Corporate boards in some OECD countries: size, composition, committee structure and effectiveness.

Transcription

1 Corporate boards in some OECD countries: size, composition, committee structure and effectiveness. Pablo de Andrés Alonso Universidad de Valladolid Valentín Azofra Palenzuela Universidad de Burgos Félix J. López Iturriaga Universidad de Valladolid Abstract: In recent years, the debate about the efficiency of corporate governance mechanisms has focused on the activity of corporate boards of directors. This paper tries to join this debate by analyzing the effect of board size, composition and structure on firm value in a sample of 450 non-financial companies from ten Western Europe and North American countries. The econometric method combines uniequational regression analysis with simultaneous equations in order to control for the possibility of board size endogeneity. The results show a negative relationship between firm value and the board of directors size. This relation holds when we control for alternative definitions of firm size and for board composition, board structure, country effect and industry effect. We find no significant relationship between outside directors and firm value. These results are consistent, in an international framework, with other relevant papers. Keywords: Corporate governance, board of directors JEL classification: G32, G34. Address for comments: Dpto. Economía y Administración de Empresas Universidad de Valladolid Avda. Valle Esgueva, 6 E VALLADOLID Tel.: e Fax: pandres@eco.uva.es flopez@eco.uva.es The authors are grateful to Spencer Stuart for providing the data. This research has been supported by Spanish Dirección General de Enseñanza Superior (proyecto PB )

2 1 1. Introduction The increasing interest academia has in corporate governance can be inferred from latest developments in financial agency theory. This theory combines in a unified body of knowledge several topics related to property rights, contracts, information and corporate law. At the light of this approach, the basic agency problem of capitalism is the credibility problem facing entrepreneurs of firms when they seek to convince outside investors to contribute funds (Berglöf, 1997). Although competition in input and output markets can limit this problem, competition itself is not enough to make it out because the information that signals convey to markets is available by outside investors once they have financed the firm. The solution to this problem, traditionally formulated in terms of separation of ownership and control, implies the design of suitable corporate governance mechanisms. These mechanisms should ensure fund providers that competitive signals and other relevant information are actually transmitted to markets through investment decisions and, in turn, the signals should make the firm get external funds as cheap as possible. The discussion about the efficiency of corporate governance mechanisms has produced a great deal of research in order to know more in detail the effects of some issues of corporate governance on managers decisions and firms value. Among this research it is worthy underlining the corporate control market (Jensen and Ruback, 1983), managers compensation schemes (Baker, Jensen and Murphy, 1988), the effects of corporate ownership structure (Morck, Shleifer and Vishny, 1988; McConnell and Servaes, 1990; Shleifer and Vishny, 1986), the role of institutional investors (Pound, 1988), the influence of financial organization models (Berglöf, 1990; Prowse, 1994), the disciplinary role of corporate debt (Jensen, 1986; Hart, 1995) and the effectiveness and composition of the board of directors (Hermalin and Weisbach, 1988; John and Senbet, 1998; Yermack, 1996). In recent years the debate has focused on the activity of the board of directors, the most outstanding governance mechanism due to be on the top of the internal control systems (Jensen, 1993) and to have to monitor managers by shareholders delegation. In fact, the problem of control is endemic to large companies where ownership is widely dispersed and where small shareholders have no incentives to monitor (John and Senbet, 1998). In addition, if other corporate governance mechanisms are weakened, the inefficiency of boards can be very costly to companies and, in turn, to the whole society. At the same time, the interest of academia in boards has run parallel to the attention practitioners have also paid to it. In the main developed countries, board behavior codes have been written (Cadbury, Vienot, Peters, etc.) as a demonstration of the concern with having effective means of monitoring to improve companies value creation. In the two fields (academia and practitioners) there is no doubt about the need of monitoring and control by boards of directors, so that corporate governance will improve as long as board functioning will be more properly understood. The recent literature about boards is basically empirical and relies on three main questions: the size of the board (Eisenberg et al., 1998; Jensen, 1993; Yermack, 1996), its composition and independence (Baysinger and Butler, 1985; Bhagat and Black, 1998; Hermalin and Weisbach, 1988, 1991; Rosenstein and Wyatt, 1990, 1997; Weisbach, 1988), and its internal structure and functioning (Klein, 1998). From a theoretical point of view, just a few papers have considered endogenous board structure

