The Relationship between Firm Performance and Bord Characteristics in Romania

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1 The Relationship between Firm Performance and Bord Characteristics in Romania Abstract Raluca-Georgiana MOSCU Ph D Student, Dimitrie Cantemir Christian University, Faculty of Finance moscu.raluca@yahoo.com The purpose of this study is the association between firm performance or firm financial performance and bord size and bord composition for companies quoted on Bucharest Stock Exchange. I also investigate the impact of firm size or debt to equity ratio on the relationship firm performance and aforementioned bord characteristics. I find some evidence: i) bord size has a positive relationship with firm performance, ii) there is a negative association between non-executives dierctors and firm performance, iii) there is a positive and significant association between firm performance and dummy which take value 1 when the percentaje executives on the board is more than non-executives percentaje Keywords: Performance, Bord Size, Bord Composition, Non-executives Directors, Executives Directors. 1. Introduction The connection between internal mechanism of corporate governance, like board characteristics, and performance has been the subject of an important and ongoing debate in corporate finance literature. The empirical studies about the relation between variable seem to have yielded conflicting results. The empirical literature on the relationship among company performance and board characteristic such as size and composition is quite extensive, but two global findings are apparent. First, some researches offers mixed evidence with regard the impact of board size on company performance. Second, other studies largely failed to establish a convincing link between the proportion of non-exectutives and firm performance. The objective of this study is to examine the relationship between company performance (ROA) or the company's financial performance (ROE) and board characteristics in Romania. The paper is structured as it follows: Section 2 presents theoretical foundation, in Section 3 it is described the variables used and the work methodology, and Section 4 contains the results of empirical testing. The last part is dedicated to conclusions. 2. Literature Review The membership of the Board is a case of corporate governance that has an impact on agent theory (Weisbach, 1998, Hermalin, Weisbach, 1991)

2 While the Board consists of a mixture of members from outside / independent members and inside / executive members, discussions on the membership of board of directors are always focused on the advantages and disadvantages of external members. Inside members are active participants in the overall decision of the company making progresses; they have access to all relevant information that facilitates decision over firm s activities. Therefore, the role of internal directors is very important. External members do not hold any executive power which usually are also on the Board of other companies. When members from outside the company raise the question of company s operation during Council meetings, it is expected that members from inside to provide a satisfying explanation. Outsiders should pay more attention to shareholders interests and to achieve a more efficient monitoring. The empirical results support the existence of external directors represents a more effective control method of the executive managers (Coughlan and Schmidt, 1985; Hermalin, Weisbach, 1991). Several studies (Borokhovich, Parrino and Trans (1996), Weisbach, (1988) and Rosenstein and Wyatt, 1990) demonstrate the following relationship: as the percentage of outside members is greater, the more likely is that an executive manager who does not make productivity to be fired and significant positive reactions to appear for share parts. Specialized theory often confirms a positive relationship between firm s performance and the proportion of members from outside the company occupying a place in Board of Directors. Studies by Weisbach (1988), Mehran (1995) and Pinteris (2002) have demonstrated a positive relationship between the existence of external members within the Board of Directors and firm s performance. Unlike inside members, outsiders are more able to challenge executive managers. There are also works that have not found a significant relationship between firm performance and the proportion of outside members within the Board of Directors (Bhagat and Black, 2002, Hermalin and Weisbach, 1991, Yermack, 1996, Metrick and Ishii, 2002, Weir and Lange, 2001). H 1 : The existence of non-executive members has a positive impact over the firm s performance. In the UK a minimum of three outside directors is required in the Council of Administration, in the United States the Regulation requires that external members, independent members to constitute at least two-thirds of the Board of Directors (Bhagat and Black, 2002). Members from inside have an important role in monitoring the general manager and in exchange the insiders are under careful observation of the general manager. In other words inside members may send information to outside members if there is evidence of abuse made by the general manager. In other words, if inside members play an effective role to monitor and facilitate information asymmetries, this may increase the firm's corporate governance structure that ultimately will lead to better performance. However, in general within companies of the market inside members are usually aligned with the general manager and because of their relationship with the latter default, members of the interior can t contribute to the effective monitoring of general manager. Therefore, Board of Directors with many executives does not necessarily lead to better firm s performance. Structure of Board of Directors must ensure a balance between executive and non-executive members so that no individual or small group of individuals can dominate, in general, the decision of the Board

