associated with firm financial performance.

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