3 in order to achieve the optimal corporate governance solution to the monitoring problem (Hermalin and Weisbach, 1998; Warther, 1998). The results of these papers show the negative influence of board size on firm value, the indetermination of the effect of board independence on firm value and a certain endogenous relationship among directors turnover, board composition and some external elements. This paper tries to join this empirical literature by analyzing the influence of board size, composition and functioning on firm value. We use a sample of 450 companies from ten countries, three out of them are from the anglo-saxon corporate system (Canada, USA and UK) and seven countries from the continental one (Germany, Belgium, Spain, France, Holland, Italy and Switzerland). The availability of data from a number of countries allows us to expand the study about the board of directors broader than anglosaxon system on which most of the research has focused. To deal properly with the problem of board size endogeneity that some authors have stressed, our econometric methodology combines the uniequational ordinary least squares (ols) with simultaneous equations analysis by using three-stages least squares with instrumental variables. The main results we achieve are: i) there is a negative relationship between firm value and board size; this relationship holds after controlling for alternative measures of firm size and for board composition, internal board functioning, country effect and industry effect. This relationship does not depend on the estimation method; ii) we do not find any consistent relationship between the proportion of outside directors (a proxy for board independence) and firm value; iii) the descriptive analysis shows there are relevant institutional differences in the corporate system (anglo-saxon vs. continental). In summary, these results confirm, in an international framework, those suggested by Jensen (1993) and estimated by Yermack (1996) and Eisemberg et al. (1998). The paper is divided into four sections. Section 1 surveys the theoretical foundations of boards of directors (size, composition and internal structure), its relationship with firm value and presents the hypothesis to be tested. Section 2 is a description of the database, the variables and some methodological issues. In section 3 we present and discuss the main empirical results. Finally, section 4 contains some conclusive comments and directions for future research. 2. Boards of directors and firm value: theoretical background. The topic of corporate governance and its linkage to firm value has attained increasing importance in recent years. One of the most plausible explanations to this fact is based on the agency theory, so that, given the separation of ownership and control, corporate governance becomes a way of diminishing agency costs. Although there are also some external mechanisms to deal with agency costs, as far as internal mechanisms are concerned, a clear relationship between the structure and management of the firm and its ability to produce cash flows can be conceived. The ownership and decision rights allocation inside the firms, the incentives of agents having the decision rights and the distribution of information to both of them are key points, so that firm performance is abound to be affected by these factors. Our paper joins this research about the effectiveness of internal mechanisms and focuses on the linkage of firm value to several corporate governance issues such as board size, composition and structure. To answer this question, an essential point is defining clearly 2

4 the board function and objective. As said by Fama and Jensen (1983), the board of directors is seen as the instrument shareholders have to monitor top managers. Nonetheless, boards are not always able to play fairly this role and the lack of effectiveness they sometimes show requires a more-in-depth analysis coping with three board issues (size, composition and committee structure) along with the idea that board itself can be the result of the interaction of other factors Board composition and firm performance Directors are usually divided into insider and outsider ones on the basis of their participation in firm ownership since they can have quite different behavior and incentives 1. Although both groups have some advantages and disadvantages, most of the authors would prefer outside directors-dominated boards. In these authors opinion, non-management directors provide superior performance benefits to the firm as a result of their independence from firm management (Baysinger and Butler, 1985). This is why some papers stress the positive market reaction to outside directors appointments (Rosenstein and Wyatt, 1990) and to poison pills when outside directors have reached a minimum level (Brickley et al., 1994). However inside directorship has been also justified on the basis of the better knowledge this kind of directors have about the company and the industry where the company operates, so that their experience can improve firm performance (Baysinger and Hoskisson, 1990; Bhagat and Black, 1998). There is still an intermediate position including the papers which have not found any conclusive evidence. For instance, Hermalin and Weisbach (1991) find no relationship between firm performance and board composition despite of having found a close relationship with ownership structure. Moreover, Rosenstein and Wyatt (1997) reveal that adding an inside director to an outsider-dominated board improves shareholder wealth and so does adding an outside director to an insider-dominated board. Another key point on board composition and its ability to look for shareholders interests is related to CEO appointment and destitution. As long as insiders directors careers are tied to the CEO position, CEO turnover and managers compensation schemes depending on firm performance are likely to take place more often in outsiders dominated boards (Weisbach, 1988; Hermalin and Weisbach, 1988; Rosenstein and Wyatt, 1997). This conclusion can be inferred from the findings of these authors who show that near a new CEO appointment, insiders tend to be added to the board more than outsiders and that insiders and outsiders have a quite different average tenure when leaving the board Board size The number of directors is a relevant feature that can have much to do with board monitoring and control activity. Whereas board capacity to monitor increases as more directors are added, the benefits can be outweighted by the conflicts in decision making 3 1 Of course, this is not the only possible classification. In addition to these two groups, some authors also consider grey o affiliated directors (non-employee directors with personal or business relationships with the company) and block-holder directors (those in a peculiar status because of their ownership proportion).