3 H 2 : It is recommended that the number of external members to be at least equal to the internal ones for a good performance. The third mechanism proposed to deepen the problem of agent in the management structures of companies is the size of the Board. Yermack (1996) reached the following conclusion: large boards of directors tend to be slow in decision making and their members and executive managers rarely criticize the policies of executive managers and this issue tends to increase with the number of members of Councils (Yermack, 1996, Lipton, Lorsch, 1992). While Yermack (1996) found a negative relationship between the size of the Board and firm performance, Bhagat and Black (2002), have not seen any concrete evidence on the relationship between the two variables. Bonn, Yokishawa and Phan (2004) showed that between the size of the Board and performance there is a negative connection for Japanese firms and found no relationship between the two variables for Australian companies. H 3 : A Board of Directors of large dimensions has a negative impact over the performance of the company. 3. Data Base And Research Methodology The analysis is based on identifying variables values that influence firm performance and have been stated in previous assumptions and quantitative statistics achievement using these values. The results obtained in this stage of the analysis are then used to perform an empirical analysis using various multivariate regression models that followed, first, the identification of the type of relationship between firm performances and influencing factors. In the previous section there have been mentioned some relationships drawn from the literature, relationships that are established between performance and some determinants. Thereby in table No.1 it is listed the variables used in the research: 169

4 Table 1 Definition of used variables Variables Description Dimension ROA Return on assets Net Income / Total Assets ROE Return on equity Net Income / Shareholder s equity BORD SIZE Dimension of the Board of Directors Number of members of the Board of Directors EXECUTIVE /NON EXECUTIVE Balanced ratio between executive and non-executive members of the management board Dummy variable: The value of dummy is 1 if the percentage of executives on size board. is more than non-executives percentage; on the contrary 0; The percentage owned of the company's shares INSTIT Institutional investors shareholders in the company OWN Shareholder structure Dummy variable: 1 majority shareholders, 0 - minority shareholder SIZE The size of the company Natural logarithm of exchange capitalization D/E Debt-to Equity Ratio The proportion between Total Debt / Shareholder's equity The dependent variable is the ROA (Return on Assets) or ROE (Return on Equity), variables which measures performance. From the available data we can construct a vector of repressors X i (BORD SIZE, EXECUTIVE /NON EXECUTIVE, INST, OWN, SIZE, D / E), which can influence the outcome Y result. Specifically, we assume that the model takes the form: Y = α + β 1 X 1 + β 2 X β k X k + ε where k = 1,2, 62 (number of companies listed in Bucharest Stock Exchange), Y - dependent variable which measures the return on assets or return on equity given by listed companies and noted with ROA or ROE, X k - independent variables described in table 1. Based on predictions of financial theory and previous discussion, we consider the following two regression models. MODEL 1: ROA = f (BORD SIZE, EXECUTIVE /NON EXECUTIVE, INST, OWN, SIZE, D / E) MODEL 2: ROE = f (BORD SIZE, EXECUTIVE /NON EXECUTIVE, INST, OWN, SIZE, D / E) 4. Empirical Results Descriptive statistic for the main variables is presented in Table 2. Statistics show two important remarks: average board size is equal to 5, then the Boards of Directors consist of 5 members, for the practice of listed companies and it is noted that the relationship between 170

5 executive and non-executive members exceeds the threshold of 50% for 77 % of companies listed on the Bucharest Stock Exchange. Skewness and kurtosis values show that the BOARD SIZE variable distribution is leptokurtica (kurtosis> 3) and asymmetric (Skewness> 0). Table 2: Descriptive statistics EXECUTIVE BORD SIZE NON EXECUTIVE /NON EXECUTIVE INSTIT OWN SIZE D/E Mean Median Maximu m Minimu m Std. Dev Skewnes s Kurtosis The information in Table 3 shows in the model no. 1 the testing of the connection between performance of companies listed on the Bucharest Stock Exchange and board size, the existence of an equitable ratio between executive and non-executive members of the Board of Directors, concentrated structure of ownership, the percentage held by institutional investors, company size and leverage. It is noted that an increasing of the management board component with a percentage would increase company performance by about 2%. Also an increase in the ratio EXECUTIVE / NON-EXECUTIVE would lead to an increase in performance. Corporate Governance Code recommends (and applies by companies in the statement "Comply or Explain"), as the structure of the Board of Directors to ensure a balance of at least 1:1 between executive and non-executive members, but preferably several non- executives members, so that no person or small group of individuals can dominate, in general, the decision of the Board of Directors. This variable is significant in Model 1, so the existence of several senior executives leads to increased company performance. This relationship is a significant and positive one. One possible explanation would be that inside members are more familiar with the activities of the company and they can better monitor the executive management if they see an opportunity to advance to positions held by incompetent executives

