Conflicts of Corporate Governance Affecting Firm Performance

Corporate governance as a topic of interest in academic literature dates back to the work of Berle and Means (1932) and till recently, efforts are being made to understand and minimize conflicts that could affect firms performance. The problem that arises in trying to separate ownership (the shareholders) from control (managers) leads to the concept of corporate governance. A most welcomed view of corporate governance is that given by Shleifer and Vishny (1997) as “ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”. It has been argued that such view is constricted and other stakeholders such as the consumers, suppliers etc are interested in the way the firm is run. A more accepted view was given by Denis and McConell (2003) where corporate governance is “a set of both institutional and market based mechanisms that persuades the self‐interested controllers of a company (who make decisions regarding how the company is operated) to make decisions that maximize the value of the company to its owners (the suppliers of capital)”.

2.2 Corporate Governance Problems and Solutions

Shareholders are interested in increasing the value of their shares and getting vale for money but since they have limited expertise to do so, they employ managers. The managers main interest are normally slightly different from that of the shareholders though they may not be against value maximization and may decide to pursue their interest ahead of the interest of the shareholder termed the value maximization of the firm.

There are three major agency conflicts stated by Denis (2001) that may arise between shareholders and their managers which could affect firm performance. First, is the managers desire to remain in power where the manager needs to be changed to increase the value maximization goal either because they lack the know-how or underperformance is seen. Another aspect of serious conflict is, managers are generally referred to as risk averse while shareholders are known as risk takers knowing that shareholders own diversified portfolios and managers have most of their capital tied to one firm and has more to loose something goes wrong. Thirdly, what is being done with the excess money stands as a major agency conflict, whether he pays it out to shareholders and lenders or holds on to it.

2.2.1 Monitoring Managers/Executives:

In an attempt to increase firm performance agency conflicts have to be reduced, different solutions are proposed to reduce such conflicts of which one is monitoring. Monitoring on behalf of shareholders could be internal or external. It is done internally by the board of directors who possess adequate expertise to confirm if a decision is value maximizing or not. Also, some executives on the board are termed ‘busy’ because they serve on multiple boards has been reported to affect firms value. An external form of monitoring is done by large shareholders who have quite a substantial amount of the firm than the average shareholder and could benefit (loose) more if the firms value is appreciating (depreciating). I review below previous literature considering the size of board, ownership by institutional investors, the presence of a busy director and the effect shown to have on the performance of the firm.

2.2.1.1 Board of Directors and Firm Performance:

The Board of directors is an important determinant of governance in firms and has been argued to reduce agency conflict and affect a firms performance when effectively managed. Some prior quantitative research believes firms with large boards perform worse than those with smaller boards; an inverse relationship exists between board size and a measurement of performance, Jensen (1993), Yermack (1996), Hermalin and Weisbach (2003), and Lipton and Lorsch (1992). Reason being that as the board size increases, there is an increased problem in coordination, communication and decision making leading to more agency conflicts between owners and controllers. Having an efficient board size reduces such conflicts. Jensen (1993) believes that an efficient board size is six while Lipton and Lorsch (1992) approve an adequate board size between eight and ten. Eisenberg et al (1998) also finds a similar result of a smaller board size being more effective but believes that the appropriate size varies across small and medium Finnish firms as compared to large firms.

Contrary, some other studies find other existing relationships; Ferris et al (2002) found a positive relationship between firm performance and board for US firms. Bhagat and Black (2002) find no robust association between firm performance and board size, also that firms with independent board perform worse than other firms. Their reason for a different result was attached to the sensitivity of the regression results to the control for endogeneity or to whether one uses a simultaneous equation approach or an OLS.

2.2.1.2 Ownership by Institutional Investors and Firm Performance:

An associated set of findings have focused on the impact of equity holdings by institutional investors or blockholders have on a firms performance , Shleifer and Vishny (1997) believe that shareholders who hold a significant amount of equity in a particular firm have an important position to play in the governance system of a firm. Institutional investors have an increased interest in activities of corporate governance by introducing proposals put forward mainly when firms are performing poorly such institutional investors aim to improve performance, Morck et al 1988, Karpoff et al 1996 but whether they increase the firm value is the issue. Shleifer and Vishny (1986) believe that large blockholders are better able to put a check on management and help enhance the firms value than the average shareholder whose monitoring will be costly than the envisaged benefit and equity holdings by Institutional investors positively impacts firms market value but sometimes tends to takeovers. Holderness and Sheehan (1985) looked at six large blockholders termed as ‘corporate raiders’ and found shareholdings in firms targeted by ‘corporate raiders’ had statistically improved returns upon announcement because they improve management by monitoring and they are well informed enough to recognize underpriced stocks. Similar studies that find excess returns upon announcement of an institutional investor are Mikkelson and Ruback (1985) and Barclay and Holderness (1991) however they argue that restructuring of the corporation or takeover needs to quickly follow. McConnell and Servaes (1990) report a positive significant relationship between block ownership and firm value but their result was not robust to the inclusion of an alternative measure of performance. In Contrast, there has also been evidence of institutional investor having little or no effect on firm performance. Karpoff et al (1996) finds little evidence proposals by institutional investor prompt improved performance by observing no improvement in the share value of firms. There has rather been little research looking at the direct impact of institutional activism on firm performance bearing in mind that such effect is not easily observable because it has an economic positive impact but may not be easily seen due to noisy factors that may affect performance, Black (1998). Also, most studies fail to consider and state the degree to which blockholders are active or passive and do not consider several different alternatives for measuring ownership by institutional investors.

2.2.1.3 Busy Directors and Firm Performance

The number of boards an executive gets to sit on also effects firm performance. Having directors that serve on multiple boards have reputational effect on the directors, assist in providing quality monitoring and signal the worth of the firm (see Fama and Jensen (1983) and Kaplan and Reishus (1990)). Ferris et al (2003) builds on Fama and Jensen’s (1983) work and they make use a cross-sectional model, they argue that limitations should not be placed on the number of board a director can sit on because serving on multiple boards is positively correlated with firm performance. On the other hand Bhagat and Black (1999) believe the reverse, arguing that better performing firms tend to attract directors that serve on several boards. Some other studies believe that the presence of directors on multiple boards leads to more agency conflicts and adversely affects firm performance knowing they are too busy to effectively monitor the business of several firms. Core et al