5 in terms of the cost of poorer communication and decision making associated with larger groups (Lipton and Lorsch, 1992; Jensen, 1993). The empirical evidence proves this last one assertion when showing an inverse relationship between firm value and board size after controlling for the size of the firm, its age and growing opportunities (Yermack, 1996; Eisenberg et al., 1998). Yermack presents evidence that small boards of directors are more effective and companies with them exhibit more favorable values for financial ratios. Furthermore, financial markets show positive reaction to announcements of boards downsizing while announcements of higher number of directors usually reduce equity value. However, it is not a linear reaction but the bigger the board, the smaller the negative effect of an additional director. In other words, the most affected companies by this problem are those medium and small ones whereas big companies, in spite of its negative effect, do not bear the problem to such an extent. There are even some papers setting out a non-monotonic relationship and thus estimating the optimal number of directors (Fernández et al., 1997). Other alternative explanations to this negative relationship between firm value and board size can be grounded on the fact that in small companies the directors incentives scheme is clearly defined and there are active block-holders who monitor more efficiently. That is why, in small companies, one can notice less directors turnover, probably as a consequence of more efficient management and the threat of dismissal operating more strongly 1.3. Committee structure Another alternative answer to explain the lack of relationship between firm value and directors ownership is based on the analysis of the board internal administrative structure (Klein, 1998). If this is the case, the little association between firm performance and overall board composition turns into significant ties between firm performance and how boards are structured. The committees are nominated by board delegation and are a way of specifying the task directors are responsible of, so that, the bigger the firm, the more important their role. There are several types of committees and it could be interesting a brief description of them for a better understanding of the function that inside and outside directors perform. There are two committees, those of auditing and compensation, which primarily serve as monitoring committees. While the first one tries to reduce the information asymmetry between insiders and outsiders by releasing unbiased accounting information, the second one constructs and implements the incentives schemes to align the goals between managers and shareholders. Thus, these committees should be mainly comprised of directors independent of management. In fact, compensation committee is so important that some authors assert that managers will lead corporate strategy biased toward their personal incentives instead of profit maximization (Kedia, 1997). On the other hand, there are two other productivity-oriented committees (those of finance and strategic investment) requiring a great deal of specialization and expertise knowledge about firm activities, so the proportion of insiders in these committees should be higher than in others since insider directors are supposed to know more about the firm that their outside counterparts. This hypothesis has been proved by Klein (1998) who found a significantly positive connection between the percentage of insiders 4

6 on finance and investment board committees and accounting and stock market performance measures Board structure and endogeneity So far we have taken for granted the board structure. Now it is pertinent to wonder about the factors affecting the board size and compensation and about the factors or the people responsible of hiring and/or dismissing a director. In other words, this means to face the endogeneity of board structure (Hermalin and Weisbach, 1998; Eisenberg et al., 1998; Yermack, 1996). To some extend, this is a new question because causality has been traditionally thought to run from corporate governance to firm performance, but there was almost no research in the opposite direction (Barnhart et al., 1994). Nonetheless, this issue is relevant as stressed by several papers presenting the reaction of the board of directors to firm financial performance. Hermalin and Weisbach (1988) shows that bad performance modifies board structure because the more industries the firm exits, the more outside directors get added ceteris paribus. At the same time, the proportion of insiders and outsiders in the board is related to CEO status. When CEO nears retirement firms tend to add inside directors as possible candidates to be the next CEO and, just after a CEO change, insiders with short tenures seem to leave the board. There are some more indicators of board endogeneity as the trend to include outsiders after a dividend cut-off Hypothesis The above presentation of the theoretical basis of the linkage of financial performance to board size, composition and functioning leads us to propose some hypothesis to be tested for a sample of ten countries in the following sections of the paper. One must know that, in some cases, there is no unanimity among the authors about the significance and the effects of some of the variables we use, so if some opposite to expected results arose, it should no be disheartening but an incentive to widen our sample and to use more accurate analysis techniques. The main hypothesis we are interested in concerns the negative relationship between board size (in terms of average number of directors) and firm value. Efficiency, flexibility, communication and coordination reasons along with most of the empirical papers allow to support this hypothesis. Secondly, we try to test the positive effect of outsiders' percentage on firm performance given that outsiders -as a synonymous of board independence- are supposed to strengthen monitoring and control. This hypothesis although suggested in several papers is no supported by conclusive evidence. Furthermore, some authors claim for balanced boards with the same proportion of each class of directors. Thirdly, we forecast a positive relationship between a group of variables that could influence the efficiency of the board (number of meetings per year, directors remuneration and the existence of specialized committees) and firm value. Lastly we are concerned with the possibility of board size endogeneity as recent literature have stressed and we propose to cope this issue by using the appropriate statistical method of estimation. 5