6 Table 3 The relationship between alternative measures of performance and board characteristics in Romania Model Model 1 Model 2 Dependent Variables ROA ROE Independent Variables Coefficients Probabilities Coefficients Probabilities BORD SIZE NON EXECUTIVE EXECUTIVE /NON EXECUTIVE INSTITUTIONAL OWN SIZE D/E R % 17.25% Prob(Fstatistic) The relationship which is established between NON EXECUTIVE variable which is a dummy variable that takes the value 1 for those companies that have non-executive members of the Board of Directors and the company's performance or financial performance is a negative one. Hermalin and Weisbach (1991) conclude that there is no relationship between the proportion of our non-executives members and firm s performance in the U.S., the work performed by Andres et al (2005) does not establish a significant relationship statistically between firm performance and composition of the Board of Directors for several OECD countries. For companies listed on the Bucharest Stock Exchange the sign of the relationship between the two variables is negative, the sign found in other empirical works that show companies with a higher proportion of inside members are less likely to record low profitability. It can be seen that although BOARD SIZE variable is not a significant variable relationship which is established between it and the companies performance is a positive one. Barnhart and Rosenstein (1998) have also found that firms with small boards perform better than firms with large boards. Vafeas (2000) noted that small firms Councils (minimum five members of the Council) have better informed members about company s earnings and therefore they have a better monitoring capacity. Mak and Yuanto (2003) showed for companies in Singapore and Malaysia that the best performances are obtained by companies that have the Board of Directors consisting of five members. For companies listed on the Bucharest Stock Exchange the average non-executive members is equal to 5 (table no. 2). A relationship statistically insignificant has also been demonstrated by Bennedsen, Kongsted and Nielsen (2004), in their analysis of companies small and medium sized from Denmark. The authors noted that the Board size has no effect on performance for Boards with less than 6 members

7 When a Board of Directors is very small, they lack the advantage of having an advice, an opinion from an expert, someone who is usually seen when larger boards. Large boards are more diverse in terms of experience, skills, gender, nationality (Dalton and Dalton, 2005). So, another explanation is that information available to a firm is directly proportional with the number of members of the Board of Directors. Another idea would be the expropriation of shareholders wealth that can be performed by the general manager, fact that becomes relatively easier for smaller councils. For model no. 2 only significant variable is the presence of institutional investors and it is explained as follows: an increase in the percentage owned by the shareholders-institutional investors leading to an decreased financial profitability of the listed companies. Institutional investors have an influence on corporate governance. When the company's shares are held by these investors, by privileged position which they have, they tend to have a more effective communication with managers, even a communication "behind closed doors", they know better the situation of the company and can work with managers to obtain personal benefits. Relationship is not common in literature. Note that regardless of how we express the performance either as ROA or ROE, the variable OWN has a negative impact, but it is not statistically significant. OWN variable is dummy variable that takes value 1 when the company's top three shareholders hold more than 50% of the company s shares, so they have power of decision and they form a structure of concentrated ownership. The reason of negative relationship comes mostly from the fact that these concentrated investors are mostly interested in personal benefits and less of enviable performance of the company. 5. Conclusion This study made use of OLS data regression analysis for 62 firms listed on the Bucharest Stock Exchange, in 2010, to examine the relationship between some internal governance mechanism and firm performance. We also notice that the capital market in Romania prefer in general a Board of Directors consisting of 5 members. The relationship that is established between BOARD SIZE variable and the corporate performance is a direct one, therefore an increase in the size of the board of management is preferred as it leads to increased profitability, diversity and information in the company. It is observed that variable showing board management size is not a significant variable, but has assigned a positive sign which shows that increasing the number of members leads to increased performance of enterprise, inverse relationship in the vast majority of research undertaken on this theme. From a statistical point a view the relationship between the number of non-executive members and corporate performance (ROA) or financial performance (ROE) is not significant. The presence of institutional investors does not improve company performance; they are privileged 173