7 6 3. Sample, variables and methodology 3.1. Data The sample includes data of big non-financial companies from ten countries. Three out of these ten countries belong to the anglo-saxon corporate system (Canada, USA and UK), whereas the other seven do to the continental one (Germany, Belgium, Spain, France, Holland, Italy and Switzerland). The data have been obtained from Spencer Stuart Board Index, a publication of Spencer Stuart consulting. Although the index was firstly published in USA in 1990 and thereinafter it has been annually published, it is not until 1996 that this index is available for the other countries. We have, in turn, data about the board of director of big companies from ten developed countries. After dropping out financial and insurance companies, those companies with too many missing data and outliers, our sample reduced to 450 companies. As table 1 displays there are big differences in terms of size and number of companies per country, but there is not any sample bias since our observations correspond to the largest companies in each country. In addition, all the companies have an unitary board with the sole exceptions of Germany and Holland where companies by law are forced to have a two-tier board system with a Supervisory Board and a Management Board. We will show later some differences among the countries after having defined the variables we will use. # of companies Table 1. Number of included companies by country Average size (mill. $ sales) Average size ($ market value) # of Average size companies (mill. $ sales) Average size (mill $ market value) Belgium , ,90 Netherlands , ,95 Canada , ,62 Spain ,68 930,88 France , ,76 Switzerland , ,19 Germany , ,40 UK , ,23 Italy , ,74 USA , ,88 Total , ,99 The method Spencer Stuart uses allows for homogeneous information structure of the companies from the ten countries. Notwithstanding, the collected information is not completely equivalent due to the different requirements each country imposes, so that anglo-saxon countries release more information than the other countries. In sum, the Board Index provides information on board size and composition (number of insiders, outsiders and foreign directors), the number of meetings per year, the directors average age, the directors average tenure, the remuneration the members of the board perceive and, just for few counties, the kind of committees the board delegates its authority to. The Global Vantage Database was also used in order to get information on financial statement at both book and market value. That information concerns sales, equity market value, gross and net profit, debt, assets and number of employees. The method Standard & Poors uses also allows for homogeneity among different countries.

8 Variables and descriptive analysis Firm s value has been proxied by equity market to-book ratio (PBV). Fama and French (1992) show how this ratio, combined with firm size, is a robust, simple and easy to measure indicator of firm performance. While some papers use market-to-book ratios as dependent variable (Barnhart et al., 1994), others use some versions of Tobin s q ratio (Yermack, 1996; Baghat and Black, 1998). We have also defined accountancy performance measures as the return on equity and the return on assets (see table 2) The average number of directors (TAMC) measured board size. As table 2 shows, mean and median board size are repectively 11.6 and 12 directors, which is consistent with 12 directors reported by Yermack (1996), Barnhat et al. (1994), Rosenstein and Wyatt (1997) and Klein (1998), and slightly higher than Fernández et al. (1997) and Denis and Sarin (1998) data. The differences in board size are closely related to the firm size and country features. Figure 1 plots the relationship between mean and median market-to-book ratio (hereinafter PBV) and the number of directors. PBV decreases quickly at the beginning when board size increases from 4 to 9 directors and later more slowly, having a small peak at 9-10 directors. For companies with more than 12 directors the slope is monotonically although almost imperceptible- downwards. This relationship is consistent with the negative coefficient of correlation among board size and firm performance we have found not reported in the paper-. Figure 1. Firm market value and board size Mean Median PBV Board size Board composition includes three variables: the percentage of insider directors over the whole board (INTP), the percentage of foreign directors (FORP) and the percentage of outside directors (EXTP) as defined by Spencer Stuart Board Index 2. This last variable is considered to proxy board independence as long as foreign directors are not managers. We would have liked to distinguish between grey directors and true outside directors, but the available information was not enough to separate both groups. Table 2. Variables descriptive statistics Obs. Average Median Stand. Dev. Max. Min. TAMC , ,0000 3, Spencer Stuart Board Index defines inside directors as those directors having executive responsibilities (managers), whereas outsiders are the non-manager directors

9 8 EXTP 408 0,7087 0,7500 0, INTP 408 0,2831 0,2426 0, FORP 285 0,0954 0,0000 0,1417 0, LONG 408 3,4037 3,0000 2, ,65 1 AAGE ,39 57,6333 8, COMYEA 437 6,60 6,0000 3, REMCOD ($) COMN 237 2,9705 3,0000 1, PBV 450 3,3346 2,2945 3, ,7361 0,1053 ROE 450 0,1232 0,1227 0,2536 1,3153-4,2034 ROA 445 0,0575 0,0469 0,0788 0,8207-0,4265 DLPAT 450 0,2101 0,1877 0,1421 0,9206 0,0000 ATD (mill $) , ,85 SALES (mill $) , ,13 MKT (mill $) , ,84 EMPL , ,50 The average value of the percentage of outsiders is quite high and this means that more than half of the boards were dominated by outsiders (we considered an outsiderdominated board when EXTP is higher than 0.7) while insider-dominated boards (INTP) were only 17% of the sample. This is not irrelevant since outsiders dominated boards are more independent and are supposed to monitor more effectively. Nonetheless, the empirical evidence is not conclusive and balanced boards benefiting both from the insiders expertise and from the outsiders independence- seem to be preferable. Despite the fact that the percentage of foreign directors is not usually reported in previous papers and although this variable has a small value this data is only available in 285 companies-, foreign directorship (FORP) is more and more frequent. In fact, this variable has an increasing trend as a consequence of the globalization process. To describe properly the board internal functioning, three more variables were defined. Firstly, COMYEA is the number of board meetings held in a year. It is interesting since can be used as a proxy of the intensity of board activity and will used to control for board monitoring in the next section estimations. The other two variables were the directors average age (AAGE) and the directors average tenure (LONG), representing board stability and even directors entrenchment. Both of them are positively correlated with board size. We report also the whole remuneration of the board (attendance fees, retainers, etc.). In order to avoid board size-originated bias we have calculated the remuneration each director perceives (REMCOD) in USA dollars. As table 2 displays, the average income per director is $ 40,465 although this only includes fixed payments. There are also some kinds of variable payments as options, bonuses, etc. which are not included. Furthermore, that information is only available for few counties and is very heterogeneous in terms of individual vs. bulk remuneration. So, most of Canadian and US companies remunerate their directors depending on firm value in addition to attendance fees- as a way of aligning directors interests with those of shareholders. In the other countries, performance-contingent remuneration is no usual at all, has been constrained (Cadbury report in UK, although it was later modified by Hampel

10 Committee) or even banned (France). There are still some countries as Germany where directors are paid depending on the dividend the company pays. Table 3. Committee structure of the companies in the sample The average number of committees in the companies of each country is shown (# of committees), along with the percentage of firms having a remuneration, auditing, finance, nominating, strategy or other committee. Firm average size is included. Canada, Italy, Belgium and Germany data are average values from Pic (1997) since there is not firm-level data available. 9 Spain France U.K. Netherlands U.S. Canada Italy Belgiu m Obs % Companies with committees Germany 57% 77% 100% 54% 100% 100% 40% 65% 93% # of Committees 1,2000 1,4286 2,5758 1,8421 4,8360 4,0 1,1 2,1 2,0 Remuneration 28,00% 68,57% 100,00% 73,68% Auditing 28,00% 57,14% 100,00% 63,16% Finance 4,00% 17,65% 0,00% 0,00% Nomination 0,00% 26,47% 57,58% 10,53% Strategy 0,00% 14,71% 0,00% 36,84% Others 12,50% 8,82% 0,00% 5,26% Av. Size (mill $) As far as board committees are concerned, data on the number of committees each board includes were available and, just for few countries, the type of committee (auditing, remuneration, nomination, finance, strategy and others) was also available. If this is the case, sample size decreases to 237 companies since only five countries report that sort of data (France, Spain, Holland, UK and USA). Table 3 displays how anglosaxon system companies (especially those from USA) are more prone to use committees and the high number of auditing and remuneration committees existing. These committees usually tend to monitor managers and that is why they comprised basically outside directors while other executive committees (finance and strategy) include mainly insiders. Any case, nearly all the reports about corporate governance recommend the committees structure and they are seen as a practical solution to rigid, oversized and lacking of operative capacity boards (Klein, 1998). USA boards example, the first country to introduce committees, seems to begin to flourish in European companies The control variables used were firm size (proxied by total assets ATD, by sales SALESD and equity market value MKTD), firm debt (long term debt over total assets, DLPAT), the number of employees (EMPL) and industry and country effect. The institutional differences because of the corporate system where companies operate were introduced by a dummy variable (ANGLO) taking 1 for USA, UK and Canada and 0 otherwise. This variable has an important role since it is supposed to count for the differences in ownership structure between both systems. Some variables to control the ownership percentage each one of the directors has, the presence of institutional investors, R&D expenses or corporate diversification would have been helpful but unfortunately the lack of information prevented us from its usage. Table 4. Descriptive statistics by corporate system Anglo Continental General Anglo Continental General TAMC 12, , ,6778 PBV 3,6192 3,0500 3,3346

11 10 0,0000 0,0924 EXTP 0,6798 0,7443 0,0011 0,7087 ROE 0,1416 0,1048 0,1236 INTP 0,3202 0,2375 0,2831 ROA 0,0688 0,0460 0,0000 0,0021 FORP 0,0963 0,0952 0,0954 DLPAT 0,2677 0,1524 0,9519 0,0000 LONG 2,5022 4,5120 3,4037 ATD (mill $) ,0000 0,0010 AAGE 57, , ,3877 SALES (mill $) ,0050 0,0000 COMYEA 7,6451 5,5000 6,5995 MKTD (mill $) ,0000 0,0002 REMCOD($) EMPL ,0869 0,0058 COMN 3,9041 1,4725 2,9705 0,0000 0,1232 0,0575 0, Differences between anglo-saxon and continental system are more evident when dividing the whole sample into two groups. Table 4 reports the mean value of each variable and the p-value to test the hypothesis of different mean in each group. As we can see, bigger boards in anglo-saxon companies relate to larger company size with no respect to the alternative definitions of firm size. These companies usually are those ones with older directors but shorter tenure, and more active boards -by a higher number of meetings per year-. This evidence could be understood as pointing at more effective monitoring and control by anglo-saxon boards, consistent with their better performance as market and book ratios show. This more intense activity of anglo-saxon directors has nothing to do with remuneration, although some caveats must apply because REMCOD variable does not include all the payments anglo-saxon directors perceive. Finally it is a bit surprising the higher proportion of outsiders in European companies relative to anglo-saxon ones, although this result could be affected to some extend if data about grey directors and director ownership were available Empirical specification In this section we present some comments about the specification of the model to be tested. As said above, we are interested in testing the efficiency in managers monitoring by the board of directors along with identifying some factors potentially affecting this fact. Since the possible reasons to answer both questions can be grouped in a few explanations, we will do several estimations with a number of points in common. After testing the simplest version of the model, we will introduce additional variables to take into account the issues on which boards of directors research relies: composition size, effectiveness and committee structure. The method we will use is regression analysis, so that we have to identify one or more variables to be explained as a function of the other ones. Since we are interested in board efficiency -in the sense of firm value creation-, we have chosen PBV as dependent variable. This variable will be made to depend firstly on the board size under the hypothesis that bigger board size can make coordination and communication more difficult than in small groups.