8 investors holding a significant percentage of company s shares where they are shareholders. So we are talking about major shareholders who prefer personal benefits, increases of beneficiary course at the expense of higher dividends which they would receive if it was a financial profitability growth and of profitability respectively. Percentage of executive members in the Board of Directors should be approximately equal to that of non-executive members for that there are no persons or groups of persons who influence the decisions of the Board. It is noted that an increasing of executive members helps improve company s profitability. The conclusion would be that inside executive members by the privileged information that facilitates certain decisions of the company activity manage to improve the performance. In spite of the findings in this study, there are many issues in corporate governance in Romania that remain unresolved. The dearth and poor quality of data continue to be a major constraint in a comprehensive study of corporate governance in Romania. However, it should be noted that the main general trends and findings that have been disclosed in the study, but other conclusions could be identified in future studies. References Barnhart, S. W., Roseinstein, S., 1998, Board Composition, Managerial Ownership, and Firm Performance: An Empirical Analysis, The Financial Review, vol. 33, pp Bennedsen, M., Kongsted, H. C., Nielsen, K. M., 2004, Board Size Effects in Closely Held Corporations', CAM Institute of Economics, University of Copenhagen Working Papers, vol. 25. Bhagat, S., Black, B., 2002, The Non-correlation between Board Independence and Long-term Firm Performance, Journal of Corporation Law, vol. 27, no. 2, pp Bonn, I., Yoshikawa, T, Phan, P. H., 2004, Effects of Board Structure on Firm Performance: A Comparison between Japan and Australia, Asian Business & Management, vol. 3, pp Borokhovich, K. A., Parrino, R., Trapani, T. 1996, Outside Directors and CEO Selection, Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 31(03), pp Coughlan, A.T. and R.M. Schmidt, Executive Compensation, Managerial Turnover and Firm Performance: An Empirical Investigation, Journal of Accounting and Economics, Vol. 7, No. 1/3, 1985, pp Dalton, C. M., Dalton, D. R. 2005, Boards of Directors: Utilizing Empirical Evidence in Developing Practical Prescriptions, British Journal of Management, vol. 16, pp Hermalin, B. E., Weisbach, M. S. 1991, The effects of board composition and direct incentives on firm performance, FinancialManagement 20(4), Lipton, M., Lorsch, L., 1992, A Modest proposal for improved corporate governance, Business Lawyer, (48(1) pp Mak, Y.T.,Yuanto, K., 2003, Board Size Really Matters: Further Evidence on the Negative Relationship Between Board Size and Firm Value, Pulses by Singapore Stock Exchange 174

9 Mehran, 1995, Executive Compensation Structure, Ownership, and Firm Performance, Journal of Financial Economics 38(2), Metrick, A., Ishii, J.,2002, Firm-level corporate governance, Paper presented at Global Corporate Governance Forum Research Network Meeting, Washington, D.C. April. Pinteris, G., 2002, Ownership Structure, Board Characteristics and Performance of Argentine Banks. Mimeo. Department of Economics, University of Illinois. Rosenstein, S., Wyatt, J. G., Outside Directors, Board Independence, and Shareholder Wealth, Journal of Financial Economics 26, 1990, pp Stiles, P., Taylor, B., 2001, Boards at work how directors view their roles and responsibilities, Oxford University Press, Oxford. Vafeas, N., Theodorou, E., 1998, The relationship between board structure and firm performance in the UK. British Accounting Review 30, Weisbach, M., 1988, Outside directors and CEO turnover, Journal of Financial Economics, 20: Weir C, Laing D., 2001, Governance Structures, Director Independence and and Corporate Performance in the UK, Euro. Bus. Rev., 13(2): Yermack, D., 1996, Higher market valuation of companies with a small board of directors, Journal of Financial Economics, 40: Web links:

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