12 Other control variables must be added in the right hand side of the equation. These additional variables are: 1) financial leverage DLPAT- under the hypothesis that debt disciplines managers and makes them reject negative net present value projects; 2) Return on assets ROA- because financial performance should improve equity value; 3) ANGLO dummy in case the features of the financial organization provide some explanation; 4) firm size (log ATD, log SALESD, log MKTD), given that it usually plays a significant role, although its sign cannot be forecasted. This basic model will be completed by introducing additional variables, either individually or in groups. We will begin by including board composition through EXTP and later the monitoring board activity (measured by COMYEA) and the incentives directors have (through REMCOD) will be incorporated. As far as the econometric method is concerned, ordinary least squares provides one of the first techniques to undertake the analysis. A priori, there is nothing wrong in using this method and it is worth underlining the fact that most of the papers about the board of directors role make usage of it, so we will do it too. Nonetheless, as long as a uniequational model can suffer from endogeneity, some precautions should be taken. This is why we have estimated an alternative simultaneous equations model comprising two equations. The first one is the above described, whereas the second equation present board size as a function of the proportion of outsiders, the size of the firm, the marketto-book ratio and the ANGLO dummy variable. In order to improve the efficiency of the estimators and to avoid any bias we have used the so-called three-stages least squares or instrumental variables method over the whole system of equations. At the same time, some robustness tests were run as, for instance, an additional estimation using full information maximum-likelihood method. Broadly speaking, the results achieved (tables 11-13) were very closed to those ones from the three-stages least squared. If this is the case, when the plausibility of endogenous board size is taken into account, the choice of the variables to be used as instruments becomes a key point. One of the most suitable solutions should be to include lagged values of the own variables. Unfortunately, we are not able to make the problem out in this way because our sample consists of only one year observations, so we have to use as instruments those predetermined variables whose exogeneity there is not doubt about, along with industry dummies. Any case, the estimation is robust and the choice of the method scarcely modifies the results we achieve. 4. Results The results of the analysis are displayed in tables 5 and 6. Firstly, a regression was run where PBV was made to depend on several variables: TAMC, ROA, ANGLO, DLPAT and ATD. As said previously, that equation was estimated by two different methods in order to deal properly with the possible board endogeneity: an ordinary least squares estimation (table 5) and a system of equations estimation (table 6). In the system of equations estimation, since an inaccurate specification of the model could be utilized, table 6 shows the likelihood ratio test. In order to detect some errors in the specification of the system, we have calculated a test which can measure the model validity. As it can be seen, the likelihood ratio test values are often high enough to accept the validity of the system of equations as it was initially suggested. 11

13 The most remarkable result is the negative impact of board size on firm performance. We had pointed at this issue in the descriptive analysis and our impressions are now confirmed. As column A in both tables show, this result appears in all the estimations with a very high confidence level and does not depend on the specification of the model or the statistical procedure. In addition, the negative relationship between TAMC and PBV holds in both simultaneous equations. Table 5. Firm value and boards of directors Ordinary least squares coefficients and t-statistics are shown. The dependent variable was always PBV. All the estimations include industry dummies. Column B incorporates also country dummies. Dep.: PBV (A) (B) (C) (D) (E) (F) C TAMC(log) EXTP COMYEA REMCOD ROA ANGLO DLPAT SALES(log) E Obs R R2-Aj F-Ratio () for p-value <1%; () p-value <5%;() p-value < 10% To interpret this result we should remember the debate about the influence of board size (Yermack, 1996; Eisenberg et al., 1998) when the shortcomings of large boards were exposed. The benefits of a more detailed monitoring that big boards enhance seem to be outweighted by the problems of the poorer coordination, communication or flexibility inside the board. At the same time, the log form implies a convex relation and thus, the negative impact of the board size on firm performance decreases as along as boards become bigger. This idea confirms what we said in the previous section (figure 1) when we displayed a convex and downwards-slope relationship between board size and firm performance. For instance, if board size increases from the average number of directors to 14, (it means a 19.88% growth), PBV will decrease for 7.37%, whereas if board size increased up to 16 directors (a 37.01% growth), PBV would go down just for 12.81% ceteris paribus. This is perhaps the most outstanding result but it could be complemented by a set of additional evidence. Return on assets has a clear positive effect, although it only becomes true in the uniequational estimation since its coefficient in the system of equations has not any significant influence. Leverage, a variable traditionally related to 12

14 the discipline of managers, and ANGLO (to account for country effect) were not significant too. In spite of the lack of signification of these two last variables, they should not be excluded from the equations because of the omission bias. In fact, the analysis after dropping them out whose results are not displayed in the tables- distorted completely the results and was too affected by alternative formulation of the model or the method of estimation. Table 6. Firm value and boards of directors Three-stages least squares coefficients and t-statistics are shown. The dependent variable was PBV in the first regression and board size in the second one. Industry dummies, firm size, debtto-asset ratio and ANGLO were used as instruments. The likelihood ratio test follows a χ 2 distribution. (A) (B) (C) (D) (E) (F) Dep.: PBV TAMC(log) EXTP COMYEA REMCOD ROA ANGLO DLPAT SALES(log) E E Obs R Dep.: TAMC C EXTP ATD(log) ANGLO PBV R () for p-value <1%; () p-value <5%;() p-value < 10% Another relevant feature of the analysis is the effect of firm size. Our results point strongly at the positive influence of firm size on value and performance. Board size, company size and firm value can be correlated in complicated ways, so we have checked the robustness of our analysis to different definitions of firm size. The results are insensitive to alternative definitions (ATD, SALESD, MKTD) and firm size variable is always highly significant (see tables 7-10 in appendix). Firm size is not only relevant for firm value but also, as logical, for the number of directors attending the board (table

15 6). This result are totally consistent with other authors findings (Yermack, 1996; Eisenberg et al., 1998) who achieved a positive firm size coefficient when included as a control variable. In order to test the second hypothesis the one concerning the possible positive influence of board independence- we have introduce EXTP as a explanatory variable (Tables 5.B and 6.B). The results are nearly unmodified, board size keeps on being highly significant (negative) and ROA and firm size keep on being also significant (positive) too. EXTP itself has no significant effect in both of the models and, what is more important, the model adjusted signification worsens when EXTP is included. Thus, firm value seems to be insensitive to board independence. This results are again consistent with some of the available empirical evidence (Hermalin and Weisbach, 1991; Bhagat and Black, 1998), showing how insiders expertise and specialized information may be more profitable to company than the independent monitoring and control outsiders provide. An indicator of board activity (COMYEA) was later added (instead of ROA) to the explanatory variables set. This variable was found initially significant, if though a more detailed monitoring on managers by more board meetings was likely to improve firm value. However, it is not a robust result at all, because when the model is broadened to include the combined effect of EXTP and REMCOD, COMYEA is no longer significant (tables 5.E and 6.E). This fact could be understood if though COMYEA itself is not relevant to firm value but it can sometimes incorporate the effect of other initially excluded variables. REMCOD, a variable dealing with the incentives directors have to protect shareholders interests is not significant and nor is the model including it (tables 5.D and 6.D). To sum up this last group of results, the most evident conclusion is that those variables which are supposed to induce directors to act efficiently (remuneration, frequency of meetings) do not play that role and, thus, our third hypothesis do not verify. Data on board structure completed the previous estimations. We have taken into account, on the one hand, the mere existence of committees and, on the other hand, the sort of committees. So, two main groups of committees were set: those monitoringoriented (remuneration, auditing and nomination) and those execution-oriented (finance and strategy). In all the cases committees variables were found no significant, whereas the remainder variables presented the expected signs and significance (given the lack of significance, the results are not reported in tables for the sake of brevity). This fact should be interpreted in the same way than previous results: firm value does not depend necessarily on the board committee structure. Nonetheless, there are still some other incentives of directors, being likely to influence firm value which have not been included in the analysis because of the lack of availability as reputation or directors equity ownership. In sort, our results are basically consistent with the most frequent findings in the literature, because of the important influence of board size on firm value we have detected, along with the positive relationship between firm value and firm size. These results are robust to alternative definitions of company size, to different explanatory variables set and to distinct statistical estimation procedures. 14

16 15 4. Conclusions In latest years the academic and business debate about the efficiency of corporate governance mechanism has focused on the activity and functioning of the board of directors. The recent literature makes the board effectiveness rely on three main issues: board size, composition and internal structure. The results of previous research, basically linked to anglo-saxon area, stress the negative effect of board size on firm value, the indetermination of the role of board independence and, to some extent, an endogenous relationship between board size, composition and firm performance. Our work joins that strand of the empirical literature by analyzing the effect of board size, composition and way of acting on firm value. We have utilized a sample of 450 non-financial companies from ten Western Europe and North America countries: three out of them belong to the anglo-saxon corporate system (Canada, UK and USA) and the other seven countries to the continental corporate system (Germany, Belgium, Spain, France, Holland, Italy and Switzerland). The availability of data for a number of countries allows us to broaden our analysis to a wider basis than the anglo-saxon area to which most of previous research is linked. In addition, board size endogeneity is explicitly taken into account through the combination of uniequational analysis by ordinary least squares and simultaneous equations analysis by three-stages least squares with instrumental variables. The main result of our paper is the negative impact of board size on firm value. This effect persists after controlling by alternative definitions of firm size and by board composition, board internal functioning, country effect and industry effect. The disadvantages of worse coordination, flexibility and communication inside large boards seem to be more important than the benefits from a more detailed managers control by the board of directors. At the same time, the convex relation implied by the log form of the board size variable suggests that costs of larger boards accumulate at a decreasing rate as board size grows, being the small and medium companies the most affected ones. In an international framework, this result agrees with that of Yermack (1996), whose pioneering work has been later confirmed by other more recent papers. Any case, the negative effect of board size on firm value suggests some additional reflections about the way decisions are taken inside the board -mayority vs. minority rights, power distribution among the directorship, etc.- deserving further research. The relationship between board size and firm value is also affected by firm size, as the simultaneous equations system reveals. Firm size do not only influences firm value, but also relates positively to the number of the directors in the board. This relationship holds in all the estimations, is insensitive to the set of explanatory variables and shed some light on the plausibility of endogeneity. Regarding the second hypothesis of our research, we have not found any robust relationship between outside directors percentage (a proxy for board independence) and firm value. This result runs parallel to the lack of conclusive evidence about the effect of independent directors that literature shows. Many papers supports a balanced board composition, matching insider expertise and specific information with outsider independence. However, we are aware we should get a further identification of the directors (grey directors, block-holders, etc.) and incorporate directors turnover in order to achieve more accurate evidence.

17 Thirdly, we found no evidence about the positive expected effect of some features of directors behavior (number of meetings per year, remuneration and committees) linked to the incentives directors have to protect shareholder interests. This fact could be understood as a suggestion to introduce some other incentives that literature has shown highly significant and we have not include due to lack of information, as reputation or directors equity ownership. At last and just on a descriptive ground-, substantial differences were found between the way companies operate in the anglo-saxon system and the functioning of continental system companies. 16 References Baker, G. Jensen, M. C. and Murphy, K. (1988): Compensation and incentives: practice vs. theory, Journal of Finance, 43:3, pp Barnhart, S.W.; Marr, M.W. and Rosenstein, S. (1994): Firm performance and board composition: some new evidence, Managerial and Decision Economics, 15, pp Baysinger, R. D. and Butler, H. N. (1985): Corporate governance and the board of directors: Performance effects of changes in board composition, Journal of Law, Economics and Organization, 1, pp Baysinger, R. D. and Hoskisson, R. E. (1990): The composition of boards of directors and Academy of Management Review, 15, pp Berglöf, E. (1990): Corporate control and capital structure. Essays on property rights and financial contracts, Institute of International Business, Stockholm. Berglöf, E. (1997): Reforming corporate governance: Redirecting the European agenda, Economic Policy, 24, pp Bhagat, S. and Black, B. (1998): Board independence and long-term performance, Working paper, Graduate School of Business, University of Colorado. Brickley, J.A.; Coles, J. L. and Terry, R. L. (1994): Outside directors and the adoption of Poison Journal of Financial Economics, 35, pp Brickley, J.A. and James, C.M. (1987): The takeover market, corporate board composition, and ownership structure: the case of banking, Journal of Law & Economics, 30, pp Dalton, D. R.; Daily, C. M.; Ellstrand, A. E. and Jonhson, J.L. (1998): Meta-analytic reviews of board composition, leadership structure, and financial performance, Strategic Management Journal, 19, pp Denis, D. J. and Sarin, A. (1998): Ownership and board structures in publicly traded corporations. Working paper, Krannert Graduate School of Management, Purdue University. Eisenberg, T.; Sundgren, S. and Wells, M.T. (1998): Larger board size and decreasing firm Journal of Financial Economics, 48, pp Fama, E. F. and French, K. R. (1992): The cross-section of expected returns, Journal of Finance, 47, pp Fama, E. F. and Jensen, M. C. (1983): Separation of ownership and control, Journal of Law and Economics, 26:2, pp Fernández Álvarez, A.I.; Gómez Ansón, S. and Fernández Méndez, C. (1997): The Effect of Board Size and Composition on Corporate Performance, in Balling, M. et. al. (eds.): Corporate Governance, Financial Markets and Global Convergence, Financial Monetary Policy Studies, 33, Kluwer Academic Publishers, Boston. Hart, O.E. (1995): Firms, contracts and financial structure, Oxford University Press, London. Hermalin, B.E. and Weisbach, M.S. (1988): The determinants of board composition, RAND